A World Without Fannie and Freddie

The ball is now in Congress’ court to create a new housing finance system. The Treasury Department released its white paper, but that is only the first baby step into the future.

Mortgage Banking
April 2011

By Robert Stowe England

“We will work closely with the Federal Housing Finance Agency [FHFA] to determine the best way to responsibly reduce Fannie Mae and Freddie Mac’s role in the market, and ultimately wind down both institutions.”

Those words mark a watershed in the history of housing finance in America, and were something many thought they would never hear. Treasury Secretary Timothy Geithner uttered them March 1 at a hearing before the House Financial Services Committee.

The two mortgage giants were placed into conservatorship on Sept. 8, 2008, and have provided critical funding for a mortgage market suddenly starved of investors. The near collapse and government takeover of the government-sponsored enterprises (GSEs) was a pivotal event in a severe financial crisis that brought with it the Great Recession.

Treasury also has clearly signaled that it favors a dominant role for the private sector in a new mortgage finance system.

“We are committed to a system in which the private market--not American taxpayers--bears the burden for losses,” Geithner testified.

The corollary of a greater role for the private sector is, of course, a lesser role for government. “Our proposal for reform breaks sharply from the past to fundamentally transform the role of government in the housing market,” the Treasury secretary said. 

Geithner defined the “primary role” of government as consumer protection, robust oversight, and targeted assistance for low- and moderate-income homeowners and renters. In addition, the government should provide targeted support for market stability and an ability to respond to a crisis.

The great American dream of homeownership for just about everyone was also toppled from its hallowed pedestal. “And while we believe that all Americans should have access to affordable, quality housing, our is not for every American to become a homeowner,” Geithner told Congress.

“We should provide targeted and effective support to families who have the financial capacity to own a home but are underserved by the private market, as well as a range of options for Americans who rent,” he said.

Geithner also recited a litany of failures of the current system, both in government and the private sector.

“For decades, the government supported incentives for housing that distorted the market, created significant moral hazard and ultimately left taxpayers responsible for much of the risk incurred by a poorly supervised housing finance market, “Geithner testified.

Even while calling for a future dominated by the private sector, Geithner also leveled broadsides at the shortcomings in banking and securitization in the private sector. “In more recent years, we allowed an enormous amount of the mortgage market to shift to where there was little regulation and oversight,” he said.

Geithner then faulted eroding underwriting standards that led to predatory lending practices. There was also a failure to insist on transparency in the securitization chain, where investors did not have full access to underlying loan-level data in securitization pools. Finally, the Treasury secretary charged, the whole financial system loaded up on risk and leverage--that is, it piled assets onto a capital base that was too thin to support them.

Treasury offered three options for the broad framework of a future mortgage finance system. The options were described in a 31-page position paper released Feb. 11 and titled (ital) Reforming America’s Housing Finance Market: A Report to Congress. (end)

Importantly, two pure-play options were taken off the table. One is a completely privatized system with no role for the government, such as that played by the Federal Housing Administration (FHA) and other government agencies. The other pure-play option taken off the table was the nationalization of the mortgage finance system, where the government would back the bulk of all home mortgages. The plan’s announced goal to wind down Fannie and Freddie underscored that this latter option was off the table.

Further, Geithner identified flaws within the design and regulation of the Federal Home Loan Bank (FHLB) System. “Today, eight of the 12 banks are under regulatory orders with respect to their capital or have voluntarily suspended dividends or the repurchase of excess stock,” the Treasury report stated.

The FHLB system, thus, also needs to be reformed even as Fannie and Freddie are wound down, according to Geithner.

Treasury described its three options around which discussions should take place this way:

• Option 1: A privatized system of housing finance, with the government insurance role limited to FHA, U.S. Department of Agriculture (USDA) and Department of Veterans Affairs (VA) assistance for narrowly targeted groups of borrowers.

• Option 2: This option provides for a government guarantee mechanism that can be scaled up during times of crisis. The rest of the system would be similar to Option 1.

• Option 3: There would be catastrophic government reinsurance behind significant private capital for private-sector guarantors of mortgage-backed securities (MBS). The rest of the system would be similar to Option 1.

The transition

The Treasury also offered the framework for a transition in which the government role would be gradually reduced even before a new system was put in place. The Federal Housing Finance Oversight Board, made up of Treasury Secretary Geithner and Department of Housing and Urban Development (HUD) Secretary Shaun Donovan, Securities and Exchange Commissioner Mary Schapiro, as well as the FHFA director, will be making recommendations on incentives and deadlines for FHFA to govern the pace at which it pursues the winding down of Fannie and Freddie, according to the Treasury report.

Further, Geithner indicated he expected it would take five to seven years before the private sector would be ready for a dominant role, given the precarious state of housing and mortgage finance and the tiny current role being played by the private sector in securitization.

