Are The Stars Aligning For Fannie And Freddie Reform?

Law360 published my op ed, Are The Stars Aligning For Fannie And Freddie Reform? It reads,

There has been a lot of talk of the closed-door discussions in the Senate about a reform plan for Fannie Mae and Freddie Mac, the two mammoth housing finance government-sponsored enterprises. There has long been a bipartisan push to get the two entities out of their conservatorships with some kind of permanent reform plan in place, but the stars never aligned properly. There was resistance on the right because of a concern about the increasing nationalization of the mortgage market and there was resistance on the left because of a concern that housing affordability would be unsupported in a new system. It looks like the leader of that right wing, House Financial Services Committee Chairman Jeb Hensarling, R-Texas, has indicated that he is willing to compromise in order to create a “sustainable housing finance system.” The question now is whether those on the left are also willing to compromise in order to put that system on a firm footing for the 21st century.

In a speech at the National Association of Realtors, Hensarling set forth a set of principles that he would be guided by:

  • Fannie Mae and Freddie Mac must be wound down and their charters repealed;
  • Securitizers need strong bank-like capital and community financial institutions must be able to compete on a level playing field;
  • Any new government affordable housing program needs to at least be on budget, be results-based and target actual homebuyers for the purpose of buying a home they can actually afford to keep;
  • The Federal Housing Administration must return to its traditional role of serving the first-time homebuyer and low- and moderate-income individuals.

I am not yet sure that all of the stars are now aligned for Congress to pass a GSE reform bill. But Hensarling’s change of heart is a welcome development for those of us who worry about some kind of slow-moving train wreck in our housing finance system. That system has been in limbo for nearly a decade since Fannie and Freddie were placed in conservatorship, with no end in sight for so long. Ten years is an awfully long time for employees, regulators and other stakeholders to play it by ear in a mortgage market measured in the trillions of dollars.

Even with a broad consensus on the need for (or even just the practical reality of) a federal role in housing finance, there are a lot of details that still need to be worked out. Should Fannie and Freddie be replaced with many mortgage-backed securities issuers whose securities are guaranteed by some arm of the federal government? Or should Fannie and Freddie become lender-owned mutual insurance entities with a government guarantee of the two companies? These are just two of the many options that have been proposed over the last 10 years.

Two housing finance reform leaders, Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., appear to favor some version of the former while Hensarling seems to favor the latter. And Hensarling stated his unequivocal opposition to some form of a “recap and release” plan, whereas Corker and Warner appear to be considering a plan that recapitalizes Fannie and Freddie and releases them back into private ownership, to the benefit of at least some of the companies’ shareholders. The bottom line is that there are still major differences among all of these important players, not to mention the competing concerns of Sen. Elizabeth Warren, D-Mass., and other progressives. Warren and her allies will seek to ensure that the federal housing system continues to support meaningful affordable housing initiatives for both homeowners and renters.

Hensarling made it clear that he does not favor a return to the status quo — he said that the hybrid GSE model “cannot be saved, it cannot be salvaged, it must not be resurrected, and needs to be scrapped.” But Hensarling also made it clear that he will negotiate and compromise. This represents a true opening for a bipartisan bill. For everyone on the left and the right who are hoping to create a sustainable housing finance system for the 21st century, let’s hope that his willingness to compromise is widely shared in 2018.

I am now cautiously optimistic that Congress can find some common ground. With Hensarling on board, there is now broad support for a government role in the housing sector. There is also broad support for a housing finance infrastructure that does not favor large financial institutions over small ones. Spreading the risk of default to private investors — as Fannie and Freddie have been doing for some time now under the direction of their regulator — is also a positive development, one with many supporters. Risk sharing reduces the likelihood of a taxpayer bailout in all but the most extreme scenarios.

There are still some big sticking points. What should happen with the private investors in Fannie and Freddie? Will they own part of the new housing finance infrastructure? While the investors have allies in Congress, there does not seem to be a groundswell of support for them on the right or the left.

