Mortgage Banking
November 2007
Mortgage Banking recently interviewed James B. Lockhart, director of the Office of Federal Housing Enterprise Oversight, to talk about current market conditions and the role of Fannie and Freddie in restoring liquidity.
By Robert Stowe England
The Office of Federal Housing Enterprise Oversight (OFHEO) is a federal regulator with oversight authority of Fannie Mae and Freddie Mac, and is charged by Congress with ensuring the capital adequacy and safety and soundness of the two government-sponsored enterprises (GSEs). Lockhart has headed OFHEO since May 2006. He also previously served as the deputy commissioner of Social security, and was executive director of the Pension Benefit Guaranty Corporation from 1989 to 1992. Lockhart was co-founder and managing director of Greenwich, Connecticut-based NetRisk Inc., a firm that provides risk-management and software consulting to financial institutions and investment-management firms. Mortgage Banking interviewed Lockhart in October.
Q: What is the dollar volume of mortgage-backed securities [MBS] outstanding guaranteed by Fannie Mae and Freddie Mac?
A: At the end of August, the net MBS outstanding was $3.2 trillion, and their retained portfolios were about $1.5 trillion. So, their total book of business was $4.7 trillion. That's up $360 billion from the beginning of the year. Another number I like to look at-and it's important in relationship to people saying they need to have portfolio caps raised-this year on a gross basis, they securitized about $700 billion in new mortgages and they purchased for their portfolios, which have a cap, $300 billion. They were able to do this because of the run-off of their portfolio. Of that $300 billion, about $120 billion was their own MBS. So, they have a lot of purchasing power and they've been very, very active in this market, which has been useful because the conforming loan market has been performing reasonably well compared to the other Darts of the mortgage market.
Q: What are Fannie's and Freddie's combined share of the market's new issuance as a portion of overall MBS issuance?
A: The numbers are up significantly, obviously because there's not a lot else going on-certainly in the mortgage-backed securities market. The share of new issuance was 60.9 percent in July and 69.3 percent in August [see Figure 1]. This compares with 45.1 percent in July 2006 and 41.2 percent in August 2006. These numbers exclude Ginnie Maes.
Q: Given the fact the new-issue market for private-label residential mortgage-backed securities [RMBS] is essentially dead, isn't Fannie's and Freddie's share of mortgage originations and overall RMBS likely to grow even faster than originally assumed? Are there dangers to the safety and soundness of Fannie and Freddie in assuming a significantly greater share of the overall origination market than they presently hold?
A: Yes, they're going to grow more than they assumed in the conforming loan area. And it's certainly higher than their business plan was-although the overall market is also shrinking somewhat, so not all the market share is totally coming to the bottom line. Yes, there are safety-and-soundness concerns. Obviously, we have the ongoing safety-and-soundness concerns of the inability to put out timely financial. Some of their systems need work. Some of their models need work. Risk management is improving, but still needs work. Internal controls are not Sarbanes-Oxley-compliant yet. So, there's a whole series of things that need work there.
But, certainly on top of that, what's happening in the mortgage market does add more potential risk. They have $4.7 trillion of mortgage-market exposure at this point on a capital base of about $80 billion. They're highly leveraged in relationship to the credit markets. The good news is their credit book is above-average in quality. They also have mortgage insurance on some of it.
Q: In the current environment, how do you balance the goal of meeting the mortgage borrowing needs of consumers with the Office of Federal Housing Enterprise Oversight's [OFHEO's] ongoing efforts to enhance the safety and soundness of the GSEs?
A: Well, it's tough. One of the things we did in September was to give them some flexibility around the caps, and we actually raised Fannie's cap by 2 percent over the next year to equal the flexibility Freddie has. On top of that, we are giving them a [cap] number that can be an average rather than an absolute ceiling, to make it easier for them to manage their portfolio and a number [the unpaid balance] that won't fluctuate as much as the market prices. So, we've made some changes to make it a little more flexible and give them an ability to take advantage of all that's approved within the cap.
