Mortgage Banking
April 2008
Temporarily higher loan limits for Fannie, Freddie and FHA, plus a lifting of portfolio caps and a reduction in the surplus capital requirement, pave the way for the GSE’s and FHA to gain market share and expand overall lending. At the same time, the Fed has taken extraordinary steps to improve liquidity. Still, a full recovery of the mortgage market depends on a revival of the non-agency market. As of early spring, that was nowhere in sight.
By Robert Stowe England
The current illiquid private-label secondary market is a credit desert where very few mortgages bloom.
As thirsty mortgage originators, lenders, Realtors®, policy-makers and homeowners trek through this desert in pursuit of a fountain of credit, they can see an oasis in the far distance where former investors in non-agency mortgages, as well as a few portfolio lenders, appear to have beat a retreat.
Yet, as the trek continues and time passes, that oasis seems to be moving farther away rather than nearer. Is there a recovery ahead for the non-agency secondary-or is it only a mirage?
When will the non-agency market come back? No one wants to venture a guess. "It's in a tough spot," says Pankaj Jha, agency analyst at RBS Greenwich Capital Partners, Greenwich, Connecticut. "Investor confidence is eroded in mortgage credit. It will come back, but who knows at what point?"
There is some hope that the free-fall in non-agency residential mortgage-backed securities (RMBS) issuance may have hit bottom. "It may be at a bottom because it is so close to zero it can't go much lower," says Guy Cecala, publisher of Inside Mortgage Finance, Bethesda, Maryland.
The monthly volume of non-agency RMBS issuance stood at $108.2 billion in February 2007, just as the subprime meltdown made its debut. By December 2007, total RMBS issuance had fallen to $10.3 billion-a fall of 90 percent in a 10-month period, according to Inside Mortgage Finance. The December issuance of $10.3 billion was made up of $3.79 billion in prime jumbo issuances, $0.92 billion of alternative-A and $0.79 billion of subprime. The rest was re-securitizations. In January 2008, RMBS issuance was slightly higher at $10.83 billion-made up of $2.4 billion prime, $2.08 billion subprime, with the rest in resecuritizations. By February 2008, RMBS was down to $8.04 billion, with $1.94 billion in prime jumbo, $0.37 in alt-A and the rest in re-securitizations, according to Inside Mortgage Finance.
The fall of the non-agency market completely reshuffled the deck of mortgage originations in the second half of 2007. The share of the market represented by both non-agency securitizations and the portfolio-lending sector has been sharply reduced, while the agency share has zoomed to absolute dominance.
In 2006, agency RMBS issuance represented a minority 44 percent share, or about $899.3 billion of the total RMBS originations of $2.045 trillion that year. The breakdown by agency was as follows: Fannie Mae, $456.9 billion; Freddie Mac, $360 billion; and Ginnie Mae, $82.4 billion, according to Inside Mortgage Finance.
By contrast, the non-agency RMBS issuance stood at 56 percent, or about $1.146 trillion, according to Inside Mortgage Finance. By product sector, the RMBS issuance was as follows: jumbo prime, $219 billion; alt-A, $365.7 billion; subprime, $446.6 billion; second mortgages and home equity, $74.2 billion; with re-securitizations making up most of the rest.
By the fourth quarter of 2007, the agency piece stood at 85 percent, or about $296.5 billion of the total $349 billion in RMBS issuance. Fannie Mae's share was $164 billion, while Freddie Mac issued $100.4 billion and Ginnie Mae issued $31.9 billion in RMBS, according to Inside Mortgage Finance.
The shift to agency financing has also reshuffled the mix of products and the amount of financing for each type of product that is available to borrowers. Not surprisingly, non-conforming, non-prime products-now almost entirely originated by portfolio lenders-have taken a much smaller share .
What occurred was a complete reversal of fortune for the agency lenders (on the plus side), while the availability of jumbo, subprime, alt-A and home-equity financing was drastically reduced.
The decline of jumbos
Jumbo prime mortgage originations-whether held in portfolio or securitized-have historically represented about 18 percent of overall originations, according to Cecala. The share for jumbo prime originations, however, fell to 14 percent for all of 2007, and jumbo prime represented only 10 percent of originations in the fourth quarter, he says.
"That's the real crux of the issue," he says-the portfolio lenders have not been able to take on the demand for jumbo mortgages created by the collapse of the private-label RMBS market.
"Lenders are reluctantly making jumbo mortgages in portfolio," says Cecala. "That's why to some extent it's overpriced," he adds. Portfolio lenders have not originated and held jumbo mortgages for portfolio for a long time. "The securitization market was so efficient and so cost-effective that most jumbo originators found it better to securitize the product rather than hold it in their portfolio," Cecala says.
Since September, however, "they have had to rejigger their whole operations to support portfolio lending," he says. "And at a time when they are all capital-challenged-meaning it's hard for them to raise money-portfolio lending, especially for jumbo loans, is a very expensive business to get into," he adds. "When you see Bank of Americaand [Citigroup] having to go over to the Middle East to raise money, the last thing they want to do is to tie it all up in portfolio loans-even if the return is good."