How much of a commitment should there be to affordable housing? Hensarling acknowledges that the Federal Housing Administration should serve first-time homebuyers and low- and moderate-income individuals, but he is silent as to how big a commitment that should be. Democrats are invested in generating significant resources for affordable housing construction and preservation through the Affordable Housing Trust Fund. Hensarling appears to accept this in principle, while cautioning that any “new government affordable housing program needs to at least be on budget, results based, and target actual homebuyers for the purpose of buying a home they can actually afford to keep.” Democrats can work with Hensarling’s principles, although the extent of the ultimate federal funding commitment will certainly be hotly contested between the parties.

My cautious optimism feels a whole lot better than the fatalism I have felt for many years about the fate of our housing finance system. Let’s hope that soon departing Congressman Hensarling and Sen. Corker can help focus their colleagues on creating a housing finance system for the 21st century, one with broad enough support to survive the political winds that are buffeting so many other important policy areas today.

GSE Investors Propose Reform Blueprint

Moelis & Company, financial advisors to some of Fannie and Freddie investors including Paulson & Co. and Blackstone GSO Capital Partners, has release a Blueprint for Restoring Safety and Soundness to the GSEs. The blueprint is a version of a “recap and release” plan that greatly favors the interests of Fannie and Freddie’s private shareholders over the public interest. The blueprint contains the following elements:

1. Protects Taxpayers from Future Bailouts. This Blueprint protects taxpayers by restoring safety and soundness to two of the largest insurance companies in the United States, Fannie Mae and Freddie Mac. This is achieved by (a) rebuilding a substantial amount of first-loss private capital, (b) imposing rigorous new risk and leverage-based capital standards, (c) facilitating the government’s exit from ownership in both companies, and (d) providing a mechanism to substantially reduce the government’s explicit backstop commitment facility over time.

2. Promotes Homeownership and Preserves the 30-Year Mortgage. This Blueprint ensures that adequate mortgage market liquidity is maintained, the GSE debt markets continue to function without interruption, and the affordable 30-year fixed-rate conventional mortgage remains widely accessible for every eligible American.

3. Repositions the GSEs as Single-Purpose Insurers. Given the substantial reforms implemented by the Federal Housing Finance Agency (“FHFA”) since 2008, the GSEs can now be repositioned and safely operated as single-purpose insurers, bearing mortgage credit risk in exchange for guarantee fees with limited retained investment portfolios beyond that necessary for securitization “inventory” and loan purchases.

4. Enables Rebuild of Equity Capital while Winding Down the Government Backstop. The Net Worth Sweep served the purpose of dramatically accelerating the payback of Treasury’s investment in both companies. The focus must now turn to protecting taxpayers by rebuilding Fannie Mae’s and Freddie Mac’s equity capital and winding down the government’s backstop.

5. Repays the Government in Full for its Investment during the Great Recession. Treasury has retained all funds received to date during the conservatorships. The government has recouped the entire $187.5 billion that it originally invested, plus an additional $78.3 billion in profit, for total proceeds of $265.8 billion. Treasury’s profits to date on its investment in the GSEs are five times greater than the combined profit on all other investments initiated by Treasury during the financial crisis.

6. Produces an Additional $75 to $100 Billion of Profits for Taxpayers. Treasury can realize an estimated $75 to $100 billion in additional cash profits by exercising its warrants for 79.9% of each company’s common stock and subsequently selling those shares through secondary offerings. This monetization process, which follows the proven path of Treasury’s AIG and Ally Bank (GMAC) stock dispositions, could bring total government profits to $150 to $175 billion, the largest single U.S. government financial investment return in history.

7. Implements Reform Under Existing Authority. This Blueprint articulates a feasible path to achieving the Administration’s GSE reform objectives with the least amount of execution risk. It can be fully implemented during the current presidential term by FHFA in collaboration with Treasury utilizing their existing legal authorities. Congress could build on these reforms to develop an integrated national housing finance policy that accounts for the Federal Housing Administration, the Department of Veterans Affairs, and Rural Housing Service, and emphasizes (i) affordable housing, (ii) safety and soundness, and (iii) universal and fair access to mortgage credit for all Americans. (1)

As can be seen from the last paragraph, GSE investors are trying to use the logjam in the Capitol to their own advantage. They are arguing that because Congress has not been able to get real reform bill passed, it makes sense to implement a reform plan administratively. There is nothing wrong with such an approach, but this plan would benefit investors more than the public.

