A former regulator of the government-sponsored enterprises talks about what’s needed in a future housing finance system.
Mortgage Banking
September 2015
By Robert Stowe England
Edward DeMarco, former acting director of the Federal Housing Finance Agency (FHFA) from September 2009 to January 2014, oversaw the operations of Fannie Mae and Freddie Mac as conservator during the critical time when the agency put in place policies to stabilize their financial condition and to support the housing market.
He is currently senior fellow-in-residence at the Santa Monica, California-based Milken Institute’s Washington-based Center for Financial Markets, where he oversees the center’s work on housing finance and housing policy issues. From 2006 to 2009, DeMarco also served as chief operating officer and deputy director of the Office of Federal Housing Enterprise Oversight (OFHEO), FHFA’s predecessor agency.
Before coming to OFHEO, DeMarco worked at the Social Security Administration (SSA), where, as assistant deputy commissioner for policy, he led the agency’s policy, research and statistics function.
Earlier DeMarco served as director of the Office of Financial Policy at the Treasury Department, focusing on public policy issues involving the government-sponsored enterprises (GSEs), including Fannie and Freddie, the Federal Home Loan Bank System and other financial institutions. Prior to his 10-year tenure at Treasury, he worked at the U.S. General Accountability Office for seven years.
DeMarco received a doctorate in economics from the University of Maryland and a Bachelor of Arts degree in economics from the University of Notre Dame, Notre Dame, Indiana. (ital) Mortgage Banking (end) caught up with DeMarco at the Washington, D.C., offices of the Milken Institute in June.
Q: What are some of the important elements and guiding principles you would like to see shape the architecture of a new and improved mortgage finance system?
A: Thinking of the housing finance system going forward, first it should have consistency and reliability in the data, in the standards and in the disclosures that define the mortgage market. That would give more legal certainty and transparency to loan originators, loan servicers and investors.
So, let’s take an example. An investor advocate or what is sometimes called a deal manager is frequently part of the discussion. Having an investor advocate would give investors greater certainty.
There should be more standardization in the pooling and servicing agreements that actually govern mortgage securitization. That would give greater transparency and confidence to investors. And having robust data disclosures using a standardized set of data definitions and so forth would give investors greater insight into the credit quality and actual performance of the loans that they are investing in.
Q: What do you see as essential to a future mortgage finance system?
A: Competition. The GSE model that we’ve had is not a competitive model. It’s a protective duopoly. Fannie Mae and Freddie Mac operated with numerous benefits in the marketplace that other firms didn’t have. So the market lacked the freedom of entry and exit. Fannie Mae and Freddie Mac were not diversified. Moreover, by having public charters, they were subjected to substantial politicization of their activities.
A more competitive market would spur innovation, spur consumer choice, allow for entry and exit, and could certainly lead to less concentration of mortgage credit risk and mortgage rule making.
Q: What role should the government play in a new mortgage finance system?
A: In a future mortgage finance system, we’ve got to develop clarity about the role of the government. For example, the Federal Housing Administration [FHA], the [Department of Veterans Affairs (VA)], and Ginnie Mae as the securitizer of FHA and VA loans, will most likely remain explicit government guarantee programs. So, we start with that.
But there are things that can be done to enhance the clarity and the effectiveness of these programs. Take the FHA, for example. What’s the target market segment? Who are the targeted borrowers? What other ways could FHA be strengthened?
GAO and others have come up with a number of proposals to do that. There have been legislative proposals in the House and in the Senate, things that would alter the accounting that’s used. There have been proposals to place FHA outside of HUD [the Department of Housing and Urban Development], to give it more independent funding, which would help it to be more self-sufficient. So, that’s a place where we could certainly clarify the role of government.
We really ought to ensure transparency and basic fairness in the lending process. Certainly in the marketplace of eight, 10 years ago, there were some highly questionable behavior and practices with regard to how consumers were being treated, misled and so forth. Certainly steps have been taken to address that. The establishment of the Consumer Financial Protection Bureau [CFPB] was a direct response to that.
The market needs to have consumer responsibility in it. But consumer responsibility should also be a goal that is tied with or associated with strong disclosures, financial education and transparency in the process to the consumer.
Q: What could the government do to facilitate an expanded role for the private sector?
A: In many ways the mortgage market--both the primary market and the secondary market--have not modernized as much as other credit markets. I think that’s due in part to the heavy role of government regulation, the existence of government agencies and the GSEs. But the interesting thing is that government could actually lead to a modernization of this market in ways that would help the market itself work better. I’ve already mentioned data standardization, as an example, standardized disclosure. There are areas, such as laws governing second liens and laws governing appraisals, where the government could actually contribute by reconsidering some of those laws to help make the market operate more efficiently.
Q: What about the role of government subsidies in the future?
A: The mortgage market, and housing in general, has countless sources of subsidies and targeted assistance, whether for rental or ownership. But I think some of this should be reconsidered so that we better identify where assistance needs to be provided to advance a policy objective and determine what’s the most efficient and targeted way of delivering that support.
