Author Archives: David Reiss

Mortgage Bankers Ask Permission to Hijack GSE Reform

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The Mortgage Bankers Association issued a concept paper that calls for a board of mortgage industry representatives to “have the authority to direct the scope and immediate priorities of the [Central Securitization] Platform’s development, and the capability to redirect resources from the GSEs’ back offices to aid the project.” (3) So, to be clear, the mortgage industry wants not only to (a) define the scope and activities of the Platform but also (B) tell Fannie and Freddie how to spend their money to do so.  As Christmas is still a ways away, let’s spend some time working through this industry wishlist in the concept paper, The Central Securitization Platform: Direction, Scope, and Governance.

To start, what is the purpose of this mysterious “Platform?” According to the FHFA, it is supposed to “streamline and simplify those functions that are commoditized and routinely repeated across the secondary mortgage market.”(Building a New Infrastructure for the Secondary Mortgage Market, 5-6)

The MBA is calling for the establishment of “a strong panel of industry representatives to guide the development of the Platform.” (1)

But here is where I become nervous: “this Platform is just one piece of a much larger puzzle that impacts borrowers, lenders and the market as a whole. For these reasons, it is critical to appoint an industry advisory panel with real authority over the Platform’s early development. FHFA should establish and convene this panel before any further development is undertaken.” (2, emphasis added) Moreover, the MBA “believes the Platform should ultimately be owned by the industry as a cooperative.” (2)

So we have an acknowledgement that the Platform impacts “borrowers” and “the market as a whole.” But we have a call for a board with real powers that is only made up of “industry representatives.” Where have I heard a similar story like this before?  Oh, the Mortgage Electronic Recording System (MERS), a system designed by the mortgage industry that has been consistently attacked by local government officials and borrowers.

For now, I am agnostic as to whether the Platform is a good idea or not. But I certainly do not believe that only the industry should have the power to define its “scope and activities” and I certainly don’t believe that the industry should have the power to spend Fannie and Freddie’s money to pursue its vision. There are a lot more interests at stake than just the special interests represented by the MBA.

 

 

Where’s Perry? Are Phannie and Freddie Busted?!?

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With all apologies to Perry the Platypus who stars in my sons’ favorite TV show, Phineas and Ferb, today I look at the complaint in Perry Capital, LLC v. Lew et al. Perry Capital has sued the federal government for destroying the value of Fannie and Freddie securities held by Perry and the investment funds it manages. In particular, the complaint (drafted by Theodore Olson and others at Gibson Dunn) states that

Perry Capital seeks to prevent Defendants from giving effect to or enforcing the so-called Third Amendment to preferred stock purchase agreements (“PSPAs”) executed by Treasury and the FHFA, acting as conservator for the Companies. The Third Amendment fundamentally and unfairly alters the structure and nature of the securities Treasury purchased under the PSPAs, impermissibly destroys value in all of the Companies’ privately held securities, and illegally begins to liquidate the Companies. (2)

The plaintiff alleges that the government’s actions violate the Administrative Procedures Act (APA) and the Housing and Economic Recovery Act of 2008 (HERA). The APA governs the decision-making procedures of federal agencies like Treasury and independent agencies like the Federal Housing Finance Agency (FHFA). HERA was passed at the outset of the financial crisis and governs the process by which Fannie and Freddie may be put into conservatorship. (I discuss the enactment of HERA in Fannie Mae and Freddie Mac and the Future of Federal Housing Finance Policy: A Study of Regulatory Privilege, which is also available on BePress.)

[Warning:  necessary but complex details follow.  Those who are not GSE geeks may skip to the end.]

After the two companies were put into conservatorship in 2008,

Treasury and the FHFA executed the PSPAs, according to which Treasury purchased 1 million shares of the Government Preferred Stock from each company, in exchange for a funding commitment that allowed each company to draw up to $100 billion from Treasury as needed to ensure that they maintained a net worth of at least zero. As relevant here, the Government Preferred Stock for each company has a liquidation preference equal to $1 billion plus the sum of all draws by each company against Treasury’s funding commitment and is entitled to a cumulative dividend equal to ten percent of the outstanding liquidation preference. The PSPAs also grant Treasury warrants to purchase up to 79.9% of each company’s common stock at a nominal price. (2-3)

 According to the complaint, the Third Amendment to the PSPA changed the way that profits would be distributed by the two companies:

Under the original stock certificates, Treasury’s dividend was paid quarterly in the amount equal to an annual ten percent of the Government Preferred Stock’s outstanding liquidation preference. In the Third Amendment, the FHFA and Treasury amended the dividend provision to require that every dollar of each company’s net worth above a certain capital reserve amount be given to Treasury as a dividend. . . . Treasury’s additional profits from the Third Amendment are enormous. (5)

This is a very complex case, and I will return to it in future posts.  For now, I would just flag some issues that may pose problems for Perry.