Treasury will confer with the Federal Housing Finance Agency to devise a plan to ensure that the role of Fannie and Freddie is gradually reduced while the role of the private sector is gradually increased. The private-sector role will consist of both portfolio lending and securitization.

In a briefing on Feb. 11, a Treasury official made it clear that Treasury envisions a primary role for private-label securitization in the new world of mortgage finance. Furthermore, there may also be a role for covered bonds.

Treasury also envisions FHA scaling back its current 30 percent share of new mortgages to a level of around 10 percent to 15 percent.

The Treasury report identified the following ways that FHFA might scale back the dominant current role of Fannie and Freddie.

• Higher guarantee fees. Based on the contention that the GSEs have been underpricing the guarantees, and by increasing them, this proposal aims to create a level playing field with the private sector.

• More private capital ahead of guarantees. This would include a larger role for private mortgage insurers and larger down payments by borrowers.

• Lower conforming loan limits. The temporary increases in limits that were part of the Housing Economic Recovery Act of 2008 would expire as expected Oct. 1, 2011. That would keep the basic overall limit at $417,000, but, under the law, it could be indexed to rise every year. The highest limit of $729,750 for areas in locations with the highest median home pries would fall to $629,500.

Winding down investment portfolios. (end) Faulting the portfolios as “government-backed hedge funds,” Treasury reiterated in its report the requirement that accompanies the Preferred Stock Purchase Agreement between Treasury and each of the GSEs that the portfolios be wound down at an annual pace of no less than 10 percent.

Restructuring servicing

The Treasury white paper also supported the following reforms in the short and near term to address current problems in mortgage servicing and foreclosure processing.

• New servicing standards. The Obama administration is calling for national servicing standards to provide more consistency, especially in addressing delinquencies, so borrowers’ and investors’ concerns will be adequately addressed.

• Restructure servicing compensation. The FHFA had already announced in January an initiative with Fannie and Freddie and HUD to review servicing compensation. The current pricing with a low, flat percentage fee is seen by the Obama administration as not providing sufficient income for servicers to invest the time and effort to work with troubled borrowers to avoid default or foreclosure. Currently servicing fees range from 25 basis points to 50 basis points.

• Second liens. Treasury called for reducing conflicts of interest between first and second mortgages, as well as requiring mortgage documents disclose any existing second liens. The paper suggested that mortgage documents should also define the process for modifying a second lien when the first lien becomes delinquent.

Early response

For the most part, the framework offered by Treasury is garnering plaudits from observers of both the mortgage and housing sectors.

“I think the Administration has done a good job of articulating the major proposals,” says Michael Berman, chairman of the Mortgage Bankers Association and president and chief executive officer of CWCapital, Needham, Massachusetts.

“I think it’s safe to say [that Secretary Geithner and Secretary Donovan] have been directed by the President to be agnostic across the three proposals,” Berman says. “However, I think it’s safe to say they have a special place in their hearts for option 3,” he adds.

“They certainly haven’t endorsed option 3, but they see its advantages to the market place, to the consumer, for both single-family and multi-family of having that basic underlying stability to the market it would provide, particularly through times of stress in the system.” Berman says.

The reception from other corners of the industry was also positive.

“I was pleased with what I read in all 31 pages. I thought it was a fair and honest assessment of the three options that are available to Congress,” says Tom LaMalfa, a mortgage industry veteran who is president of TSL Consulting, Shaker Heights, Ohio.

“The Treasury did an adequate job of reviewing each of these options and specifying the strengths and weaknesses of each of them,” he adds. “And so I was especially pleased with the decision to unwind Fannie and Freddie,” LaMalfa says. “[T]he efforts to unwind them with loan limits, higher down payments and a reduced investment portfolio--all of those things made eminent sense to me.”

The larger role for the private sector has been garnering widespread support, as has scaling back the role played by FHA in the market.

In testimony before Congress on Feb. 6, Stevens underscored the administration’s position on the FHA’s future role. “Ultimately, however, we do not want FHA to have such a substantial share of the market--and we are very aware of the risks this elevated role poses,” he testified, referring to the FHA’s recent 30 percent share of the market.

“While the FHA’s countercyclical role has been essential to providing liquidity to the housing market to prevent further disruptions in the broader economy, the Obama administration believes that meeting the diverse homeownership and rental needs of the country requires a strong, safe and healthy market for private capital,” Stevens testified.

LaMalfa agrees with Treasury’s call for tighter underwriting standards. “The reason that we ended up where we did has a lot to do with the loosening that occurred over the years,” he says. “The greater emphasis and, in fact, really a shift to affordable rentals makes eminent sense to me, again,” he adds.

LaMalfa also was pleased to see Treasury call for greater disclosure in securitizations. More disclosure will “resonate” with potential investors and help restore the mortgage security investment to “its traditional double-A-rated status,” La Malfa says. “We have tarnished that and I think if all those things are done, we will go a long way toward restoring that. And that, in turn, will help interest rates because they will narrow relative to [Treasuries],” he adds.