But we were very reluctant to go further because of these safety-and-soundness issues, and also because we felt they had the ability to do more for the market with just the purchases they make to replace liquidations. About half their portfolios are in their own securities, and I've been saying for a long time that purchases of those do not give them any affordable-housing credit and do not add that much to the marketplace. They could be selling some of those to be doing more in the market.
Q: So they could expand the market by selling some of their MBS and buying more new loans?
A: Yes, exactly. And their MBSes are trading well at this point.
Q: What are the systemic risks to a growing share of MBS held by Fannie and Freddie, and what can OFHEO do to keep the share at a level that would pose less systemic risk? Indeed, does not the collapse of the private-label MBS market pose risks for Fannie and Freddie? If so, how would you describe those risks?
A: You know, if you go back a little bit in history, the fact that OFHEO was tough on Freddie and Fannie because of all their operational problems over the last two or three years turned out to be good. We did impose a 30 percent extra capital charge and we did cap their portfolios. Without that, they certainly could have been more at risk than they are at the moment.
Actually, one of my concerns going forward is that those powers [to put on caps and raise the capital charge] really are only available because of their operational problems, and once they're remediated, those powers may go away if we don't have legislation. Then we could have potentially much higher systemic risk.
Q: How do you respond to the calls for raising the caps and the conforming loan limit?
A: We're sticking to our guns at this point on both the portfolio caps and the 30 percent surcharge. And, to the extent some people are talking about a conforming loan limit temporary increase, I agree wholeheartedly with [Treasury] secretary [Henry] Paulson and [Fed] Chairman [Ben] Bernanke that it should only be done as part of an overall reform package for GSE regulators-with a new law not only for OFHEO, but also for the Federal Home Loan Bank Board combined. So, I think it needs to be part of comprehensive reform before the enterprises are given additional flexibility.
Q: That will take time to get legislation through-so it won't occur anytime soon?
A: Well, they've only been working on it six years. The House passed the bill with good, strong bipartisan support. It has a lot of good features. It's really a question [of] when the Senate wants to pick it up. Everybody on the Senate Banking Committee is very familiar with all the issues. It's my view that if there was the will, it could be done very quickly.
Q: How would you assess the effect on safety and soundness of the caps that were put in place on Fannie and Freddie last year? What practical constraints has this placed on the ability of Fannie and Freddie to securitize new mortgages?
A: Well, I think it was a good safety-and-soundness move that we did last year. "Impose" is the right word for Fannie, while Freddie was a voluntary agreement-but obviously there was a lot of talking back and forth before they volunteered. And I think it's been very useful, and again I point to the fact that those caps may have been one of the reasons they have the ability to be effective in the conforming loan market right now. I have not heard there has been any impact on their ability to securitize. One of the things that is sometimes not known is that they basically can securitize almost any kind of mortgage, including subprime and alt-A.
Q: The GSEs had their affordability products for years that they offered to lenders without seeming to expose themselves to some of the risks that the private-label market didn't pay enough attention to.
A: Well, the private-label market was mispricing risk, there's no doubt about it. To their credit, Fannie and Freddie recognized that as well-that's one reason they stuck only to the triple-As in the private-label [market]. And, certainly, as the regulator, we pushed them to always stick with triple-As. But they have $170 billion on their books of those [privatelabel] triple-A securities backed by subprime loans.
Q: What are the dangers to the safety and soundness of Fannie and Freddie posed by raising the caps substantially? Some have called for this.
A: Yes, they have called for it and are still calling for it. I think you've got a conforming market that's working, that's not frozen. Fannie, through its securitization activities, is doing the job it was created to do. Increasing the portfolios would add another amount of risk on top of that. It was our judgment, given the rapid growth in their securitization activities, that it would not be appropriate to raise the mortgage portfolios from a safety-and-soundness point. It was a judgment recommended to me by our two examination teams, our capital team and our compliance group. There still are significant safety-and-soundness concerns. It's not locked in that the [two] companies will be timely financial reporters with their 2007 accounts next February.
There's a lot of uncertainty out there, and these institutions are really too important to the mortgage market to take excessive risks. It looks like when they do become timely financial reporters, the agreements we have with the two firms might mean that the caps would come off if we don't have legislation in time-and that could be as early as February or March of next year. Certainly the agreements, as read by both companies, say if they're a timely filer and [have] a clean opinion on audited accounts, that the caps will come off. Our view is that may be true, but there may be other safety-andsoundness concerns at that time. So, we're not going to say they are going to come off.