First, is this case ripe for adjudication?  Perry states that they will be harmed when the two companies liquidate, but they are nowhere near liquidation.  Will the harm Perry predicts necessarily come about? The claim that they are harmed as to their expected dividends is stronger. Yet Perry acknowledges that the PSPAs “explicitly prohibit the payment of any dividend to any shareholder other than Treasury without Treasury’s consent.” (16)

Second, to what extent is this matter governed by the APA? I am not an APA expert, and I am wary of second-guessing Olson’s complaint in a blog post. But I would note that the court may not find that the APA even applies in this case and may find that HERA governs this dispute on its own. And even if the APA applies, the court may give great deference to the decisions of Treasury and the FHFA.

Finally, does the language from HERA that Perry relies on really give it much to hang its hat on? I think the crux of Perry’s argument is that the Third Amendment “created new securities”  instead of changing the terms of existing securities. (24) If a court disagrees with Perry on this (and it seems like a bit of a stretch to me), the theory of the case will be severely weakened.

All of this being said, I would agree with Perry that the holders of the Private Sector Preferred Stock — particularly the holders that predate conservatorship — look like they are receiving a raw deal from the federal government.  Various regulations encouraged lending institutions to hold Fannie and Freddie preferred stock over other investments. Those incentives sure looked like an implied guarantee before the subprime crisis knocked Fannie and Freddie off their feet.

Bottom line: this dispute cannot be settled in a late night blog post.  We’ll have to wait and see if Agent P can pull off what may be his most difficult mission yet.

Ain’t Misrepresentin’

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According to Wikipedia, the performers in the musical Ain’t Misbehavin’ “present an evening of rowdy, raunchy, and humorous songs that encapsulate the various moods of the era and reflect” a “view of life as a journey meant for pleasure and play.” In U.S. RMBS Roundtable: Arrangers And Investors Discuss The Role Of Representations And Warranties In U.S. RMBS Transactions, S&P does something similar with securitization. It presents the views of industry players as they try to predict and shape the future of the recently emerging private-label RMBS market, in the hopes of “achieving a healthy and sustainable RMBS market.” (2)

ACT I:  Lookin’ Good but Feelin’ Bad

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The piece contains a lot of important insights, including the following point made by investors: “standardizing R&Ws would be a step towards improving the transparency and their ease of understanding. Smaller investors noted that they can be particularly limited in distinguishing R&Ws given the complexities involved.” (3)

This point encapsulates in so many words the classic market for lemons problem, famously formalized by George Akerlof.  The lemon problem leads us to ask how a buyer is to price a purchase where the buyer has less information about the product than the seller.  Because of this information assymetry, the purchaser will assume the worst about the product and offer to buy it with that in mind.

R&Ws are an attempt to overcome that problem because the RMBS arranger or the mortgage originator promises to compensate the investor for lemons that are contained with a mortgage pool securing an RMBS. Consistent with that view, investors noted that “they expected to be compensated for losses caused by origination defects, rather than legitimate life events.” (2) In other words, origination defects are the lemons that should be borne by the arranger/originator with its superior information about the mortgages. And “legitimate life events” represent the credit risk that the investors have signed up for.

ACT II:  That Ain’t Right

Arrangers and originators made the following points:

  1. [o]ne arranger indicated that the R&W process should be governed only by the contractual obligations negotiated for each deal. (2)
  2. [o]riginators have strict underwriting guidelines and said they take great care to follow those procedures before issuing a loan. Arrangers are also currently subjecting all or almost all loans to a third-party due-diligence review. (2)
  3. arrangers said that standardizing R&Ws will not be an easy task as differences between arrangers and product types will limit the degree to which R&Ws can be homogenized. (3)

These points clearly align with the interests of the seller in a market for lemons.  To restate them a bit, 1. caveat emptor; 2. arrangers and originators don’t sell lemons (!); and (3) it is too hard to come up with provisions that consistently protect investors so don’t bother trying.

ENCORE:  Find Out What They Like

S&P notes that there “was broad agreement that one of the keys to achieving a healthy and sustainable RMBS market is aligning the interests of arrangers and investors.” (2) From that broader perspective, S&P is right that the industry should work toward a state of affairs that “minimizes the cost of unknown risks and ultimately reduces losses and related litigation.” (2) Given the spate of lawsuits over reps and warranties, we had fallen shy of that mark in the past (here, for example).  It remains to be seen if the industry can get it better next time and if the incentives are aligned enough to do so.

 

FHA Whitewash, Redux

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Richard Brooks and Carol Rose have recently published their book Saving the Neighborhood:  Racially Restrictive Covenants, Law, and Social Norms.  This well-written book brings to mind my recent post on the FHA Whitewash which reviewed a recent paper by HUD-affiliated researchers.  The paper minimized the role that the FHA played in furthering housing discrimination.  I mentioned that Kenneth Jackson’s classic book, Crabgrass Frontier, documented this sorry chapter of the FHA’s history.  Saving The Neighborhood covers some of the same ground, but from a legal and legal history perspective.  By doing so, it adds depth and texture to the historic record.