Hope for growth in the volume of mortgage originations now centers on the ability of the agency market to absorb more of the demand for jumbo mortgage originations that the non-agency market and portfolio lenders have been unable to meet. Indeed, recognizing their ability to successfully securitize in the current mortgage market turmoil, Fannie Mae, Freddie Mac, the Federal Housing Administration (FHA) (and Ginnie Mae) were given a temporary entrée by Congress into the jumbo market with higher conforming loan limits. The hope is that they can provide additional funding potentially at lower loan rates than would otherwise be available to higher-priced home markets, where the collapse of the private-label market has been taking its toll.
The decision by the Office of Federal Housing Enterprise Oversight (OFHEO) to eliminate the caps on the investment portfolios at the government-sponsored enterprises (GSEs), followed by the decision March 19 to scale back the capital surplus requirements from 30 percent to 20 percent, have been taken at least in part to address the lack of funding from the non-agency market for prime credit borrowers. The reduction in the surplus capital requirement is expected to provide up to $200 billion in immediate liquidity to the mortgage-backed securities (MBS) market. According to a statement released by OFHEO, the reduction in the surplus capital requirements, coupled with the removal of the caps on the investment portfolio, "should allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year."
Both Fannie and Freddie, responding to calls from OFHEO Director James Lockhart and Treasury secretary Henry Paulson, also announced March 19 they would begin the process of raising significant additional capital to further expand their ability to lend.
A boost from higher loan limits
Temporary authority for higher loan limits was given to Fannie, Freddie and the FHA as part of the economic-stimulus package sought by President Bush, quickly approved by Congress and signed into law Feb. 13. The authority covers loans up to 125 percent of local median home prices for a maximum of $729,750-significantly higher than the $417,000 GSE limits in force prior to the increase.
The Department of Housing and Urban Development (HUD) published a county-by-country breakdown of all markets in early March, identifying the loan limits that apply for each. Not surprisingly, most markets in California and major cities on the East Coast were eligible for the highest loan limits. (See Figure 3 for a list of the markets that are eligible for the highest loan limits.) Of the 320 metropolitan areas identified by HUD, 11 metropolitan areas and seven wealthy counties and micropolitan areas (small, wealthy resort areas) will have loan limits at the new higher limit of $729,750, including eight metro areas in California, plus Salt Lake City in the West as well as the broad metro areas of New York City and Washington, D.C., and outlying counties in the East (see Figure 3). Three markets in Hawaii have limits higher than $729,750-markets that had higher loan limits prior to the policy.
For both Fannie and Freddie, the higher loan limits cover jumbo loans originated between July 1, 2007, and Dec. 31, 2008, that meet their underwriting criteria. For FHA, there are higher temporary new limits in all its markets, because FHA had a lower maximum loan limit of $362,790 prior to March 6.
FHA will temporarily have loan limits ranging from $417,000 in markets with lower-priced homes to $729,750 in the same metro areas where limits have been raised for Fannie Mae and Freddie Mac.
Ginnie Mae, which provides a government-backed guarantee on securities backed by FHA-insured mortgages, was the first out of the gate-announcing it would be ready to pool and back the higher loan limits in new securities issued by April 1. "We believe it's important that Ginnie Mae support the stimulus package and creates a vehicle that will improve market liquidity as soon as possible," says Thomas R. Weakland, acting executive vice president of Ginnie Mae.
Observers have a wide range of expectations as to the potential benefits from higher loan limits. On one end of the spectrum, mortgage bankers who specialize in jumbo mortgages are elated. "It's a brilliant policy," says Michael Covino, president of LUXMAC® Home Mortgage, Tarrytown, New York, which specializes in jumbo and super-jumbo mortgages.
Covino believes it will provide much-needed liquidity to the market-but still not enough, because it does not address the once-considerable alt-A jumbo market.
An estimated $372 billion GSE boost
Some others, such as RBS Greenwich Capital Markets' Jha, are cautiously optimistic that the higher loans limits, removal of the caps and reduction of the capital surplus will help. Jha predicts that if the GSEs fully maintain their current underwriting standards, they will be able to securitize $312 billion, or just 12 percent of the estimated $2.6 trillion in the total outstanding prime jumbo market.
The impact on alt-A will be somewhat less-about $50 billion, or 5 percent, of the total outstanding $1 trillion alt-A market is expected to qualify under GSE standards. Only about $10 billion, or 5 percent, of the outstanding $1 trillion subprime securitized market is expected to benefit, according to RBS Greenwich Capital Markets. The total potential GSE securitization boon would equal $372 billion for jumbos, alt-A and subprime combined. The securitizations could occur across the board, from refinancing to purchase mortgages and the pooling of whole loans currently held in bank's own portfolios.