Private sector

There are a number of steps that need to be taken before the private sector can stage any significant comeback, according to most industry observers. The issuance of a definition of a qualified residential mortgage (QRM), expected soon from federal regulators, is a necessary first step to begin to give private markets an idea of the rules under which they will operate.

Mortgage industry players are divided on which of the three administration-proposed options to support, with many supporting Option 3 because it provides a way for the government to backstop private-sector guarantors.

Option 1, however, also has considerable support. “I would argue very much for Option 1. Because I think we need to have a truly bifurcated market, with all the social housing policies programs and initiatives in one box--let’s call that FHA--and then everything else would  be private without any type of federal guarantees,” LaMalfa said.

LaMalfa foresees a private-label market that can support AA and AAA securities, helped along by improved transparency with full disclosure of loan-level data in securitizations.

How would the data be provided? “A party to the transaction, probably the guarantor--say, a mortgage insurance company--for every security that’s issued, will make available a spread sheet that has all of the LTVs [loan-to-value ratios] and all of the credit scores--the important things,” says LaMalfa.

LaMalfa cautions against misleading summary data on average LTV and FICO® scores. “You and I and [Microsoft Corporation Chairman] Bill Gates in the room, and we’ve got an average of $10 billion in net worth and we know we don’t have $10 billion,” he says. “We need a spread sheet. For each loan, we need to know what its LTV is, what its [debt-to-income ratio] is, what its FICO score is.”

New securitizations will also need to make investors confident about the documentation of information in the loan applications. “And again, I see that as the guarantor’s role by putting the final blessing on it by virtue of their guarantee to make that transparent,” LaMalfa says.

Re-creating Fannie and Freddie?

There is some fear that Option 3, which provides a government catastrophic reinsurance behind significant private capital from private mortgage guarantor companies, would recreate entities that would be similar to Fannie and Freddie.

House Financial Services Chairman Spencer Bachus (R-Alabama) is one of those worried about such an outcome.

“The American Banker this morning (March 1) says Option 3 is Fannie by another name,” Bachus told Geithner at a congressional hearing on March 1. Bachus also was concerned that a government backstop in times of market crisis under Option 2 could amount to the same thing. “As long as you have that backstop, it’s almost an implicit government guarantee, in my mind. Am I wrong?,” he asked the Treasury secretary.

“It is not fair to say that Option 3 is an option to re-create Fannie and Freddie. And know that I would not support that,” Geithner said.

“Even if this group of people in this room thought that was appealing, we would not support that,” Geithner added for emphasis. Bachus reassured him, “We would not think that.”

Geithner explained how he thinks people should view the options. “I don’t think it’s right to think about these things as a stark choice between a purely private market and a market where the government in a crisis or normal times is guaranteeing mortgages,” he replied.

“If you look at the model that Canada and most of the European countries have adopted, in contrast, they leave mortgages in the banks,” Geithner said, as opposed to securitizing them, as the practice has been in the United States. “The government provides a lot of support for those banks and is reluctant to let them fail in a crisis,” he added. “So, the support is there. It’s just implicit, not explicit. Banks don’t have to pay for it, but it’s not quite the private-market ideal many people seem to think,” he explained.

Reassurances about Option 3, however, will not entirely be convincing until full details of a proposal emerge, according to Edward Pinto, former chief credit officer for Fannie Mae, an industry consultant and resident fellow at the American Enterprise Institute, Washington, D.C.

“The problem with Option 3 is how do you price for it?,” says Pinto, referring to the price of the guarantee, as well as the government catastrophic reinsurance.

Geithner had already expressed his concerns a year and a half ago about the Fannie and Freddie model for mortgage finance in closed-session comments to the Financial Crisis Inquiry Commission. “Moral hazard is everywhere in the financial systems--it’s endemic,” he told the panel on Nov. 27, 2009. “Of course, what we had in the crisis makes it bigger going forward. The biggest moral hazard was Fannie and Freddie. The GSEs were entirely moral hazard.”

Pinto points out that Geithner expanded on his earlier-stated views about moral hazard at Fannie and Freddie during his March 1 testimony. In that hearing, he expressed a view that “not only were Fannie and Freddie too big to fail, they were too big to regulate,” Pinto says.  
“What you don’t want is a system where there’s this implicit guarantee, or a guarantee is inappropriately priced--those are the things we want to avoid,” Geithner said in reply to a question by Rep. Judy Biggert (R-Illinois), who asked if Treasury had considered setting up a new guarantor as a public utility.

Rep. David Scott (D-Georgia) made an appeal to Geithner urging that the administration consider Option 3 “as a base from which we can work,” because it “has a degree of certainty” the other options lack.

“Even members of financial services community--the banks, the mortgage companies--all of them realize that the private capital isn’t coming in at any price,” Scott said. “There is a need for the housing market [to have] some sort of federal guarantee, some way to come down in these catastrophic situations.”

