Mortgage Banking
December 2008
An exclusive interview with the head of the new oversight agency for Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
By Robert Stowe England
Since July 30, James B. Lockhart III has been the director and chairman of the oversight board of the Federal Housing Finance Agency (FHFA)-the new regulator of Fannie Mae and Freddie Mac, as well as the 12 Federal Home Loan Banks.
In September, FHFA put both Fannie and Freddie into conservatorship at the same time that the federal government took a 79.9 percent share ownership of each. Also at this time, the Treasury Department agreed in a preferred stock facility to provide up to $100 billion to each of the government-sponsored enterprises (GSEs) as capital to guarantee that each would continue to have positive net worth, even in the face of huge write-offs.
FHFA, which officially launched Oct. 27, has the mission of ensuring the capital adequacy and safety and soundness of the two GSEs as well as the Federal Home Loan Banks. A new Web site was also launched at www.fhfa.gov.
The new FHFA combines the Office of Federal Housing Enterprise Oversight (OFHEO), which formerly regulated the safety and soundness of Fannie Mae and Freddie Mac; the Federal Housing Finance Board, which regulated the 12 Federal Home Loan Banks; and the Department of Housing and Urban Development's (HUD's) GSE mission oversight team.
Like Fannie and Freddie before the government takeover, the FHLBanks are privately capitalized government-sponsored enterprises. The FHLBanks finance loans for home mortgages and other community lending activities.
From May 2006 to Oct. 27, Lockhart headed OFHEO, where he called for new legislation to provide stronger oversight of the GSEs. From 2002 to 2006, he served as the deputy commissioner and chief operating officer of the Social Security Administration, 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 one-on-one in late October and again in early November.
Q : How would you describe the effect so far of the government rescue of Fannie Mae and Freddie Mac on the availability and pricing of mortgage credit? What is your outlook for both credit availability and mortgage rates?
A : First of all, I guess the key thing is that if we hadn't put them in conservatorship, the impact at this point would be extremely adverse because they were at the point where they would actually start to pull back. And they were actually starting to sell their portfolio out, and it was going to have an extremely negative impact.
The conservatorship itself has been positive in my view, and certainly you [could] see that in the first week or two. But since then, there have been so many other moving pieces; it's hard to say what the impact has been on the mortgage market. Our view is that as the dust settles and people understand all these changes, then we'll start to see mortgage spreads starting to shrink again and then mortgage rates come down.
Q : And in terms of credit availability, have the GSEs expanded their market share? They had slipped some in the summer.
A : Effectively what's happened, when you look at it, Fannie and Freddie and FHA [the Federal Housing Administration] are really the providers of mortgages at this point in this country-and what's really happened is that mortgage share has gone from Fannie and Freddie [over] to FHA as [Fannie and Freddie] raised some of their fees and tightened their credit [underwriting]. At this point, as you know, they decided not to increase . . . their adverse market fees-they were going to double from 25 basis points to 50 basis points. They decided not to do that and they are relooking at their credit lines, if you will, to see where it makes sense to make changes. They still have a very big market share.
Q : You say that part of their share has been lost to FHA?
A : The reason their market share has come down is that FHA's share has gone up. [FHA's market share] has gone up a couple of percent to 15 percent, and so that's really what's happening, to the extent they are losing market share-and not a lot, but they are losing some. They were 80 percent and they are probably somewhere below that now, but still they've conquered the mortgage market.
Q : To what extent has the conservator-the Federal Housing Finance Agency-been able to look more closely at the holdings of Fannie and Freddie, which is something that you have wanted to do in the past? What are you finding in those holdings? Are there any unforeseen problems there?
A : [W]e have been very close to them for the last so-many years, [so] we had a pretty good understanding of their holdings. I don't think there have been any big surprises. Before we put them into conservatorship, we did a very intensive review of the portfolios and their credit exposures.
Q : You've mentioned that one of the two GSEs was on the verge of selling some of its assets.
A : Well, [one of them] did. You can see actually in the monthly reports that Freddie peaked at $800 billion [in portfolio holdings in July), and in its most recent report [for September] it was $737 billion. It got lower than that in September. They actually had started to sell for capital reasons; neither firm was able to raise additional capital. And without that additional capital, as they were taking losses, the natural result was going to be the need to shed assets, which would have just been the wrong thing to do in this marketplace.
Q : But now they are able to expand their portfolios?