RBS Greenwich Capital estimates that $2 trillion out of the $2.6 trillion jumbo market is held in portfolio by banks, which will have an incentive to sell these loans to Fannie and Freddie for securitization. "The rising value of loans has grown on bank balance sheets as they have been unable to securitize jumbo loans," explains fha, who notes that $2 trillion is an estimate. There are no official data available on overall mortgage loan portfolio holdings.
"We expect banks to securitize [some] loans," says Jha, "because they believe this opportunity will increase liquidity and that would help banks reduce their balance-sheet [charges]." The risk-weighting for capital for loans that have been securitized through the GSEs is 20 percent, compared with 50 percent when the whole loan is held in portfolio by the bank, he explains.
"In good markets, they would normally securitize the jumbo loans into the non-agency secondary market. But that market is completely dead right now," says Jha. "That's the reason they have been holding these loans." The estimate of $250 billion for securitization is based on an estimate of the portion of jumbo loans held in bank portfolios that would qualify under Fannie's and Freddie's current underwriting standards.
The lift from higher loan limits, however, will also have an ongoing impact on the market for new jumbo refinancing and home purchase mortgages, according to Jha.
The potential advantage will depend on how strict or relaxed the agencies make their underwriting guidelines when purchasing loans with larger loan balances. The refinancing, in turn, will depend on the savings in monthly payments that consumers can garner over their current mortgage rates. RBS Greenwich Capital estimates that between 10 percent and 25 percent of the outstanding non-agency market could be refinanced as Fannie Mae or Freddie Mac loans. This is part of the estimated potential $372 billion gain in new GSE business. This business would occur gradually over time and be limited by other factors. For example, Jha explains, "not all of [the potential refit borrowers] will have an incentive greater than 50 basis points," which is the level at which consumers are likely to refinance to have lower payments.
Jha expects higher guarantee fees of 15 to 20 basis points would be assessed on the jumbo agency loans lenders sell to the GSEs.
This translates to a potential $10 billion to $15 billion a month in net new loans financed by the agencies, with 75 percent of that coming from refis and 25 percent from purchase loans. This estimate takes into account the lifting of the portfolio caps at Fannie and Freddie by OFHEO on March 1, and also assumes Fannie and Freddie are likely to use available capital to guarantee loans and avoid adding more loans or mortgage-backed securities to their own investment portfolios, according to Jha.
The reduction in the required capital surplus from 30 percent to 20 percent does not affect the estimates by RBS Greenwich Capital, according to Jha, because the estimates are based on how much of the jumbo portfolio could meet the guidelines of the GSEs.
A modest short-term impact
Doug Duncan, chief economist at the Mortgage Bankers Association (MBA), who will soon take a new position as vice president and chief economist at Fannie Mae, says he does not expect the higher loan limits to have "a whole lot of impact in the near term." Duncan expects that the new jumbo agency program will begin to take full effect no earlier than this summer.
Duncan explains that the agencies and FHA have to put in place the mechanics to execute the new policy. They have to issue guidelines to lenders, and the lenders have to incorporate those into their lending practices. Further, he notes, the securities Industry and Financial Markets Association (SIFMA), New York, has announced it will not allow the agency jumbo loans to go into the to-be-announced (TBA) pools. This means that there will be a separate structure for the agency jumbo loans.
"Because these loans will not have a track record, there's probably not going to be that great an interest-rate advantage initially until people see how those securities behave," Duncan says.
Duncan expects the underwriting criteria at Fannie and Freddie are likely to be very conservative, because many of the markets eligible for higher loan limits are in places where house prices are falling. This could mean that down payments will have to be higher. "From our perspective, people are being too optimistic-not that it won't help," Duncan adds, but some people are overstating the benefits "in the short run." he says.
Lifting the portfolio caps
What benefits will come from OFHEO's decision to lift the caps on the size of portfolios at both Fannie Mae and Freddie Mac? "That will ultimately help, but in the short run, the GSEs have had to go out and raise capital," Duncan says. Further, he notes, the GSEs have been shrinking their portfolios to keep their capital at the required levels.
"Until they see an improvement in their capital position, they can't expand their portfolios," he says. The reduction in the surplus capital requirement from 30 percent to 20 percent "will help," Duncan adds, "and it will help quite rapidly."
Fannie and Freddie face capital constraints due to significant losses reported in the fourth quarter. Fannie Mae, for example, reported a loss of $2.1 billion for the fourth quarter. Fannie Mae had bolstered its capital prior to this by issuing $7.8 billion in preferred stock.
Freddie Mac reported a slightly higher $2.5 billion loss for the fourth quarter and bolstered its capital by $6 billion in December. There may also be more losses in the first quarter for both GSEs, as credit performance has continued to deteriorate and mortgage assets values have continued to fall. Despite these worries, on March 12 Freddie MacChief Financial Officer Anthony Piszel reassured analysts that the agency has "sufficient capital to continue to grow" its business. Further, he said, as Freddie Mac raises its capital, it will not be done in a way that would dilute the value of common shares.