The book makes clear just how much of a role the FHA played.  The FHA’s

Underwriting Manual reflected private developers’ and brokers’ views of the kinds of features that made housing values stable and secure. Those features clearly included racial segregation.  In a section on “Protection from Adverse influences,” the Manual stated bluntly that “[a] change in social or racial occupancy generally leads to instability and a reduction in values” (par. 233). Thus property evaluators were to investigate the surrounding areas for the presence of “incompatible racial and social groups” and to assess whether the location might be “invaded” (par. 233). The Manual specifically noted that deed restrictions on “racial occupancy” could create a “favorable condition” (par. 228). in the section on subdivisions that were still in the development stage, the Manual recommended deed restrictions that included, among other matters, “. . . (g) Prohibition of the occupancy of properties except by the race for which they are intended” (par. 284(3)). (109)

The authors argue that these preferences gave developers, even those who did not favor segregation, an incentive to employ racially restrictive covenants in their projects. (110)

The FHA’s record of racial discrimination during the first few decades of its existence is clear, for all to see.

Assignment Ball and Chain

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An undated Nationwide Title Clearing, Inc. “White Paper” (actually, more of an advertorial), Understanding Current Assignment Verification Practices, is making the rounds of the blogosphere. It opens,

The scrutiny of the completeness of collateral review and valid assignment chains has hit the mortgage industry hard, primarily because the industry went from  a securitization process that didn’t  require assignments to be recorded to a heavily scrutinized process requiring complete chains to be recorded at the county. This has made compliance extremely difficult for many lenders and others, especially because the industry went for so many years without this  level of scrutiny. (1)

I’ll say!

This widespread lack of assignments could have negative consequences under the REMIC Rules. This is particularly a concern if it undercuts claims by purported REMICs that they acquired mortgages within the time required by statute.

I also found this passage intriguing:

just because a loan is supposed to be in MERS doesn’t always mean it is. We’ve found many examples of loans never having been assigned to MERS on land record, as well as loans that have been assigned multiple times out of MERS by prior investors/servicers, I would assume due to a poor review and preparation process . . ..(4-5)

I am not sure how courts would unwind such transactions. But I am sure we will find out . . ..

Thrilla in Vanilla: Freddie v. Jumbo

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Kroll BondRatings issued an RMBS Commentary, Mortgage Credit Trends:  Freddie Mac vs. Prime Jumbo. This commentary is important because it offers some help in evaluating the proposed “risk sharing” securitizations that Fannie and Freddie are considering. It is also important because if compares plain vanilla agency issues with comparable private label jumbos as well as not-so-comparable limited doc jumbos.  The differences are revealing.

Kroll’s key findings are

  • Freddie Mac default and loss rates were much higher for vintages that experienced severe home price declines. The worst vintage was 2007, which experienced an estimated aggregate home price decline in excess of 18% with 12.3% of the original vintage balance liquidated to date.
  • A rapid and significant improvement in credit characteristics sharply curtailed Freddie Mac mortgage liquidation rates, which fell from 8.3% for the 2008 vintage to 0.9% for the 2009 vintage.
  • Current Freddie Mac originations continue to be of very high credit quality, with a weighted average (WA) FICO score of 767 and a WA loan-to-value ratio (LTV) of 70% for the 2012 vintage.
  • Credit performance of jumbo prime mortgages and Freddie Mac mortgages is highly comparable when controlling for characteristics such as FICO, LTV, balance, and income and asset documentation. (2)

I am most interested in the last finding. While Kroll controlled for many characteristics, the fact remained that Freddie, as a general rule, allows for fewer high risk characteristics like low doc loans and high CLTV [combined loan to value]. For instance, almost all of Freddie’s loans were full doc while about half of the private label loans were low doc. So, while Kroll appears to be correct in stating “that the credit analysis tools developed for analyzing jumbo prime loans can be productively applied to agency mortgages,” we should not take that to mean that the two products are effectively the same. (7)

 

State of the Nation’s Housing 2013: Build It and They Will Come

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The Joint Center for Housing Studies of Harvard University released The State of the Nation’s Housing 2013.  As always there is much of interest in this annual report. I was particularly intrigued by Figure 21 on page 20, “The Government Continues to Have an Outsized Footprint in the Mortgage Market.” The report states

Despite efforts to entice private capital into the mortgage market, the GSEs and FHA continue to back the vast majority of loans(Figure 21). In 2001, loans securitized into private-label securities or held in bank portfolios accounted for nearly half of loan originations. Their market share rose to about two-thirds at the height of the housing boom before retreating to the low single-digits. Beginning in 2009, government-backed loans have accounted for roughly 90 percent of all originations. While the private securities market was still moribund in 2012, portfolio lending by banks showed its first substantial increase in years (albeit to a modest level), bringing the government share down slightly. (20-21)

As Fannie and Freddie return to profitability, policymakers are acting as if only the government can provide credit to the residential mortgage market, but from Figure 21 we can see that over a relatively short time period, capital can meaningfully shift from the secondary market (private MBS) to the government (FHA, Fannie and Freddie) to the primary market (portfolio lenders). Instead of assuming that the present structure is the best of all possible worlds, we should design the system we want and incentivize capital to find it.

Build it and they will come.