Tag Archives: FHA

Frannie Reps and Warranties Crisis Brewing

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The Inspector General of the Federal Housing Finance Agency released an audit, FHFA’s Representation and Warranty Framework. Reps and warranties are a risk-shifting device that sophisticated commercial parties use in transactions. If a party makes a representation or warranty that turns out to be false, they other party may have some remedy — maybe the ability to return something or to get some kind of payment to make up for the failure to live up to the promise.

For instance, a lender may sell a bunch of mortgages to a securitizer and represent that all of the borrowers have FICO (credit) scores of 620 or higher. If it turns out that some of the borrowers had scores of less than 620, the securitizer may be able to make the lender buy back those mortgages pursuant to a rep and warranty clause. The IG undertook this audit because of recent changes to the reps and warranties framework for Fannie and Freddie. Before these changes were implemented,

the Enterprises’ risk management model primarily relied on reviewing loans for underwriting deficiencies after they defaulted as the representations and warranties were effective for the life of the loans. In contrast, the new framework transfers responsibility to the Enterprises to review loans upfront for eligible representation and warranty deficiencies that may trigger repurchase requests. If the Enterprises fail to do so within the applicable period, their ability to pursue a repurchase request expires if it is based upon a representation and warranty that qualifies for repurchase relief. (2)

The IG’s findings are disturbing. It “found that FHFA mandated a new framework despite significant unresolved operational risks to the Enterprises.” (3) It also found that

FHFA mandated a 36-month sunset period for representation and warranty relief without validating the Enterprises’ analysis or performing sufficient additional analysis to determine whether financial risks were appropriately balanced between the Enterprises and sellers. Freddie Mac, in contrast to Fannie Mae which provided analysis limited to a 36-month period, provided FHFA with the results of an internal analysis of loans that indicated loans with a 48-month clean payment history were significantly less likely to exhibit repurchaseable defects than loans with a 36-month clean payment history. Thus, losses to the Enterprise could be less with a longer sunset period. Therefore, FHFA cannot support that the sunset period selected does not unduly benefit sellers at the Enterprises’ expense. (3)

This is all very technical stuff, obviously. But it is of great significance. Basically, the IG is warning that the FHFA has not properly evaluated the credit risk posed by changes to the agreements that Fannie and Freddie enter into with the lenders who convey mortgages to them. It also implies that this new framework “unduly” benefits the lenders.

The FHFA’s response is unsettling — it effectively rejects the IG’s concern without providing a reasoned basis for doing so. Its express rationale for doing so is to avoid “adverse market effects” and because addressing the IG’s concern “may not align with the FHFA objective of increased lending to consumes . . ..” (32)

Whenever federal regulators place increased lending as a priority over safety and soundness, warning bells should start ringing. Crises at Fannie and Freddie (and the FHA, for that matter) begin with this kind of thinking. Increased lending may be important today, but it should not be done at the expense of safety and soundness tomorrow. We are too close to our last housing finance crisis to forget that lesson.

Hope for Housing Finance Reform?

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The former Acting Director of the Federal Housing Finance Agency, Edward Demarco, has issued a short policy brief from his new perch at the Milken Institute’s Center for Financial Markets.While there is nothing that is really new in this policy brief, Twelve Things You Need to Know About the Housing Market, it does set forth a lot of commonsensical views about the housing markets. I do take issue, however, with his optimism about the structural improvements in the housing finance sector. He writes,

The crisis showed that numerous structural improvements were needed in housing—and such improvements have been under way for several years. Poor data, misuse of specialty mortgage products, lagging technologies, weak servicing standards, and an inadequate securitization infrastructure became evident during the financial crisis. A multi-year effort to fix and rebuild this infrastructure has been quietly under way, with notable improvements already in place.The mortgage industry has been working since 2010 to overhaul mortgage data standards and the supporting technology. New data standards have emerged and are in use, with more on the way. These standards should improve risk management while lowering origination costs and barriers to entry.