Back to square one
The expansion of the conforming loan limits will have two immediate effects, according to Michael Youngblood, managing director, Friedman, Billings, Ramsey & Co., Arlington, Virginia. "One, it will clearly lead to the refinancing of in-the-money jumbo mortgage loans up to the limit into conforming mortgage loans," he says.
The basis-point premium for jumbo mortgage rates over conforming loans reached a near-historic high of 14 percent in February. That compares with the highest premium prior to that of 15 percent in 1986, Youngblood notes.
"We've essentially rolled the market back to the effective beginning of non-agency securitization," he says. "So, effectively, the expansion of the conforming loan limit has nationalized a significant portion of the jumbo mortgage market and will certainly facilitate refinancing of eligible borrowers at an accelerated pace," he says. "It will also help facilitate, to a lesser degree, the net new demand for mortgage credit."
Will the new conforming loan limits help or hinder the restart of the non-agency market? It will be a hindrance, Youngblood says. The higher GSE loan limit "will undoubtedly impede the recovery of the [prime non-agency] jumbo mortgage marketand by extension, the [entire] non-agency market," he says.
Prior to the announcement, he says, Friedman Billings had expected that the decline in mortgage rates that the Fed has precipitated with its 125-basis-point cuts in the Federal Funds Rate in January "would lead to a demand for refinancing credit." In response to this demand, "the major providers of that creditthe leading commercial banks, the leading investment bankswould force open the jumbo part of the non-agency market in order to avoid portfolioing an excessive number or dollar amount of those loans," he adds.
"To the extent that now Freddie and Fannie are able to acquire and securitize many of these loans, that need diminishes," Youngblood says. "So, I think it postpones perhaps through the entire period of this temporary authority the need [on the part of] these major market participants to shed excess volumes of jumbo loans. And I think it is unlikely that the alt-A or subprime markets will open in advance of the jumbo market," he adds.
Youngblood expects mortgage real estate investment trusts (REITs) to avail themselves of the higher GSE loan limits and originate jumbo loans guaranteed by Fannie Mae and Freddie Mac. "Companies like Thornburg Mortgage and Redwood Trust will be able to convert part of their non-conforming portfolios into conforming loans," he says.
"Unambiguously, the extension of this authority is a benefit to many homeowners in jumbo markets in 2008, but to the extent it postpones the normal operation of the nonagency mortgage market, it paradoxically reduces opportunities for borrowers with higher-valued jumbo loans, say above $730,000-and also for alt-A and subprime borrowers."
Borrowers will not get the full benefit of conforming loan rates, Youngblood says, due to the tightened underwriting at the GSEs and higher premiums from mortgage insurers, "who themselves are mildly panicked by the erosion in their insured books of business," he says. "There will be extraordinary prudence exercised in markets with declining home prices."
This means that borrowers refinancing into agency credit for loan values more than $417,000 will not get the same deal available to borrowers whose loans are $417,000 or less. "It's likely to be a much better deal than they can get in the non-agency loan market right now. But it's not as good a deal as the narrowly defined conforming market would get," Youngblood says.
Will lenders who sell jumbo loans to Fannie and Freddie then, in turn, be able to finance alt-A loans? Not necessarily, Youngblood says. "It remains to be seen whether company management will want to expand their holdings of single-family mortgage loans in light of realized losses on related securities in recent quarters and heightened scrutiny of exactly such exposures," he says.
There may be another wrinkle for some borrowers in markets with declining prices. Youngblood expects that the GSEs may require that these borrowers have mortgage insurance for loans that are above So percent. "I expect the agencies to embrace this new authority, but to do so prudently and very likely conservatively," Youngblood says. "After all, this is not a part of the market where they have any historical experience," he says.
"Their existing risk metrics are not guaranteed to apply for such larger-valued loans the way they had applied for smallervalued loans," he says. With the lifting of the caps on the investment portfolio, Youngblood expects that the GSEs will "likely be able to own or guarantee as many loans as they want."
Crowding out the private sector
In addition, the odds are good that higher loan limits will be permanent as part of overall GSE reform or even afterward, Youngblood says. "There will definitely be a new administration of one stripe or another come next January, and it will be a new game then. So, what powers are not accorded [to the GSEs] in 2008 may be forthcoming in 2009," he says.
If the loan limits do indeed become permanent, are we not then witnessing the dawn of a new era for the secondary market? "Yes, absolutely," says Youngblood.
"To the extent that Fannie and Freddie crowd out the private sector, the reopening of these markets will be prolonged-and when they do reopen, the volumes that they originate will be sharply diminished," he says.
"Clearly, in the public policy arena, without expanded bank regulatory-like powers for OFHEO, that's a recipe for potential disaster," he adds. "At some point, the interests of the American people and the risk of systematic failure have to be balanced against the aspirations of Fannie and Freddie for larger books of business and higher returns to their shareholders," Youngblood says.
"Just imagine, given what we've seen with the failure of a relatively small number of very small companies, what would have been the implications for the United States and the international economy if Fannie or Freddie had failed," Youngblood says.