Q: While there are caps on the enterprises' mortgage portfolios, what limits exist on the ability of the GSEs to guarantee mortgage securities?
A: From the securitization standpoint, there's no cap on it. Obviously there's a balance-sheet constraint. To guarantee a security versus buying it, you need 18 percent of the capital you would need if you bought it, the way the numbers are prescribed by law. They have five times as much buying power with a guarantee as they do with a portfolio purchase, if you will.
Q: That's why they can do so much right now with the powers they have?
A: Right.
Q: How do you assess the progress of Fannie and Freddie toward the goal of ensuring that the private-label MBS they purchase do not violate guidance on nontraditional mortgage product risk, as well as guidance on subprime lending? That would seem to be a complicated regulatory monitoring task.
A: Well, yes, it is. They are putting in procedures there that will be part of their automated underwriting systems, and part of it will be through the examination process from time to time.
Q: Will the examination process be done by OFHEO? The enterprises?
A: Freddie and Fannie go in and look at the mortgage originators from time to time. We will be monitoring their procedures, obviously, and the structures they put around it. And our examination team may be doing some deeper dives if we suspect [there are] issues.
Q: This may be, in a practical and indirect way, the only kind of regulation that is occurring on the nonconforming, securitized mortgages being originated in some sectors of the mortgage industry.
A: The mortgages that are not originated through federally chartered banks and through state banks that are implementing the guidelines, yes-there are areas that are not regulated, where this will be the only way they are touched if they sell them to Fannie and Freddie directly or they do it through private-label MBS.
Q: It would seem this kind of indirect regulation would positively affect the part of the market that was the weakest.
A: Going forward, I think it will be important, especially when the market is re-established. That's why we did it. We felt it was very important. We talked to the other bank regulators, and they were scratching their heads about what can be done about this part of the market that's not regulated at this point. This was an outcome from those discussions.
Q: Is it fair to say the bad behavior of the weakest part of the market brought down the whole market? Other people may have been trying to do a good job, but it didn't make any difference.
A: It's Gresham's Law-bad money drives out good money, or something along that line. Or better, you could say bad practices drive out good practices. That's really what happened, to a large extent. People weren't going to Freddie and Fannie or the FHA [Federal Housing Administration] because there was a much easier route to go. If you don't have any underwriting standard, it's very much easier. Over a three-year period, underwriting quality went down pretty dramatically, if you look at how many [loans] were documented or look at loan-to-value [LTV] ratios or debt-to-income ratios. Everything fell. They were just pumping it out to Wall Street.
Q: The Wall Street firms were fairly new entrants into the mortgage business in terms of setting up origination arms. So, they had no real experience to temper their judgment from the past.
A: The subprime market has been around for a while, but nowhere near in this quantity-so they were attracting a lot of people that historically had not been able to get a mortgage, and doing some financial innovation to get them one, and then selling them products where they didn't understand the inherent risk. A teaser rate or floating rate might be appropriate for someone who can take the financial shocks, like a higher-income person. That's where it started out.
Q: These restrictions are going to bring some type of discipline to an undisciplined market. But, at the same time, do you think they're going to have any effect on the ability of that market to recover?
A: I'm hoping it will be positive, because people will have more faith in the product coming out. There will be less of it, but people would know it's being written to a higher standard. Eventually that should pass on to pricing, too. So, basically, if you have a higher-quality subprime, there will be some people who can't get mortgages, but the people who can get a mortgage may actually be able to get a smaller spread than they could have before.
Q: At this point, there are virtually no new private-label MBS issues to purchase, except some small deals that have been privately placed. Would it be wise for Fannie and Freddie to be out purchasing tranches of new private-label MBS? Or should the enterprises be waiting for some private investors to show some confidence in the mortgages?
A: Fannie and Freddie can buy the triple-As. The problem is that the lower-quality tranches-30 percent of the deals in subprime issues-who are they going to place it with? That's one of the reasons the market has dried up. I wouldn't discourage them from buying some triple-A [securities], and we haven't. They have actually bid on some.