A : They have the ability under the preferred stock agreement [with Treasury] to increase their portfolios, both to $850 billion, and they certainly have that capability. And they are slowly both building their portfolios now and are taking advantage of when they think it is appropriate to go out and buy their own mortgage-backed securities [MBS], basically.
Q : So it is the inflow of new capital from Treasury that allows them to do that?
A : The new facility allows them to do that, yes. The senior preferred facility is an agreement by Treasury to provide capital up to $100 billion [to each of the GSEs]. It's an agreement to keep them in a positive net-worth [position]. So, anytime they show [that their] net worth went negative, Treasury will put money in. And that's a long, long-time commitment because it's really a commitment to support [agency] debt outstanding today and also any debt that they borrow in the future. So, yes, there's $100 billion of committed capital there from the Treasury Department.
Q : Have they had to use that capital yet?
A : At this point [mid-November] they have not.
Q : The Treasury's rescue package for Fannie Mae and Freddie Mac also incorporates the promise of additional purchases of mortgage-backed securities by Treasury. Does any of that go to purchase assets from the portfolios of Fannie and Freddie?
A : Well, there's a couple different things. At the time we put them into [conservatorship], there were really three facilities that Treasury offered the GSEs. One is the senior preferred we just talked about [of $100 billion each]. Another was the liquidity facility, which is basically a secured lending mechanism, almost like going to the Fed discount window where they could bring in securities and borrow against them. And that's an unlimited facility and it's not only Fannie and Freddie, but it's for the Federal Home Loan Banks. And then there was a third facility, which the Treasury has put into place and hired investment managers to manage a portfolio of mortgage-backed securities issued by Fannie and Freddie. And they've been actively buying those securities. So, not only are Fannie and Freddie buying their own securities, but the U.S. Treasury is as well.
Q : There seems to be a lot of volatility in spreads between Fannie and Freddie's and Treasuries. Could you comment on that? [See Figure l.]
A : Per Freddie's weekly survey, [you can see] the start of the problem last year in July-the spread between [five-year] Treasuries and [Fannie and Freddie securities]. And it was about a 153-basis-point [spread in July 2007], and now it's over 350 basis points. It actually got up to 390 in the Bear Stearns [& Co. Inc. ] days [in March 2008 that ended in the emergency acquisition of that company]. [W]e need to get the spread to come back to more normal levels and get those mortgage rates down, so we can start to allow refinancings and hopefully stabilize house prices.
Q : If that spread were to return to normal, we would see much lower mortgage rates?
A : Dramatically lower. The chances of that happening are not large in the near term, but we can start to chip away at that. A lot of that is the fear factor and confusion about what is going on in the marketplace. [Rates will come down] to the extent over time we rebuild some confidence in this market-rebuild confidence in both Fannie and Freddie, but also rebuild confidence in the mortgage market overall.
And it's not just a Fannie and Freddie phenomenon. Ginnie Maes are trading pretty closely to Fannie and Freddie even though they have the full faith and credit [of the U.S. government [see Figure 2].
Q : That is kind of amazing when Ginnie Mae securities are explicitly government-backed.
A : Ginnie Maes have the full faith and credit [of the U.S. government], and obviously my view is that Fannie and Freddie are effectively guaranteed because of this senior preferred [facility with Treasury.] The ability to always have a positive net worth from the U.S. Treasury is, to me, the equivalent of a guarantee. But it is not written on paper the way Ginnie Maes are. But, as you can see [from the spreads], normally there is a reasonable spread between Fannie and Freddies and Ginnies-but it has become very tight.
Q : And yet we are still seeing the flight to quality from all around the world into U.S. Treasuries?
A : Yes, but it's not flowing into [government-backed mortgage securities]. [This can be explained in part because] there's obviously some supply issues that we were talking about. There are a lot more Ginnies being issued because of [FHA's expanding market share]. But there's just this concern out there and confusion that will take a little while to work its way through. Hopefully, over six or 12 months we will get [spreads] back to normal.
Q : Haven't rates come down from higher levels earlier this year?
A : Mortgage rates have been fluctuating-down one week, up one week. If you go back [to the spread data], you can see that when we put [Fannie and Freddie] into conservatorship the rates dropped pretty dramatically [in early September]. Then [in October during the global financial crisis] they spiked back up, and now they've come back some. I don't think until we see some of this spread factor go away, it's not going to happen.