"The failure of a very small [mortgage company] on Valentine's Day in 2007 set off the largest decline at that point in the ABX [asset-backed security] indexes," he says. "Imagine what the failure of either Fannie or Freddie would have done for all of our markets."
But, on the other hand, could Fannie and Freddie actually help contribute to the return of the non-agency market by buying non-agency securities? "Yes, it's certainly possible if the non-agency securities market reopens, Fannie and Freddie may become regular buyers of those securities, as they have in the past," says Youngblood.
"They are very large holders of subprime mortgage loans, generally super-senior and senior triple-A classes," he adds.
However, Youngblood says he is not aware of the GSEs ever being buyers in the jumbo market, "apart from the frontier effect, as every year their loan limit increased, they picked up another portion of what had previously been jumbo loans." It represents a different set of risk-management challenges, he says-originating jumbos, securitizing them and potentially owning jumbo mortgage-backed securities, both agency and non-agency.
Youngblood does not expect the higher loan-limit authority to significantly expand the availability of mortgage credit. He instead thinks it will expand the market share for Fannie and Freddie and shrink the share for depository institution portfolio lenders and the non-agency market.
The degree to which loans are moved from portfolio lenders to the GSEs "will depend on the risk appetite of both the GSEs and portfolio lenders," he says. "I suspect the risk appetite [at banks] for mortgage credit has diminished," he says, and that, as a consequence, many portfolio lenders will be happy to sell their jumbo mortgages to Fannie and Freddie for securitization.
What does this mean for the GSEs?
How will the new higher loan limits and other developments impact Fannie and Freddie? Inside Mortgage Finance's Cecala thinks the impact will be significant and likely permanently alter the mortgage landscape.
"Over time, it's going to be an incredible windfall for [Fannie and Freddie]," he says.
"First of all, this mortgage crisis we're in is not going to go away in six months," he says. He adds it is doubtful that the higher limits can be implemented and effectively in place sooner than late spring or early summer.
Further, Cecala maintains, "History has shown [that] once you raise loan limits, it's very, very difficult to lower them."
The higher loan limits are also going to drive sharply higher loan origination volume at the GSEs, something that has occurred in the past even with small increases in the limits. "We estimate that about $225 billion in last year's [origination] volume fell between $417,000 and $750,000-roughly the increase in the current loan limit," says Cecala. "That suggests as much as $225 billion [of overall market share] potentially could be shifted to Fannie and Freddie," he adds.
Are higher loan limits good for Fannie and Freddie? "Absolutely yes," says Cecala. "They're not going to come out and say it, but it's a huge victory for them," he says. "There's nothing that Fannie and Freddie would rather have than no loan limits at all. So higher loan limits are certainly better."
Both GSEs saw their market share decline because they were not "quick enough to change their underwriting" to compete with the nontraditional products offered in the non-agency sector in recent years, Cecala says. Now, with higher loan limits, "they can just cherry-pick the best loans and have a bigger pond to do it in," he says.
Cecala notes that Freddie Mac has already announced it will charge an extra fee for jumbo loans that do not have at least a 700 credit score and a 25 percent down payment. "That is what we traditionally call super-prime," he says.
A source at Freddie Mac reports that there is a 25 basis point fee on jumbos with at least a 700 FICO® score and loan-to-value (LTV) of less than 75 percent. If the LTV rises above 75 percent, there is a 5o-basis-point fee, which rises to 100 basis points if there is a cash-out refi. If the loan is an adjustable-rate mortgage (ARM), the basic fee is 75 basis points if the LTV is less than 80 percent, with a i5O-basis-point charge if it's higher than 80 percent.
Cecala says the GSEs will also have an incentive to go after as much of the market as they can, because their fees are based on a percentage of the loan amount. "They'll make considerably more on a $700,000 loan than on a $200,000 mortgage," he says.
The reduction in the surplus capital requirement will make it easier for Fannie and Freddie to do even more jumbo business and to even hold some of it in their portfolio, according to Jha.
If they refocus more on jumbo loans, does it not run counter to their affordable-housing mission? "It does," says Cecala. "And that's the reason you're not going to hear them come out and say, 'This is fantastic,' " he says.
"But you do have to look at it from that standpoint. Who is going to benefit from the higher loan limit? It will not help anybody who is underwater with their mortgage, delinquent on it, or anybody else [caught up in the mortgage crisis]," he says. "The only hope [troubled borrowers] are going to have is that somehow FHA will loosen up their program enough so they can refinance into an FHA mortgage," says Cecala.
Fannie Mae President and Chief Executive Officer Daniel Mudd said on March 19 that the agency is "working with our customers, regulators and policy-makers to minimize foreclosures, increase affordability [and] restore liquidity in the market"-suggesting to some that some troubled borrowers might benefit from the efforts made to enable the GSEs to do more lending.
An 80 percent GSE market share in 2008?