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Structural improvements will take several more years. A new securitization infrastructure has been in development for more than two years. This ongoing work should be a cornerstone for the future secondary mortgage market. Other structural improvements will include updated quality assurance (rep and warrant) systems for the Federal Housing Administration, Fannie and Freddie, revamped private mortgage insurance eligibility standards, and completion and implementation of remaining Dodd-Frank rulemakings. (2)

DeMarco himself had led the charge to develop a common securitization platform while at the FHFA, so I take care in critiquing his views about structural change. Nonetheless, I am worried that he is striking too optimistic of a note about the state of Fannie and Freddie. They have been in a state of limbo for far too long (which DeMarco acknowledges). All sorts of operational risks may be cropping up in the entities as employees sit around (or walk out the door) waiting for Congress to act. I think commentators should be striking a far more ominous tone about our housing finance system — something this big should not be treated as an afterthought by our elected officials.

Insuring Mortgages Through the Business Cycle

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Mark Zandi and Cristian deRitis of Moody’s, along with Jim Parrott of the Urban Institute, have posted Putting Mortgage Insurers on Solid Ground. They wrote this in response to the Private Mortgage Insurance Eligibility Requirements set forth by the FHFA. While generally approving of the requirements, they argue that

Several features of the rules as currently written, however, would likely
unnecessarily increase costs and cyclicality in the mortgage and housing markets.
With a few modest changes, these flaws can be remedied without sacrificing the
considerable benefits of the new standards. (1)

I would first start by reviewing their disclosure:  “Mark Zandi is a director of one mortgage insurance company, and Jim Parrott is an advisor to another. The authors do not believe that their analysis has been impacted by these relationships, however. Their work reflects the authors’ independent beliefs regarding the appropriate financial requirements for the industry.” While, I understand that the authors believe that their views are not impacted by their financial relationships with private mortgage insurers, readers will certainly want to take them into account when evaluating those views.

The authors argue that FHFA’s requirements are procyclical, that is they become more burdensome just as mortgage insurers are facing a distressed environment. This could contribute to a vicious cycle where mortgage credit tightens because of regulatory causes just when we might want credit to loosen up. This is certainly something we should look out for.

They also argue that the FHFA’s requirements will increase mortgage insurance premiums unnecessarily because they increase capital reserves too much. I find this argument less compelling. The Private Mortgage Insurance industry has typically done terribly in distressed environments from the Great Depression through the 2000s. Not only have there been failures but they have also reduced their underwriting of new insurance just when the market was most fragile.

But there are certain shaky assumptions built into this analysis. For instance, they argue that Private Mortgage Insurance companies will need to maintain their historical after-tax return on capital of 15%. But if the business model is shored up with higher capital reserves, investors should be satisfied with a lower return on capital because the companies are less likely to go bust. That is, instead of increasing premiums for homeowners, it is possible that higher capital requirements might just reduce profits.

The authors write that while “the increase in capital requirements is clearly warranted, there are certain features of the requirements as currently drafted that will increase mortgage insurance premiums unnecessarily, running counter to the aim of policymakers, including the FHFA, to encourage greater use of private capital in housing finance.” (2-4) Policymakers have lots of goals for private mortgage insurance, including having it not implode during down markets. An unthinking reliance on private capital is not what we should be after. Rather, we should seek to promote a thoughtful reliance on private capital, taking into account how we it can best help us maintain a healthy mortgage market throughout the business cycle.

Reiss on $17 Billion BoA Settlement

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Law360 quoted me in BofA Deal Shows Pragmatism At Work On Both Sides (behind a paywall). It reads in part,

Bank of America Corp.’s $16.65 billion global settlement over its alleged faulty lending practices in the run-up to the financial crisis may have made bigger waves than recent payouts by JPMorgan Chase & Co. and Citigroup Inc., but attorneys say the deal still represents the best possible outcome for the bank and for federal prosecutors, who can now put their resources elsewhere.

The settlement, inked with the U.S. Department of Justice, Securities and Exchange Commission, the Federal Housing Finance Agency, the Federal Deposit Insurance Corp., the Federal Housing Administration and the states of California, Delaware, Illinois, Kentucky, Maryland and New York, released most of the significant claims related to subprime mortgage practices at Countrywide Financial Corp. and investment bank Merrill Lynch, both of which Bank of America picked up during the crisis.

Although the hefty price tag, which includes $7 billion in consumer relief payments and a record $5 billion in civil penalties, is nothing to balk at, the settlement will help Bank of America avoid a series of piecemeal deals that could stretch out over a much longer period without the prospect of closure, according to Ben Diehl of Stroock & Stroock & Lavan LLP.