Q : If Fannie and Freddie had not been rescued, what would we be seeing in terms of rates?
A : My view is that if they had not been put into conservatorship, the mortgage market would be in a much different situation.
Q : A worse situation?
A : Much worse, yes.
Q : What mandates have you given to the new executive teams at Fannie and Freddie, and how closely do you monitor the decisions of the executive teams, and how is that done?
A : We have hired new CEOs [Herbert Allison, president and CEO at Fannie Mae; and David Moffett, CEO at Freddie]. They have hit the ground running. They are very actively managing the companies. We have delegated significant amounts of responsibility.
We have chosen new non-executive chairmen [Philip A. Laskawy at Fannie and John A. Koskinen at Freddie], and they are reconstituting the boards. They are going to keep a few members from the previous boards and get some new members.
And so, to a large extent, it's business as usual. But we certainly spend a lot more time working with this set of new CEOs than we did with the last set of CEOs. And we're looking at things like how [the companies] are impacting the mortgage market. It's certainly a concern of ours, given the importance of the mortgage market to the U.S. and the world economy, that we try to take steps to help this mortgage market recover.
So, they've been looking at pricing. They've been looking at their credit standards. They've been looking certainly at the whole loan-modification area. [We are] talking about what they are doing in loan modifications, and how to be more effective in preventing foreclosures. So, there's certainly a very robust dialogue going on [between the executive teams and FHFA], with the idea of how to help this mortgage market, and ultimately to bring down mortgage rates and slow the fall in housing prices.
Q : One role Fannie and Freddie used to play was to purchase some of the private-label mortgage-backed securities. That market doesn't exist today, as far as I know.
A : There's certainly not a lot of issuance. There's maybe some on the commercial and multifamily side, but not the traditional subprime or alt-a private-label securities.
Q : And the jumbo prime private-label securities.
A : And not a lot of that is happening, either. The private-label market is pretty much frozen. [The GSEs] have not been buying and we are not encouraging them to buy anymore. They are sitting on close to $180-something billion in private-label securities in subprime and alt-A, which is the problem area.
Of that $700 billion [financial market rescue] facility, the first $250 billion is slated for banks and financial institutions. [By Nov. 1, Treasury had completed $115 billion in capital purchase transactions in eight institutions, with another $10 billion purchased in Merrill Lynch pending its merger with Bank of America]. But there are going to be other components of that facility.
Q : At this point, what capital constraints exist on the ability of Fannie and Freddie to lend?
A : I would argue that they do not have capital constraints. The senior preferred facility does give them that ability to raise $100 billion if they need it. Just to put that in context, that's about three and a quarter times' the present statutory capital requirements.
Obviously, the present statutory requirements were too low, and that's one of the reasons we had to put them into conservatorship. But still, we're talking about a significant amount of capital that is available if you need it. Again, it creates an effective guarantee of their debt, mortgage-backed securities and even subordinated debt, which is one of the reasons we have now lifted the capital requirements. We're not holding them to the minimum requirements at this point. We are effectively relying on the Treasury facility.
Q : So, the additional capital you had been requiring is no longer required?
A : There are triggers that happen when you breach minimum capital, and we have suspended that effectively. That's the best way of putting it. So, we're not constraining their ability by those potential actions.
Q : So, really, they could meet all the demand out there, in terms of funding refinancing and home purchases?
A : They certainly have the capability with $100 billion of capital, if needed-and hopefully it wouldn't be needed, and certainly under any stress scenario we've run, it comes nowhere near $100 billion. Yes, they have the capital to effectively meet the demand for the foreseeable future. Obviously, to do that they [would] have to be able to continue to borrow and issue mortgage-backed securities. But, again, those securities have effectively a guarantee of the United States government.
Q : Where do you think we are in the housing cycle? We've had three mildly encouraging reports in recent months-existing-home sales and new-home sales, as well as the Case-Shiller Index showing price gains in some markets.
A : You know, it's hard to project-and we don't project. That's the simplest answer. My personal view is that we're reaching for a bottom, but that bottoming process may take many, many months. Whether we've started now or not, we all can be hopeful. There are certainly some signs of that. A key thing will be the return of liquidity to the banking system through the TARP [Troubled Asset Relief Program] facility, the continuing ability of Fannie, Freddie and [Ginnie Mae] to support the secondary mortgage market and hopefully bring down rates over time.