Cecala predicts the share of the origination market represented by GSE mortgage products, which jumped from 36 percent in 2006 to 68 percent in the fourth quarter of 2007, will rise to 80 percent in 2008. Is there not a danger in that? "No question," Cecala says. "You have to wonder if somebody is looking at that."
He doesn't think policy-makers have considered the longrange ramifications of having the GSEs command such a dominant share. "We're so focused on the mortgage crisis and trying to give relief any way we can, we're not really looking at the long-term consequences of these trends," he says.
Prior to the mortgage meltdown, the country was, he notes, moving away from a federalized or government-related mortgage market with the rise of the non-agency RMBS market. Now the country has moved sharply away from that trend, with potential unseen dangers down the road, Cecala suggests.
"In 2010," he asks, "do we want to be a country that has a federalized mortgage market?" That seems inappropriate for an advanced nation with sophisticated financial markets. "It's the kind of development you would see in a Third-World country when you start to get credit [markets] developed," he says.
"Once you get up to an] 80 percent federalized mortgage market, it's [going to be] very hard to roll that back," Cecala predicts. "It's also going to discourage lenders, if it plays out the way I think it will," he adds, noting that Fannie and Freddie have dominated any market they have entered.
He asks, "If you're a portfolio lender and you're questioning making loans now at 1 percent above what Fannie and Freddie charge [for conventional, conforming loans], how are you going to compete if that 1 percent [differential] vanishes, and Fannie and Freddie can offer the same rate [to jumbo borrowers as it can for conforming loans]?"
Capital requirements
The same day OFHEO lifted the portfolio caps on the GSEs-Feb 27-Federal Reserve Chairman Ben Bernanke told the House Financial Services Committee, "We'd encourage [Fannie Mae and Freddie Mac] to raise capital to allow them to do more, and allow them to securitize more jumbo and conforming securities." Bernanke also encouraged banks to raise capital to allow them to do more lending.
OFHEO's Lockhart says he does not see any capital impediments to the ability of Fannie and Freddie to grow their business through securitization. The charge against capital for securitization is only 59 basis points, he notes. "They're certainly not constrained by that," he adds.
Lockhart points out the GSEs have been securitizing between $80 billion and $100 billion a month in conforming loans in the months since just after the mortgage meltdown began last August, and that the additional securitization that might occur from the higher loan limits is likely be a "relatively small percentage of that."
Of course, if the GSEs "wanted to put a lot in their portfolio, they are somewhat constrained by their capital," he says. Some of that constraint was reduced by the reduction in the capital surplus requirement.
Lockhart says he expects the GSEs to continue to grow their guarantee business rather than expand their portfolios, because they could provide more liquidity to the market at the least cost against their capital. The wild card in all this, he says, is the degree to which there might be refinancings [of any type loan], because borrowers could get a lower interest rate from Fannie or Freddie than they may have now.
When asked what it would take to remove the remaining 20 percent surplus requirement in capital that OFHEO has imposed on the GSEs, Lockhart answers, "We do have to be concerned in this kind of market that [the GSEs] do have a strong capital cushion." He notes that the GSEs have a capital base that is one-half to one-third of what is required of banks. "We do want to make sure, as we reduce the capital [cushion], that they are safe and sound as they perform and continue to have the cushion," Lockhart says.
After reducing 10 percentage points of the surplus capital requirement, OFHEO released a statement saying it "will remain vigilant in supervising the safe and sound operations of these companies, and will act quickly to address any deficiencies that may arise." The statement added, "Furthermore, we recognize the need to ensure that their capital levels are strong, protecting them from unforeseen risks as the market recovers."
With their current capital base, Lockhart says, the GSEs should have no problem doing additional securitizations somewhere "in the area of tens of billions [of dollars)" a month.
Should the GSEs be raising more capital? Says Lockhart: "What I have been saying, and continue to say, is that they are adequately capitalized at the moment. But I would have to agree with many people who suggest that in order to do a better job of supporting the market and the potential growth in the market, it would be helpful to have more capital," he says. The capital need not dilute shareholder value if it is taken as preferred capital, he adds.
Any potential [further] reduction in the surplus requirement will depend, Lockhart says, "on their continuing to make progress [in] completing their consent agreements." On March 18, OFHEO announced Fannie Mae had met all the terms of its consent agreement, while Freddie Mac lacked action on one item-dividing the position of chairman and chief executive officer into two positions.
Does OFHEO have a position on whether or not the higher loan limits should be permanent? No, says Lockhart. He notes that in the version of GSE reform that passed in the House, there is a permanent increase in the conforming loan limit. Lockhart says it would be better to have a single higher loan limit than to have varying limits in 250 counties, and indicates he would prefer a loan limit lower than the $729,725.
The Fed injects more liquidity
Restoring liquidity and an adequate supply of funding to the mortgage origination market has been one of the key objectives of much of the Fed's policy efforts since last August. Despite sharp reductions in the Federal Funds Rate in January and February, the turmoil in the debt markets-especially for short-term financings of almost any type-became more pronounced rather than less during February.