Q: In the jumbo market, the lending being done is primarily portfolio lending, where the spreads have come down considerably since the private-label MBS market first collapsed.
A: It's come down pretty dramatically. Maybe the threat of Fannie and Freddie being able to go into the market has caused some of the tightening. Who knows?
Q: It seems somewhat irrational that the private-label jumbo prime market collapsed, since many of these loans historically are documented, have high LTVs, are for borrowers with excellent credit who have put down 20 percent on a purchase or who have 20 percent or more in equity on a refi. These loans have traditionally had low defaults rates, too.
A: We did a study a while ago, looking at the proposed conforming loan limit changes in the House bill. We looked at the performance of jumbos in some high-median-price areas, mainly California, but also the New York suburbs and the Washington, D.C., suburbs. We were surprised to see that the credit risks were slightly higher in the new loans under the higher limits or newly "conforming jumbos," if you will. Their credit quality was slightly worse than the overall books of business at both Fannie and Freddie.
Q: You were looking at the ones being originated in the high-median-home-price markets?
A: Yes. We did this study six months ago. This was a relatively surprising result. One would have thought jumbos were lower-risk borrowers, but there's a lot of low-FICO® and high-LTV in that area. This is mainly California-about 90 percent [of the loans in OFHEO's recent study were on California properties],
Q: To the extent that Fannie and Freddie are buying something that meets the new standards, is it going to be good for the private-label MBS market?
A: Our view is that we don't think a higher loan limit is needed for Fannie and Freddie, and that the private-label market may come back. It may take a while and therefore, potentially, as secretary Paulson has suggested, a temporary increase might make some sense. But our view is that those loans should be securitized and that higher limits should only be for the higher-priced states. The conforming loan limit is $417,000. The [national] median house price is $233,000. So, the loan limit is well above the median house price to begin with. On the other hand, San Francisco is probably over $800,000-and if you go to Oklahoma City, it's $130,000. So, there's no reason to raise it for Oklahoma City.
Q: Is OFHEO considering a temporary increase in the loan limit?
A: We can't. It can only be raised by law.
Q: Given that the subprime market has really shrunk and you were acknowledging there could be a quality market there, as there has been in the past, do you think Fannie and Freddie are really doing enough in the subprime market? The steps they have announced seem to be fairly minimal.
A: They are starting to do more, and it's one of the reasons we gave them flexibility in the caps to do more. When we announced the new flexibility, we asked that they forward their commitments-$20 billion each over several years-to the period over the next six months. Particularly, we're looking here at the rescue-mortgage-type products, for people who have teaser rates that are about to skyrocket. In some cases, they can provide these borrowers mortgages they can better afford-in some cases fixed rates, some cases 40 years and in some cases interestonly. We're encouraging them to do that. But, obviously, we have to make sure they are properly underwritten. And also, because of their charter, anything with a loan-to-value ratio above 80 percent has to have mortgage insurance or some other sort of protection.
Q: So, what are your concerns going forward?
A: We obviously have ongoing concerns about these companies. We also have concerns about the growth and their sheer exposure to the mortgage market in this country. Therefore, we think the regulator needs many more tools than it has today, including capital, portfolio and other tools the bank regulators have. And that's why we really think it's critically important to get the [reform] legislation through Congress.
This kind of market proves we really do need a strong Fannie and Freddie, and we do need a stronger regulator. There's really no market discipline on these two companies. The credit markets are treating their debt very well even though they can't provide financials. And, yes, their spreads are widening somewhat against Treasuries, but they've gotten a lot better against banks and other financial institutions. Our view is that if the markets aren't going to provide discipline, then the regulator has to provide it.
Q: So at this point you're saying that if Congress really wants to do something about it, it can be done rather quickly?
A: Yes, in my view. And I think that would be the view of most people on the Hill. It's really getting the will in the Senate Banking Committee. They all say they want to do it, but it's not quite on the top of their agenda yet.
Copyright Mortgage Bankers Association of America. All Rights Reserved. Reprinted By Permission.
END