“They want to start being looked at and considered by the market, their customers and regulators based on what they are doing today, in 2014, and not have everything continue to be looked at through the perspective of alleged accountability for conduct related to the financial crisis,” said Diehl, who formerly oversaw civil prosecutions brought by the California attorney general’s mortgage fraud strike force.

And the bank isn’t the only one looking for closure, according to Diehl.

“It’s in a regulator’s interest as well to be able to look at what is currently being offered to consumers and have a dialogue with companies about that, as opposed to talking about practices that allegedly happened six or more years prior,” he said.

The government also saw great value in getting a big dollar number out to a public that has expressed frustration over a perceived lack of accountability of financial institutions for their role in the financial crisis.

“The executive branch get a big news story, particularly with the eye-poppingly large settlements that have been agreed to recently,” said David Reiss, a professor at Brooklyn Law School, who added that the federal government also has an interest in global settlements that keep the markets running more predictably.

Housing Finance at A Glance

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The Urban Institute’s Housing Finance Policy Center really does give a a nice overview of the American housing finance system in its monthly chartbook, Housing Finance at A Glance. I list below a few of the charts that I found particularly informative, but I recommend that you take a look at the whole chartbook if you want to get a good sense of what it has to offer:

  • First Lien Origination Volume and Share (reflecting market share of Bank portfolio; PLS securitization; FHA/VA securitization; an GSE securitization)
  • Mortgage Origination Product Type (by Fixed-rate 30-year mortgage; Fixed-rate 15-year mortgage; Adjustable-rate mortgage; Other)
  • Securitization Volume and Composition (by Agency and Non-Agency Share of Residential MBS Issuance)
  • National Housing Affordability Over Time
  • Mortgage Insurance Activity (by VA, FHA, Total private primary MI)

As with the blind men and the elephant, It is hard for individuals to get their  hands around the entirety of the housing finance system. This chartbook makes you feel like you got a glimpse of it though, at least a fleeting one.

The Cost of Doing Nothing

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Yesterday, I wrote about the Securities Industry and Financial Markets Association (SIFMA)’s FHFA comment letter. Today I write about SIFMA’s comment letter in response to Treasury’s request for input relating to the future of the private-label securities market. Like the FHFA comment letter, this one is written with the concerns of SIFMA’s members in mind, no others, but it identifies many of the structural problems that exist in the housing finance system today.

If I were to identify a theme of the comments, it would be that the federal government has not moved with sufficient speed to establish a well delineated infrastructure for the housing finance market. Some commentators identify benefits of a slow approach — time to get consensus, time to get rules right, time to for trial and error before committing for the long term. Few identify the costs of regulatory uncertainty — failure to get buy-in for capital-intensive ventures, atrophy of existing resources, limited investor interest.

Now, SIFMA’s members want a vibrant private-label MBS market to make money. But a vibrant private-label MBS market is also good for the overall health of the mortgage market as it spreads risk to private MBS investors and reduces the footprints of the gargantuan GSEs and the government’s own FHA. After all, most of us want the private sector taking a lot of the risk, not the taxpayer.

Notwithstanding the strengths of SIFMA’s comment letter to Treasury in critiquing the status quo, I will highlight a few passages from it that hit a false note. The first relates to the role that private-label securities (PLS) have played

in funding mortgage credit where loan size or other terms may differ from those available in the Agency markets, or where economics dictate that PLS execution is superior. The PLS market may also be more innovative and flexible than the Agency markets in adapting to economic conditions or consumer preferences, or to changing capital markets appetite. (3)

This innovation has obviously cut both ways in terms of introducing new products that can help expand access to credit as well as expand access to credit on abusive terms. The latter way seems to have predominated during the most recent boom in PLS MBS.