“Do you not agree,” he asked Geithner, “that, given the difficulty of the situation we are in . . . that there is a need to move more with Option 3?”

Geithner did not exactly agree. “You could envision a mix of the three options as the best way to land this ultimately,” he said.

“But you’ve got to be very, very careful. Again, I would caution you. You know this better than anybody. If banks and real estate companies together are in favor of something that involves a guarantee, I would be careful. They will always be in favor of guarantees by the government in this case. You’ve got to be very, very careful about that,” Geithner said.

Geithner added, “There are ways to design Option 3 by the FHFA that would be a dramatic improvement on our current system. The test is whether we can design a system that won’t have the kinds of risks as Fannie and Freddie.”

Option 1 or Option 3?

Geithner was equally unwilling to be pinned down when he was pressed on the advantages of Option 1.

Rep. Scott Garrett (R-New Jersey), chairman of the Capital Markets Subcommittee, described the findings of economist Dean Baker, co-director of the Center for Economic and Policy Research, Washington, D.C. Baker, in turn, based his calculations on a February study by Moody’s Analytics, West Chester, Pennsylvania, that found that a hybrid system would save 90 basis points over a purely private system.

The Moody’s paper, The Future of the Mortgage Finance System, by Mark Zandi and Cristian deRitis, chief economist and director at Moody’s Analytics, respectively also estimates that a hybrid system will boost house prices 8 percent higher than a purely private system.

Taking Moody’s numbers, Baker calculates the difference in the monthly cost of a mortgage on a median-price house between the hybrid and purely private system.

Under the hybrid system, the current median house price is $170,000, he said. Adding in 20 basis points for the new system because its government guarantees would be weaker, would yield a mortgage rate of 6.2 percent. That would mean a monthly principal and interest payment of $833.

Under a purely private system, Baker calculated, the median house price would be $156,400 and the interest rate would be 7.1 percent (90 basis points higher), and the monthly payment would be $841. That leads to only a savings of $8 under the hybrid system compared to the purely private approach, according to Baker’s analysis.

“The basic story is that the benefit of the lower interest rate is largely offset by the fact that buyers will have to pay more money for their house,” Baker maintained in a blog on Feb. 10.

Baker also calculated that when real estate taxes are factored in, given that the average house price is higher under the hybrid system, the monthly cost of the purely private system is actually $4 less than the hybrid.

Citing Baker’s analysis, Garrett asked Geithner: “Even if his numbers are off a few dollars, doesn’t the fact the dollars are so close indicate that a hybrid system does not outweigh the cost of a private system with all [the hybrid system’s] inherent risks to the taxpayer at the end of the day?”

Geithner again was careful in his response. “As you just said, you should be cautious about predicting the future,” he said. “I don’t think you can make any of those judgments without knowing the precise details of what the government role is in that context. And I think it’s almost certain that the cost to the homeowner, all in, would be higher under Option 1 and higher under Option 2 than it would be under Option 3,” he added. “And, under all those options, it will be somewhat more expensive to borrow to finance than it was before the crisis.”

Pricing the risk

House Financial Services Committee Vice Chairman Jeb Hensarling (R-Texas) asked Geithner whether the government can properly price risk in a hybrid system. He cited Federal Housing Finance Agency Acting Director Edward DeMarco’s testimony of Sept. 25, 2010, to support his view.

“First, the presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default, at least at any price that most would consider reasonable, or cannot manage that amount of mortgage credit risk on its own,” DeMarco testified last year. “But we might ask whether there is reason to believe that the government will do better.”

Hensarling also cited the underpricing of risk in several government programs--the National Flood Insurance Program (NFIP), the Federal Crop Insurance Corporation (FCIC), the Pension Benefit Guaranty Corporation (PBGC), the FHA and the Federal Deposit Insurance Corporation (FDIC). “Why should we have any confidence that government can price the risk on Options 2 and 3?,” he asked.

“I share your concern,” Geithner replied. “It’s one of the reasons you have to be careful in embracing any of the three options on the table. And you want to remove that decision about how you price a guarantee from any interference by Congress. And you want to keep it as independent of politics as you can. One of reasons the government’s record is so terrible in those programs is because you have subjected those judgments, which are very difficult, to excess political interference by some of the stakeholders in the system.”

Pinto, however, does not think that Treasury “threaded the eye of the needle perfectly on Option 3,” recognizing that “they are trying to craft Option 3 so it wouldn’t become a moral hazard.”

Pinto says Congress has to think through how new entities will be shaped after they are created. If new private-sector guarantors of mortgage securities are created as multi-function institutions that can issue their own bonds and do multifamily securitizations, it could create moral hazard. This system could then be easily saddled with ever-rising housing goals--just as happened with Fannie and Freddie, Pinto contends.