So much of what we’ve done is through a general subsidization of mortgage credit. By subsidizing all mortgage credit, we’re not really targeting assistance to the particular borrower populations that we’re aiming to support--or in the case of rental, to support specific rental situations.
And finally, in putting all this together, the hardest thing is to keep it simple and keep it simple for both borrowers and investors. Today we’ve got a pretty complicated quilt of regulations governing lending and servicing, and I think that the market efficiency could be enhanced if we could work our way toward a simpler approach to rules governing the whole housing finance process.
Q: Your big-picture overview of the future relies heavily on securitization. Is that necessary because U.S. depository institutions are unlikely to be able to carry the great majority of all the nation’s mortgages as portfolio loans?
A: In short, yes. The single-family housing finance market is a $10 trillion credit market. While we’re trying to repair and fix and replace what has been broken, we shouldn’t be eliminating what is good and powerful and effective, and what’s effective about a well-functioning secondary market. That’s where originators can originate loans and bundle them and find ways of delivering these bundles of mortgages to the capital markets.
Whether it is through securitization or other means, I think a secondary mortgage market is really important to bring the power of global capital investors to housing finance in the United States in a way that lowers the cost of borrowing and increases the availability of credit to people seeking to buy a house.
Q: There has not been a lot of progress in generating a private-label securitization market beyond the government-backed market we now have. Is there any logical way to move from where we are to a redesigned mortgage finance system? What steps should we take to move forward?
A: In fact, I think a number of steps have been taken and progress is being made. No one is going to redo this overnight. But we shouldn’t lose sight of important progress that is already underway.
For example, progress has been made on standardization. Since 2010, FHA has been working with Fannie Mae and Freddie Mac and with the industry to develop new data standards for the mortgage market. This has been taking place through the industry standards process overseen by MISMO®. It has developed mechanisms for having a common technology infrastructure for reporting. It’s developed a process for defining data and data terms. It’s done the same thing for both loan origination data as well as appraisal data.
Another area in which progress has been made and will continue to be built upon is in risk-sharing or risk-transfer deals undertaken by Fannie Mae and Freddie Mac in the last couple of years. These efforts are drawing private capital slowly back into the housing finance system so that not all of this risk is resting on the support of the taxpayers. It is demonstrating there is an appetite on the part of private capital to invest in mortgage credit risk and it is building the foundation for how this can be greatly expanded over time as part of a securitization process.
In addition, work continues today on the common securitization platform that we started at FHFA. It may be able to serve as infrastructure for a more competitive securitization market after the Fannie and Freddie conservatorships come to an end.
Interestingly, in terms of a recent development, the discussion draft legislation recently published in May and sponsored by Senate Banking Chairman Richard Shelby [R-Alabama] helps in this area. [His proposed legislation, the Financial Regulatory Improvement Act of 2015,] basically requires the continued development of risk sharing. It would require the continued development of the common securitization platform and establish a path and a timeline for that securitization platform to evolve into a true market utility that would be there to serve both the GSEs, while they continue in conservatorship, but also to begin serving the broader market.
Q: What do you make of the performance of government programs set up to promote homeownership?
A: We have many programs--whether they run through the GSEs or whether they run through the federal tax code or they run through government programs like FHA--that are designed to reduce the cost of borrowing money to buy a home. But what they end up doing is they are subsidizing or encouraging leverage in home purchases. And leverage is not the same as ownership. Ownership is when you have actual equity.
I think that public policy in housing ought to rethink some of the approaches that are taken to encourage homeownership so that they are better targeted at the particular borrowers, segments of the market, that lawmakers determine warrant this kind of assistance.
And we should review the assistance itself and rethink how much of it focuses on leveraging family balance sheets and whether more of it can be delivered in a way that enhances the equity position families have in their home. If the policies lead to greater equity, those homeowner balance sheets will be safer and sounder. It’s a very debt-driven model we have today.
Q: What about the need to address servicing compensation, especially for nonperforming loans?
A: We now have a regime in which there’s a very robust set of requirements for servicing mortgages when they go delinquent. The compensation regime needs to better match the requirements.
Q: You talk about a greater involvement by the private sector. Where do you see the role of mortgage insurance companies in all this?
A: I think a question like that is really best answered by the marketplace. Mortgage insurers right now have an important role. And I certainly do think they can be competitive participants in the market, but they need not be the only source for pricing and bearing of mortgage credit risk. That competitive mix would also include other sources of credit risk-bearing, whether it comes through capital market transactions or broader reinsurance of mortgage credit risk.
Q: Any transition to a new mortgage finance system is going to take time. Is it helpful to have the GSEs doing both single-family and multifamily mortgage financing transactions, since doing both provides a balanced source of income for them in the interim?