The second one relates to assignee liability. SIFMA states that

Investors are concerned with the prospect of assignee liability stemming from violations of the ability-to-repay rules contained in Title XIV of Dodd-Frank and embodied in the CFPB’s implementing regulations. SIFMA has raised concerns with assignee liability in many forms over the years based on the fact that mortgage investors are not at the closing table with the lender and borrower, and should not be held liable for defects of which they have no knowledge or ability to prevent. While efforts were made by policymakers to provide some level of certainty through the inclusion of safe-harbor provisions, no safe harbor is entirely safe, and it is important to note that none of these provisions have been tested in court. It will be in litigation where the market learns the exact boundaries of the protections provided by any safe harbor. This potential liability for investors is likely to reduce the availability of higher-priced QM loans and non-QM loans, all else equal, due to higher required yields to compensate for the increased risk. (5-6)

This focus on assignee liability seems to be a red herring, one that SIFMA has floated for years. The risk from assignee liability provisions is not limitless and it can be modeled. Moreover, the notion that investors should face no liability because they are not at the closing table is laughable — without them, there would be no closing table at all. They paid for it, even if they are not in the room when the closing takes place.

The last one relates to the threatened use of eminent domain by some local governments to take underwater mortgages and refinance them to reflect current property valuations:

Investors have significant concerns with, and continuing distrust of the policy environment because of a sense that rules have been and continue to be changed ex-post. The threat by certain municipalities to use eminent domain to seize performing mortgage loans has been a focus of MBS investors for the last two years and would introduce a significant new risk into investing in PLS. These municipalities propose to cherry-pick loans from PLS trusts and compensate holders at levels far below the actual value of the loans. SIFMA’s investor members view such activity as an illegal taking of trust assets, and successful implementation of these plans would severely damage investor confidence in investing in PLS. (6)

This is another red herring as far as I am concerned.  The use of eminent domain is not an ex post legal maneuver. Rather, it is an inherent power of government that precedes the founding of this country. I understand that MBS investors don’t like it, but it is not some kind of newfangled violation of the rule of law as many investor advocates have claimed.

Notwithstanding its flaws, I recommend this letter as a trenchant critique of the housing system we have today.

Housing Finance Abhors A Vacuum

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The Securities Industry and Financial Markets Association (SIFMA) released their comment letter to the Federal Housing Finance Agency’s request for input relating to the role of the Fannie and Freddie guarantee fee (g-fee) in the housing finance market. While clearly reflecting the concerns of SIFMA’s members, the letter provides a thoughtful take on the complexities of the housing finance system. SIFMA writes,

Policymakers should not assume that increases in g-fees alone will lead to a significant increase in PLS issuance. Specific decisions on best execution for a given loan vary depending on the terms of the loan being originated. In some instances, a portfolio purchase may offer best execution, and in other instances the GSEs, private label MBS (PLS) or FHA may be optimal. Taken wholly in isolation, we do agree that increases in guarantee fees should cause originators to look toward other avenues to fund loans – in their portfolios, FHA, or in PLS. However, it is not so simple that an across the board increase in guarantee fees will result in a corresponding uptick in private-label securitization. To the extent GSE securitization becomes more expensive for issuers, PLS are one of a number of options, and not necessarily the most attractive in all instances. Today bank portfolios offer a more attractive funding alternative to the GSEs than PLS for most institutions. Of course, the appetite of banks for loans held in portfolio will vary with economic and regulatory conditions, and cannot always be assumed to comprise a certain percentage of the market.

There are also a number of reasons that increases to g-fees will not directly lead to increased PLS issuances that are not precisely quantifiable or directly related to cost. PLS issuers and investors face uncertainty as to the future shape of the mortgage market and questions related to compliance with the future regulatory regime. The re-regulation of the mortgage and securitization markets is not complete, and a number of consequential rulemakings are incomplete. These include but are not limited to risk retention and proposed revisions to the SEC’s Regulation AB. The final form of the definition of QRM and the rest of the risk retention rules will directly impact the economics of securitization. Regulation AB will impact the offering process, disclosure practices, and require fairly massive infrastructure adaptation at many RMBS issuers and sponsors. Of course, given that final rules are not available for any of these items, issuers and sponsors cannot begin this work. In this environment of uncertainty, it is difficult and indeed may be unwise for issuers or investors to expend resources to develop long-term issuing and investment platforms.

*     *     *

For these reasons, we do not believe FHFA or other policymakers should look at increases to GSE g-fees in a vacuum, and must consider them within the broader context of mortgage finance conditions. (6-7, footnotes omitted)

SIFMA is right to emphasize the regulatory uncertainty that its members face.  The federal government has not done enough to address this.  Housing finance, like nature, abhors a vacuum.  More on this tomorrow.