Q : You are also now overseeing the Federal Home Loan Banks. They are also expanding their activities. What can you tell us about that?
A : Yes, they expanded very rapidly since June of last year, again, when the turmoil started to happen. They've grown their advances, which are secured loans to banks, by 60 percent, and they just recently hit the trillion-dollar mark for advances to banks.
Q : Where did they stand back in June 2007?
A : They stood at about $640 billion or so.
Q : Explain how the secured loans of the Federal Home Loan Banks help to expand mortgage credit.
A : Banks bring in collateral-it can be mortgages, but it also can be securities-and [the Federal Home Loan Banks] can lend [to participating banks] against it. And they've had a dramatic growth both in the traditional bread-and-butter business, which is community lending, but also regional banks, and also the big money-center banks are big borrowers. Their top-10 borrowers represent about 40 percent of their book [of business]. And that would be all the big banks.
Q : It is amazing that $1 trillion can be lent by the FHLBs and it generates so little notice in the financial or general press during this time of global financial crisis.
A : The [Federal Home Loan Banks] play a very interesting role. They have what I call countercyclical capital. When you take out an advance at a bank, you effectively had to provide [new and additional] capital. It averages around 4 percent. If you are increasing your advances, you are also putting equity capital into the bank. So, that allows it to fulfill its role in this kind of marketplace. And they've been very effective at doing that. One of the things I've been talking about over the last year as we went through reform is the idea of trying to create some countercyclical capital structure for Fannie and Freddie as well.
Q : So Fannie and Freddie would be accepting assets in return for extending loans to participating financial institutions?
A : We haven't really worked out how it will happen. But it's something we have to think about going forward-if [Fannie and Freddie] are going to continue to play this role [of stability and liquidity], they need to be much more of a countercyclical force. What happened was, and what was going to really happen was, they were not going to be able to play that role of stability and liquidity in this marketplace as their capital got eroded. Going forward, we have to think about how do you have enough capital to help ride out these fluctuations [in credit cycles]?
Q : Will this make Fannie and Freddie more like banks?
A : Who knows exactly, but certainly one would look at the banking model, one would look at the federal home loan model, one would look at some other countries [that] have some more countercyclical structures built into their banking sector. But it's something we'll be looking for as we are required to put out a regulation on minimum capital [and as] we are required to put out a regulation on risk-based capital, [and] we'll be doing [a regulation] on their portfolios.
Q : How long is your term?
A : At OFHEO, I had a five-year term and I was about halfway through [that term]. With the new law, I became director of FHFA and I will be the director until the [new] president nominates and the Senate confirms a successor - so there is no term. But, on the other hand, it doesn't run out on Jan. 20 like everybody else [in the Bush administration].
Q: On Oct. 27, it was announced that the entity known as FHFA had been publicly launched. What exactly did that mean - that the agency had been launched?
A : What it means is effectively we have now put the teams [from OFHEO, the Federal Housing Finance Board and HUD] together. We had a year to do that under the legislation. We moved quick- ly toward one personnel system, one accounting system, having the one fully integrated agency. And it's moved very quickly. I've been extremely pleased, considering all the other activities that have been going on in this marketplace, that our team has been able to pull it together.
Q: What was in existence at FHFA before Oct. 27?
A : For the [first] three months, there was just one employee - and that would be me. [After Oct. 27], basically, there are no longer any employees of OFHEO or the [Federal Housing] Finance Board, and we're pulling people from HUD as well.
Q : From where in HUD?
A : There was a group in HUD that worked on the mission regulation of Fannie and Freddie. There were some lawyers . . . there were actually two or three different groups. Some of them worked for [FHA Commissioner] Brian Montgomery and some worked on the policy side.
Q: Do you have a rough idea of how many people are now consolidated under the FHFA umbrella and whether that number is expected to grow?
A: FHFA has approximately 400 employees now. The budgeted number for fiscal year 2009 is 448.
Q : What is your expectation for how Fannie and Freddie will fare under conservatorship?
A: Obviously this has been a tough market and there has been some confusion, but it is really critical that Fannie and Freddie continue to play their role of providing stability and liquidity. That's why we put them into conservatorship. That's why Treasury did those three facilities. As the dust settles, my belief is that they will do just that.
END
Copyright © 2008 Mortgage Bankers Association of America. Reprinted with Permission