A: Well, that’s the way it’s structured now. It sure would be helpful to get congressional direction on where this is ultimately going to go. But these really are separate markets. They operate within Fannie and Freddie quite differently.
The degree of private capital participation--or, to put it differently, the degree of direct competition between private-market participants and Fannie Mae and Freddie Mac in the multifamily segment--is far more robust than in the single-family segment. So, the multifamily operations of Fannie and Freddie have long been based on more of a risk-sharing model than single-family has.
So, it is not necessary to keep these lines of business together but the disposition of each line of business really goes to a disposition of the conservatorships themselves.
Q: During this period when operational investments are being made in their businesses, do you think the GSEs have enough capital to make the needed investments?
A: So, the GSEs operate today. The only reason they are able to operate today is because of the financial support provided by the senior preferred stock purchase agreement with Treasury. And as of the end of 2012, the dollar amount of support remaining there has been capped. That’s what allows them to continue to sell debt and mortgage-backed securities.
Certainly through conservatorship up to now--and I would expect this to continue--there is the capacity to continue to invest in risk-management tools and processes to enhance the business and to improve the safety and soundness of the GSEs. And certainly when it comes to enhancing risk management and strengthening safety and soundness, those are, in fact, important investments to make.
It becomes a trickier question with regard to a long-term investment in a business when the business itself is in conservatorship and when, for years at this point, leading members of Congress and the administration have been talking about winding down these companies and moving to some post-conservatorship, post-GSE model.
So what does it mean to be making long-term investments in companies backed by the taxpayers in conservatorship when you don’t know what the long-term outcome is? And this really gets to the heart of why it remains very important that Congress get to enacting housing finance legislation that’s going to give the country a more clear, long-term path here, and that path includes the resolution of the conservatorships.
Q: What do you make of the efforts being made in Congress to advance the reforms needed to create a future mortgage finance system?
A: There are some important commonalities among various legislative proposals that have been made over the past couple of years. That includes the PATH [Protecting American Taxpayers and Homeowners] Act, put forth by Congressman Jeb Hensarling [R-Texas], chairman of the House Financial Services Committee], and Congressman Scott Garrett [R-New Jersey].
Or the discussion draft put forward by [House Financial Services Committee] Ranking Member Representative Maxine Waters [D-California]. Or the Delaney-Carney-Himes bill that was reintroduced earlier this year [sponsored by John Delaney (D-Maryland), John Carney (D-Delaware) and Jim Himes (D-Connecticut)].
Or the Corker-Warner, Crapo-Johnson iterations in the Senate [the first sponsored by Senators Bob Corker (R-Tennessee) and Mark Warner (D-Virginia) and the second sponsored by Senator Mike Crapo (R-Idaho) and former Senate Banking Chairman and former Senator Tim Johnson (D-South Dakota)].
In their own way, each is clear in wanting to wind down Fannie Mae and Freddie Mac, in wanting to draw private capital back into this market. They each reference some form of a common securitization platform as the infrastructure backbone for a competitive secondary mortgage market. So these are things one can build on.
There remain important differences about the role of government and about concerns over how the housing finance system will serve particular market segments or will be able to deliver subsidies or assistance to particular segments of the market. And those need to be resolved by our elected officials.
Q: Would you say there is commonality on the major areas necessary for reform?
A: Well, we’ve narrowed down the option set to a fairly small number of approaches, and that should allow for the legislative process to start to move forward.
I wouldn’t say all the big-picture issues have been agreed to. I’m trying to point out that there is enough commonality between these approaches that there is at least a foundation on which to build and strive for some form of compromise and consensus on the rest of it.
Q: Right now, the mortgage market goes on and readjusts and reshuffles and restructures with what we have.
A: Well, what we have is a market that continues to be dominated by the government--whether it’s government agencies, government conservators, companies operating in government conservatorship--and private-market participants are awaiting greater long-term clarity about the role of the government.
What is going to be the market opportunity for private financial institutions and private investors five, 10 and 15 years from now? Well, no one knows the answer to that question because the government continues to have such a dominant stake that no one can compete with that government dominance.
And then there’s the uncertainty. How do I build a long-term business model in this market sector if I don’t know what the government’s going to do next year, two years from now, three years from now? It’s a critical source of uncertainty in the mortgage market that is dampening progress.
Q: What’s been interesting to watch is the mortgage market has evolved to a point where there are many players and the dominance of the largest lenders has been reduced. This would seem to be a good thing.
A: So, other things being equal, reducing concentration should be a good thing. We have moved a good portion of this market, both loan origination and loan servicing, out of the insured depository institutions--which have prudential regulators at the federal level; that is, the bank regulators--into institutions regulated by state agencies, as well as regulated by the CFPB for consumer protection. But they don’t have the same overall prudential regulatory regime as the one that covers insured depository institutions. So, it’s not entirely clear whether this is creating a competitive imbalance in the market and whether this is shifting risk or adding to risk over time in a way that we haven’t figured out.
MB
Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at
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