Implicit guarantees

Further, the availability of a government backup or reinsurance will lead to the creation of institutions that will become “ripe for implicit guarantees” by the government, just as with Fannie and Freddie, argues Pinto.

It would not matter that legislation would not provide for those implicit guarantees, or even that Congress stated “with a wink and nod” that there were no such implicit guarantees, according to Pinto. “Implicit guarantees are not bestowed by the government. The market bestows implicit guarantees,” he says. Thus, if the market interprets the arrangement to constitute an implicit guarantee, it will be reflected in the pricing of mortgage rates, for example, according to Pinto.

As for the explicit catastrophic risk coverage  to be provided by the government in Option 3, it is hard not to see how the pricing of the guarantee can avoid coming under political pressure, according to Pinto. Any reassurance that “this time is different and we will price it different” also has to be looked at as something that will be in place over a period of decades and, thus, under constant political pressure that, in time, is likely to prevail.

Pinto believes that Option 2 suffers from some of the potential moral hazard that could afflict Option 3. Under Option 2, the goal is to have government with a dormant guarantee that would only come into play in times of economic catastrophe.

The natural political tendency will be to make it available in more and more situations and not reserve it for true economic calamities, Pinto says. He cites the experience with the federal government’s disaster-relief program, designed for hurricanes, earthquakes or major floods, but which is now routinely tapped for heavy snowfalls and major storms.

Pinto envisions the same thing happening to a dormant guarantee for mortgage securities. “If you’re going to have a catastrophic backup, the definition of what is catastrophic over time will change. Will it be whenever the GDP [gross domestic product] goes down by a tenth of a point?,” he asks.

Charter mortgage institutions

A broad framework for a new mortgage system for both single-family and multi-family mortgages has also been proposed by the Mortgage Bankers Association’s Council on Ensuring Mortgage Liquidity.

The new system, first outlined two years ago by the council, would have a Ginnie-Mae type guarantee for mortgage-backed securities that would put private sector funds ahead of a government backstop against the guarantee.

The proposal provides for government charters to be issued to new mortgage credit guarantor entities or MCGEs. The MCGEs “would have the licensure to issue Ginnie-Mae type explicit government-guaranteed securities,” explains Berman at MBA.

The entities would pay risk-adjusted premiums into an insurance fund that set aside funds to support the MCGEs, should they need it. The insurance would function in a fashion similar to the FDIC’s insurance fund for deposits. “If there’s a catastrophic failure of one of these entities,” Berman explains, “it is only then that the Ginnie-Mae wrap becomes critically important in terms of the down side. At that point the fund would be utilized in order to protect taxpayers,” he adds.

“So the government would be stepping up, but they would be dipping into the fund as a source of dollars to repay the bondholders without any negative impact on the taxpayers,” Berman explains. “So, it would only be if that entire fund was drained that the taxpayer would have any liability.”

Berman says that the MBA’s proposal, first unveiled 18 months ago, “is very, very similar the one articulated in the so-called Option 3 in the Report to Congress” from Treasury.

The government’s guarantee would be on the timely payment of interest and principal to bonders. Thus, the instruments would explicitly carry the full faith and credit of the U.S. government.

The MCGEs would be mono-line institutions that would purchase mortgages and issue mortgage-backed securities supported by the mortgages. And, they would manage their credit risk using a combination of risk-based pricing, originator retention of risk with lender representations and warrants, primary mortgage insurance and other risk-sharing arrangements.

There would be a new government regulator for the MCGEs similar to the role now played by the Federal Housing Finance Agency in overseeing Fannie Mae and Freddie Mac. Further, the MCGEs would be limited to core mortgage products and not be involved in risky loans products. There would be no subprime mortgages, for example.

The MCGEs would be allowed to hold a limited portfolio of mortgage assets to support a range of activities. For example, they would support securitization by allowing the MCGEs to aggregate for securitizations those mortgages allowable by a new federal regulator for the MCGEs.

The portfolio would be used to manage loss mitigation through foreclosures, modifications and other activities. It would incubate mortgages that may need seasoning prior to securitization. The portfolio would also help develop new mortgage products through a strictly limited level of research and development prior to a full-scale securitization for the products.

Finally, the portfolio would be used to fund multifamily mortgages not conducive to securitization.

MBA’s Berman, its president Jay Brinkman and other representatives from MBA were, in fact, invited to a White House meeting in early March where they met with James Parrott, Senior Advisor for Housing on the National Economic Council, Bob Ryan, chief risk officer from the Federal Housing Administration and Jeffrey Goldstein, undersecretary for domestic finance at Treasury.

A proposal from the Center for American Progress (CAP), Washington, D.C., calls for the creation of private-sector charter mortgage institutions (CMIs) that would be completely backed by a catastrophic risk insurance fund run by the federal government.

The fund, in turn, would determine the product structure and underwriting standards for mortgages guaranteed by CMIs. The CMI’s would be able to hold portfolios that can also hold a limited amount of multifamily mortgages.