As signs of recession began to increase, including back-toback job declines of 22,000 in January and 63,000 in February, the stock markets sank to levels not seen since mid-2oo6. The falling dollar continued to sink against other currencies, oil prices rose ever higher and inflation began to rise above the 1 percent to 2 percent level targeted by the Fed. Market observers began to worry about stagflation.
What could policy-makers do? By late February, it seemed that lower interest rates and an economic-stimulus plan had not been successful at breaking up the debt market logjam and restoring even a small
measure of investors' loss of confidence.
The Fed returned to the drawing board and came up with yet another round of moves to improve liquidity. On Feb. 29, it announced it would conduct two auctions of 28-day credit-$30 billion each for a total of $60 billion-through its Term Auction Facility at the discount windows of the regional Feds on March 10 and March 28. The Fed also announced that it intends to conduct biweekly Term Auction Facilities "for as long as necessary to address elevated pressures in short-term funding markets." On March 7, ahead of the first auction slated for March 10, the Fed announced it was increasing the amount to be auctioned on March 10 and March 28 to $50 billion each, for a total of $100 billion.
Also on March 10, the Fed announced it would immediately initiate a series of weekly term repurchase transactions that eventually should cumulate to a total of $100 billion. The auctions, to be conducted by the New York Fed, are open to the Fed's so-called primary dealers, which include major banks and investment banking firms in New York. The primary dealers can obtain cash for 28 days under repurchase agreements in which the dealers can deliver as collateral any of a range of securities, including Treasuries, agency debt or agency mortgage-backed securities.
The stock market continued its slide in spite of the new efforts. On March 11, the Federal Reserve took additional steps to encourage banks to break the logjam of credit flow.
Before the markets opened on March 11, the Fed announced an expansion of its securities lending program, which had helped break previous credit freeze-ups that have roiled the market since last summer. Under a new Term securities Lending Facility, the Fed announced it would lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program). The Fed would offer Treasuries at a weekly auction beginning March 27 in return for a pledge of other securities from the primary dealers, including federal agency debt, agency RMBS (Fannie, Freddie and Ginnie) and, for the first time, non-agency AAA/Aaa-rated private-label RMBS that are not on watch for credit downgrades.
The addition of private-label non-agency RMBS greatly expands the types of instruments that could be pledged, and gives banks a lot more flexibility in how they can improve liquidity.
In a briefing with reporters, a senior Fed official said that the Term Lending Facility "can be selectively scaled up or down as needed." For example, if the Fed determines that more liquidity is needed, it can raise the amount it lends to primary dealers above $200 billion, the Fed official explained.
In the second initiative announced March 11, the Federal Open Market Committee (FOMC) authorized increases in its temporary currency swap lines with the European Central Bank (ECB) and the Swiss National Bank. The currency swaps began last summer, and had been set at $20 billion for the ECB and $2 billion for the Swiss National Bank. The two banks had opted out of the process Feb. 1, and funding had deteriorated.
The new agreement raises the swap level to $30 billion for the ECB and $6 billion for the Swiss National Bank, and extends the arrangement through Sept. 30. Other central banks that are part of the Group of 10 (G-io) central banks also announced on March 11 new and continuing interventions to provide liquidity, including the Bank of Canadaand the Bank of England. The Bank of Japan and the Riksbank (the central bank of Norway) issued statements welcoming the actions of the other G-10 central banks.
The response to the Fed's new Term Securities Lending Facility was mostly positive, including a healthy 416-point rally in the Dow Jones Industrial index on March 11-the biggest one-day gain since July 2002. "This was a major move by the Fed. For the first time, the Fed ... is on top of the curve," said David Jones, chairman of Investor Security Trust Co., Fort Myers, Florida, in a March 11 CNBC interview.
Stephen Stanley, chief economist with RBS Greenwich Capital, wrote in a note to clients sent out after the Fed announcement that the new facility is likely to have weekly operations up to $50 billion. "Their plan is somewhat better than Friday's [repurchase agreement], in that it directly addresses the situation in mortgage paper," Stanley wrote.
"Firms that were having difficulty financing their mortgage positions have been thrown a lifeline, though as with the [Term Auction Facility], given primary dealers' balance-sheet constraints, it is unclear whether non-primary dealers will have much luck getting the dealers to essentially lend them balance sheet by showing their mortgage paper into the [Term Securities Lending Facility] auctions," he continued. "Thus, if you are looking to identify winners and losers, the clear winners are the non-bank primary dealers. They were shut out of the discount window/TAF [temporary auction facility] process, so this is a lifeline that seems to be addressed specifically toward them," Stanley wrote.
"If the goal here is to stem forced liquidations of mortgage paper, then this should help for the time being-but it is unclear how much it helps anyone but dealers (and it certainly does not help if a firm's mortgage paper is not eligible as collateral because it is already encumbered by margin calls)."