David Min, associate director for financial markets policy at CAP, views a purely private system as “a disaster.”

Advocates for a mostly private system, in turn, view the center’s proposal and others like it with a similar level of skepticism. Proposals that have a portfolio for multifamily and room for new types of mortgages raise the issue of moral hazard, according to Pinto.

Budget-neutral fee

There also is some concern about the Treasury paper’s call for a budget-neutral fee to provide funds to fill in gaps in homeownership and affordable rentals that might not be served by FHA and new private mortgage guarantors.

“This funding stream would support the development and preservation of more affordable rental housing for the lowest-income families to address serious supply shortages, similar to the Housing Trust Fund that the president has proposed to be capitalized,” the Treasury report states.

“It would support down-payment assistance and counseling to help qualified low- and moderate-income homebuyers, in a form that does not expose them or financial institutions to excessive risk or cost,” the proposal continues.

“We would scale up support for proven nonprofit partnerships for affordable-housing production and preservation that can attract much larger amounts of private capital. And funding would help to overcome market failures that make it hard to develop a secondary market for targeted affordable-housing mortgages, such as that for small rental properties.”

Since this fee is attached to private-sector entities and is actually a portion of the profits they make, Pinto says, it is not a tax putting revenues into the Treasury. He says. “Again, you’ve now entangled these private companies in this web of good works. Fannie and Freddie got entangled in that.”

Last Sept. 29, Rep. Barney Frank (D-Massachusetts), who was then chairman of the House Financial Services Committee, said at a hearing, “One of the obvious things clearly acknowledged as a mistake was setting up what were in some ways private corporations, Fannie Mae and Freddie Mac, but infusing into their business decisions a social component. So that they, because of the goals, you could never be sure what the basis was [for their business decisions],” he said.

In contrast to this approach, Frank found more attractive the approach taken by the Federal Home Loan Bank System, where business decisions are based on business reasons and are not tied to any affordable-housing goals. Instead, a fixed portion of profits from these banks is set aside to provide subsidies for affordable housing. “And in my view, it should be [for] rental housing,” Frank said.

“I would be opposed to any mandates” to new mortgage guarantors, Frank said at the Sept. 29 hearing.

Pinto, however, thinks that setting up a “budget-neutral fee” that would be taking a share of profits from the private-sector mortgage guarantors sets the private-sector guarantors down the path to being seen as having an implicit guarantee by the government. “When I see expressions like that in a paragraph in a report, I get very nervous,” Pinto says, referring to the budget-neutral fee.

Private-sector outlook

While Washington is debating how to structure a future system, potential private-sector players are also trying to calibrate the possible outcome.

Tom Capasse, co-principal of Waterfall Asset Management LLC, New York, sees a greater role for the private sector in a future mortgage finance system, but believes that the government role will still be substantial after a new system is crafted in Congress.

“We see a four-tier market emerging,” he says. The first tier is the affordable market that will be guaranteed by FHA. That sector will, however, be 20 percent of the market--higher than the 10 percent to 15 percent historical norm for the FHA.

The second tier will be a “revamped agency product” that will fill the role played by Fannie and Freddie, according to Capasse. He foresees the new private-sector guarantors having the government as reinsurer taking the catastrophic risks. Or the guarantor role could be set up as a cooperative, again with potential government reinsurance, he adds.

This tier will represent about 25 percent of the mortgage market--slightly lower than its historical share, according to Capasse. This entity will originate mortgages that conform to the Qualified Residential Mortgage definition that was proposed in the Dodd-Frank law and will come with a conforming loan limit.

The private sector and cooperative guarantors will also rely on mortgage insurance companies to cover their risks, according to Capasse. “The credit analysis of the pools of mortgages will create an enforced discipline” on the securitizations, he adds. The securitizers will have to provide loan-level data and ratings from at least two credit-rating agencies.

The third tier will be the new private-label market. “In terms of market participation, a very significant non-agency market will emerge,” he predicts, representing about 20 percent of the overall mortgage origination market.

The private-label activity will include the new jumbo market for loans above the loan-level limits covered by the private-sector guarantors for borrowers with FICO scores of at least 700. There will also be a new alternative-A loan segment that will be made up of investor properties, loans for stated-income borrowers and the types of products that existed before 1997, with significant levels of equity. There will also be a new subprime market, again going “back to the future” and adopting the standards pre-1997, when subprime borrowers paid significantly higher rates and were required to make substantial down payments, according to Capasse.

The fourth tier will be made up of portfolio lenders, who will be expected to take a larger mortgage market share at 35 percent--sharply higher than at present, according to Capasse. This sector will gain as loan limits fall and bank appetites for mortgage assets continue to grow, he predicts. This tier will include loans financed through the Federal Home Loan Bank System.

The current private MBS market

The private-label market continues to inch forward with the second public offering in the 12 months taking place March 1, when Redwood Trust Inc., a real estate investment trust (REIT) based in Mill Valley, California, closed on a $290.4 million jumbo residential mortgage securitization sponsored by RWT Holdings Inc., a wholly owned subsidiary.

The deal securitized 302 jumbo prime mortgages recently originated by San Francisco-based First Republic and PHH Mortgage, Mount Laurel, New Jersey.

The FICO scores of borrowers with mortgages in the deal ranged from 701 to 815 and averaged 775, according to a prospectus filed Feb. 25 with the Securities and Exchange Commission (SEC). The average weighted loan-to-value (LTV) ratio was 58.8 percent, with a range from 15 percent to 80 percent. The weighted average balance was $978,269. Just over 94 percent of the loans were made for primary residences, with 5.4 percent for second homes and less than half a percent being investor properties.

The majority of the borrowers--58 percent--were refinancing an existing mortgage, while 35 percent were borrowing to purchase a home and just under 7 percent were cash-out refinancings. Documentation of two years of income and assets was done for 99 percent of the borrowers. The remaining 1 percent had documentation for one year of income and assets.

The loans did have significant geographic concentrations, with 56 percent in California and 11 percent in San Francisco.

Of the 302 loans identified in the prospectus, 109 represent $124.1 million in hybrid 10/1 mortgages with interest-only payments for the first 10 years of a 30-year mortgage, which then begins to amortize in the 11th year. The other 193 loans with a total principal balance of $171.2 million are 30-year fixed-rate mortgages (FRMs). 

The weighted average note rate on the 30-year FRMs is 5.11 percent, which is only 46 basis points higher than the conforming rate at the time those loans were originated, according to Mike McMahon, managing director at Redwood.

Brett Nicholas, chief operating officer at Redwood, finds good news in the mortgage rate that was provided to borrowers. “The pricing of this securitization transaction suggests that fears of residential mortgage rates rising by 100 to 150 basis points, unless there is government backing through Fannie Mae or Freddie Mac, appear to be unfounded,” he says. 

McMahon contends that this securitization also demonstrates to policymakers that the private market will provide 30-year fixed-rate mortgages. “This is why it’s important for the securitization market to come back,” he adds.

The underwriting was led by Credit Suisse Securities (USA) LLC, and also included J.P. Morgan Securities LLC and Jefferies & Co. Inc., all based in New York. The senior tranche, rated AAA by New York-based Fitch Inc., represented 92.5 percent of the deal.

Redwood’s president and chief executive officer, Martin Hughes, sees the transaction as demonstrating the role the private sector can play. “This transaction also supports our belief that triple-A investors will provide attractive financing for prime residential mortgages, provided their demands for enhanced disclosure transparency, alignment of interests, high-quality collateral and structural protections are responded to with improvements in these areas," Hughes adds.

The deal, known as the Sequoia Mortgage Trust 2011-01, is the second public offering of Redwood in the past 12 months. On April 27, 2010, Redwood closed a $237.8 million transaction on 255 prime jumbos originated by CitiMortgage Inc., O’Fallon, Missouri.

Redwood supports the potential lowering of the conforming loan limit for the GSEs that is expected after Oct. 1. “Currently Redwood is only able to fish in 5 [percent] to 10 percent of the pond,” says McMahon. “We’d just like to have a bigger piece of the pond to fish in.”

Redwood would support any of the three options offered in Treasury’s white paper, according to McMahon. The firm would also be open to a future mortgage finance system that would include “some new entity to replace Fannie and Freddie,” he says, and which would focus on providing loans to prime credit borrowers of median and below-median income.

While McMahon envisions a private-label market gradually returning, a significant rebound is not likely until regulators complete rules governing a required 5 percent risk retention in some securitization deals. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires regulators to require such risk retention on mortgages that do not fit the definition of a Qualified Residential Mortgage, or QRM.

Regulators are currently considering whether they should require that the 5 percent be horizontal or vertical. The horizontal approach places all of the losses on the bottom 5 percent of the deal, with the underwriter exposed to the entire 5 percent, while a vertical approach requires the underwriter to keep a portion of each tranche of the deal.

Redwood prefers a horizontal risk-retention rule. “Without any question, horizontal risk retention is a superior form of risk retention because it encourages good sponsor behavior,” McMahon says. “If your capital is first in line to absorb the first 5 percent of losses, you will have a higher incentive to sponsor a good performing deal,” he explains.

Doing nothing is not an option

A subtext to the release of the Treasury’s white paper is that the idea of doing nothing is not on the table. Yet, there is some concern that if Congress delays too long, the political will to do significant reform may pass.

The potential survival of Fannie and Freddie, for example, came up during the March 1 hearing, when Rep. Ed Royce (R-California) asked Geithner to respond to a report in (ital) The Wall Street Journal (end) that Fannie Mae and Freddie Mac had asked the FHFA to reduce the dividend they have to pay on the preferred shares held by the Treasury from 10 percent to 5 percent.