Important to note, Stanley says, this effort does not address two core issues. First, he wrote, "Sure, they've refinanced for a month (at a price), but it does nothing to free up their balance sheets." This means it does not allow the companies to do more lending, presumably. Second, "the dealers still own the mortgages, even though it's financed for 28 days," he stated. "So if a AAA mortgage sinks 20 points in price over the intervening 28 days, the dealer-not the Fed-is responsible for the loss," he wrote.
Rumors prior to the announcement suggested the Fed might be buying agency debt and/or agency mortgage-backed securities outright, according to Stanley. The fact [that] the new initiative does not do this "appears to be a disappointment," Stanley wrote, noting any agreement to "bail out" Fannie and Freddie would be "a hard pill for the central bank to swallow." Will the Fed have to take the difficult step of buying mortgages or mortgage-backed securities? "Perhaps, if things get bad enough," Stanley said.
No sooner had the Fed put into place its new facilities than a big run on the bank at New York-based Bear Stearns & Co. Inc. on Friday, March 14, forced the investment banking firm to the edge of bankruptcy. Bear Stearns, because it is not a depository institution, was not eligible to go to the discount window for cash in return for securities, and would have to wait until March 28, as a primary dealer, to access the new securities lending facility.
The failure of Bear Stearns would, in turn, threaten the whole financial system, given its counter-party status and ties to other banks and financial institutions. Over the weekend, the urgency of the situation prompted the Fed to meet with New York-based JPMorgan Chase & Co. and Bear Stearns to work out the acquisition of Bear Stearns by JPMorgan for a fire-sale price of $2 a share for a company with a book value of $80 per share.
As an additional inducement, the Fed agreed to fund up to $30 billion of $38 billion of Bear Stearns' less liquid assets-and threw in a one-quarter-point decline in the discount rate for good measure. Finally, with an eye to preventing more runs on investment banks with illiquid assets, the Fed also took the unprecedented and extraordinary move of announcing that primary dealers (mostly investment banks) could go to the discount window to obtain cash for any investment-grade securities, which would include any security rated BBB or above. Further, the rate charged on these short-term loans would be the same as the discount rate, and increased the maximum term for all primary credits from 30 to 90 days.
This new Primary Dealer Credit Facility (PDCF) was available immediately, and by March 20 lending to primary dealers had reached $28.8 billion, according to a Fed report. While the Fed did not identify who had used the PDCF, New York-based Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Morgan Stanley each said they had begun to test the new lending mechanism.
The Bear Stearns deal-combined with all the other Fed initiatives to provide liquidity to investment banks-was announced late Sunday, ahead of the Monday opening of the Asian markets. While the Asian equities markets fell 4 percent to 5 percent, followed by a slightly smaller decline in Europe, the U.S. equities markets fell and then recovered to a slight gain at the end of trading on St. Patrick's Day.
On March 18, good earnings reports from Goldman Sachs and Lehman Brothers, combined with a 75 basis points decline in the Fed funds rate to 2.25 percent and a 75 basis point decline in the discount rate to 2.50 percent sent the Dow Jones Industrials up 420 points, raising hopes that the markets had found a bottom.
The Open Market Trading Desk at the New York Fed announced new details to the Term Securities Lending Facility (TSLF) March 20, after consultation with market participants. Importantly, the list of eligible securities was expanded to include agency CMOs and AAA/Aaa-rated commercial mortgagebacked securities. The offering size for the first TSLF auction on March 27 was set at $75 billion.
OFHEO Director Lockh applauded the latest moves by the Fed. "I think it was a very good move on their part. It did instill some confidence in the market," he says. Lockhart notes that spreads between mortgage securities and Treasuries-even those of Fannie Mae and Freddie Mac-had risen to "all-time highs" ahead of the announcement. But afterward, he says, "they came back pretty dramatically." Lockhart believes the markets had gone into a downward spiral and that the Fed moves caused the markets to "snap back from their over-reaction."
It was particularly helpful that the Fed Term securities Lending Facility included private-label securities, according to Lockhart. "It is useful to have a source of liquidity in that area," he says, noting that the declines in the pricing of AAA-rated private-label securities were an over-reaction to the mortgage crisis.
Can the Fed's move help the non-agency market come back? "Hopefully, this will be a start on that road," responds Lockhart. "We would very much like to see some of that come back in a much safer fashion than it was two years ago, with the underwriting much stronger." Lockhart notes that if Wall Street firms that deal in non-agency securities want to be able to sell them to Fannie and Freddie, any new issues of private-label RMBS would "have to be following the nontraditional mortgage and subprime guidance" put out by the bank regulators.
Despite all the efforts to rejuvenate the mortgage market and encourage more lending, there are concerns about the GSEs taking on a greater and greater share of the market. The bottom line remains that the temporary fixes may not accomplish enough. Further, they seem to carry within them the germ of future problems for the mortgage industry and the financial markets. The best possible outcome is a return of investor confidence with a crust of investor wariness about structured deals, along with the revival of a more sober non-agency securitization market that can demonstrate more discipline in structuring deals.
Despite all the efforts to rejuvenate the mortgage market and encourage more lending, there are
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