“My concern is that if you took a step, that would violate [the Preferred Stock Purchase Agreement]--it would deprive the Treasury of obligated funds,” Royce told Geithner. “It would unnecessarily absolve the two institutions at the heart of the collapse of the housing bubble,” he added.

Royce then asked Geithner whether or not the administration is “going to support a reduction or elimination of dividend payment.” Royce recalled how powerful the GSE lobby had been in the past. “It was impossible to counter the weight of Fannie and Freddie in Congress. They are there now communicating again to change an agreement,” he added.

Geithner replied that the administration is going to work with FHFA “to make sure we wind these institutions down and do everything we can to minimize the ultimate losses to the taxpayer.”

“So, any proposal that is designed to keep them in existence for the long term, we will resist. Any proposal that carries ultimate risk to the taxpayer, we will resist,” Geithner said.

In fact, the more funds Treasury has to provide Fannie and Freddie, the higher and higher the dividend payments go, putting the GSEs into a death spiral without any further relief. Does that actually prevent any potential rescue of the GSEs? Brian Harris, senior vice president at New York-based Moody’s Investors Service, thinks it does--unless there are changes made to the Preferred Stock Purchase Agreement.

“I’ve heard people say that [the GSEs] are explicitly guaranteed” by the U.S. government through the Preferred Stock Purchase Agreement, Harris says. He is not buying this argument. To Harris, an explicit guarantee backing up Fannie and Freddie would have to be both unlimited and indefinite. While the agreement is indefinite, it is not infinite--that is, it does not promise to continue to invest an infinite amount of money to meet any shortfalls, according to Harris.

The agreement allows Treasury to inject the funds necessary to keep Fannie and Freddie in a positive net worth position through the end of 2012. However, after 2012, there is a cap on each of the GSEs for how much additional funds the Treasury can provide through the agreement, Harris points out. Beginning on Jan. 1, 2013, the government’s capital support is limited to an additional maximum of $274 billion--$125 billion for Fannie and $149 billion for Freddie.

FHFA released projections in October 2010 that Fannie would draw between $147 billion and $232 billion by the end of 2012, while Freddie would require between $71 billion and $104 billion.

This means the dividend payments that Fannie would have to make by 2013 would be between $14.7 billion and $23.2 billion. Fannie will owe this much every year “even though the company has never earned more than $8.1 billion in a single year,” Harris says.

Freddie would owe between $7.1 billion and $10.4 billion in dividends to the Treasury, when it only once had earnings greater than $7.1 billion. That was in 2002, when it earned $10.1 billion.

“Clearly, the failure of the GSE financial model, including their inability to service their preferred dividends over the longer term, means that reform must occur at some point,” Harris says.

The inevitability of their collapse will come even if the housing recovery resumes and losses begin to disappear, according to Harris. “Most economists predict prices will bottom out this year,” he says. “Then we will have four or five quarters of performance from each of the companies to see at least the normalization of credit losses, which would certainly be a positive thing,” he adds.

“What would be left is how much of a drain would dividends be on an ongoing basis, given a finite amount of contingent capital from Treasury,” Harris contends. Then Fannie and Freddie may find themselves again in the same situation they faced in 2008. By the summer of that year, investors were less and less willing to invest in anything longer than one-year debt.

Even after Fannie and Freddie move beyond the losses from the problem credit years of 2005 to 2008, “they will still have a very large amount of stock held by Treasury that will be earning a 10 percent dividend rate,” Harris says. “It means that both companies will be borrowing money from Treasury to pay a dividend [to Treasury]. Over the longer term, that is unsustainable,” he adds.

No matter how much Fannie and Freddie might be able to earn after they resume operational profitability, at some point they will deplete all potential funding from Treasury and be unable to pay the dividend if the current agreement remains in place, according to Harris.

This would leave mortgage finance almost entirely to the private sector. The lack of broad access to mortgage capital, in turn, will create political pressure for new legislation to create a new mortgage finance system, Harris argues.

It would appear, absent any change in policy, that the ultimate fate of Fannie and Freddie is sealed. Given the challenges Congress faces and the desire to get it right, the political equation would suggest that reform is unlikely to occur until after the 2012 elections, according to Harris. However, the bond markets could “force the issue” sooner, given that Treasury’s potential level of support will become finite on Jan. 1, 2013, according to Harris.

As Congress tries to decide on how to structure a new mortgage system, the central question will continue to be: “Are we recreating Fannie and Freddie?,” says Harris. “That’s the challenge.”

It will be challenging to design a mortgage finance system that adequately replaces the $5.4 trillion in mortgage funding now represented by the GSEs in the $11 trillion mortgage market.

Those are mighty big shoes to fill.  MB

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

Copyright ® 2011 Mortgage Banking Magazine. All Rights Reserved. Reprinted With Permission.





Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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