My takeaway from this blueprint is that the longer Fannie and Freddie remain in limbo, the more likely it is that special interests will win the day and the public interest will fall by the wayside.

Muddled Future for Fannie & Freddie

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The United States Government Accountability Office released a report, Objectives Needed for the Future of Fannie Mae and Freddie Mac After Conservatorships.  The GAO’s findings read a bit like a “dog bites man” story — stating, as it does, the obvious:  “Congress should consider legislation that would establish clear objectives and a transition plan to a reformed housing finance system that enables the enterprises to exit conservatorship. FHFA agreed with our overall findings.” (GAO Highlights page) I think everyone agrees with that, except unfortunately, Congress.  Congress has let the two companies languish in the limbo of conservatorship for over eight years now.

Richard Shelby, the Chairman of the Senate Committee on Banking, Housing, and Urban Affairs, asked the GAO to prepare this report in order to

examine FHFA’s actions as conservator. This report addresses (1) the extent to which FHFA’s goals for the conservatorships have changed and (2) the implications of FHFA’s actions for the future of the enterprises and the broader secondary mortgage market. GAO analyzed and reviewed FHFA’s actions as conservator and supporting documents; legislative proposals for housing finance reform; the enterprises’ senior preferred stock agreements with Treasury; and GAO, Congressional Budget Office, and FHFA inspector general reports. GAO also interviewed FHFA and Treasury officials and industry stakeholders (Id.)

The GAO’s findings are pretty technical, but still very important for housing analysts:

In the absence of congressional direction, FHFA’s shift in priorities has altered market participants’ perceptions and expectations about the enterprises’ ongoing role and added to uncertainty about the future structure of the housing finance system. In particular, FHFA halted several actions aimed at reducing the scope of enterprise activities and is seeking to maintain the enterprises in their current state. However, other actions (such as reducing their capital bases to $0 by January 2018) are written into agreements for capital support with the Department of the Treasury (Treasury) and continue to be implemented.

In addition, the change in scope for the technology platform for securitization puts less emphasis on reducing barriers facing private entities than previously envisioned, and new initiatives to expand mortgage availability could crowd out market participants.

Furthermore, some actions, such as transferring credit risk to private investors, could decrease the likelihood of drawing on Treasury’s funding commitment, but others, such as reducing minimum down payments, could increase it.

GAO has identified setting clear objectives as a key principle for providing government assistance to private market participants. Because Congress has not established objectives for the future of the enterprises after conservatorships or the federal role in housing finance, FHFA’s ability to shift priorities may continue to contribute to market uncertainty. (Id.)

One finding seems particularly spot on to me. As I wrote yesterday, it appears as if the FHFA is not focusing sufficiently on building the infrastructure to serve secondary mortgage markets other than Fannie and Freddie.  It seems to me that a broader and deeper bench of secondary mortgage market players will benefit the housing market in the long run.

 

Housing Finance Reform at a Glance

The Urban Institute has posted its November Housing Finance At A Glance.  This is a really valuable resource. The introduction provides a nice overview of recent developments in the area:

With a sweeping midterm election victory for the GOP, the path to legislative GSE reform got considerably narrower. Thus, the focus for reform turns to the FHFA and FHA, where we expect significant movement in the coming months. Over the past six months, the FHFA has asked for input on a variety of issues, and we have commented on them all: guarantee fees and loan level pricing adjustments, Private Mortgage Insurance Eligibility requirements (PMIERs), the single security, and affordable housing goals.
The FHFA has made a concerted effort to open the credit box, strengthening the provision by which lenders are relieved from much of their put-back risk and raising the maximum loan-to-value ratio for some GSE loans from 95 to 97. Both will help expand access without unduly increasing GSE risk. FHFA Director Mel Watt has indicated in recent speeches that work is underway to further clarify reps and warrants, with more guidance on the sunset provision, an independent resolution process for put-back disputes, and remedies short of a put-back for lesser mistakes.
As our new credit availability index indicates, these actions to open the credit box are very important. Our index shows that post-crisis loans have half the credit risk of loans made in the 2000-2003 period. The GSE channel is particularly tight, with about a third of the risk of the 2000-2003 period. This is corroborated by the data in our special feature, which shows that only 8.3 percent of recent Fannie loans (page 34) and 7.4 percent of recent Freddie loans (page 36) have FICOs under 700, compared to 35-37 percent in 1999-2004.
On the FHA side, there have also been initiatives to open the credit box, as outlined in the Blueprint for Access program. Since then, the FHA has released the initial critical draft chapters of their guidebook and a draft of the taxonomy of defects. Many hope to see lower mortgage insurance premiums to broaden access and lessen the risk of adverse selection as better credit flees to the less costly GSEs. Given that their actuary now projects that the FHA’s Mutual Mortgage Insurance Fund will not reach the statutory reserve requirements until 2016, however, such a move is far from certain.
Risk Sharing Developments
The GSEs continue to broaden their risk sharing activities, now turning to front-end risk sharing deals. Prior to this month, they had focused exclusively, and with much success, on laying off risk already on their books, known as back-end risk sharing. Fannie has laid off risk on 7.5 percent of their book of business and Freddie on 11.9 percent of theirs (page 21), both far exceeding the requirements of the Conservatorship Scorecard. The GSEs started including mortgages over 80 LTV in these transactions in May.
This month saw a very meaningful step in bringing private capital back into the mortgage market: the first front-end risk sharing deal, JPMorgan’s Madison Avenue Securities 2014-1 (page 21). JP Morgan warehoused loans made by JP Morgan Chase bank, then sold them in bulk into a newly issued Fannie Mae MBS, presumably for a very meaningful reduction in guarantee fees. JP Morgan retained the first 4.75 percent subordinated interest, and a 26.88 bps servicing strip that absorbs losses before the subordinated interest. The risk on the 4.75 percent subordinated interest was sold in the capital markets in the form of credit linked notes. Redwood Trust is also reported to be contemplating a front-end risk sharing transaction.
Front-end risk sharing bears important similarities to the private capital/catastrophic insurance structure contemplated by many GSE reform proposals. It is thus an administrative opportunity to experiment deliberately with a truly reduced government footprint in the conventional mortgage market. (3)
I am very excited by the possibility of putting private capital in a first loss position for residential mortgages and agree with UI that the stars are aligning, at least a little bit, for this to become a reality. Many interests will need to be balanced for this to move forward, but politicians of all stripes should be worried about leaving Fannie and Freddie in limbo for much longer.

Reiss on Housing Finance Reform

Inside MBS and ABS, the trade journal, quoted me in DeMarco Cites ‘Structural Improvements’ in Housing Six Years After GSE Conservatorship, More Needed (behind a paywall). It reads,

Six years after the government takeover of Fannie Mae and Freddie Mac, the former regulator of the government-sponsored enterprises noted that the housing finance system has made “significant progress.” But even as critical structural changes are underway, comprehensive improvement is still several years out.

In a policy paper issued last week, Edward DeMarco–new senior fellow-in-residence for the Milken Institute’s Center for Financial Markets–said that house prices, as measured by the Federal Housing Finance Agency, have recovered more than 50 percent since their decline in 2007.

“While the damage from the housing crisis has been substantial, we are finally seeing a sustained market recovery,” said the former FHFA chief. “The crisis showed that numerous structural improvements were needed in housing–and such improvements have been underway for several years.”

Poor data, misuse of specialty mortgage products, lagging technologies, weak servicing standards and an inadequate securitization infrastructure became evident during the crisis.

“New data standards have emerged…with more on the way,” wrote DeMarco. “These standards should improve risk management while lowering origination costs and barriers to entry.” Development of the new securitization structure, begun more than two years ago, “should be a cornerstone for the future secondary mortgage market,” he added.

DeMarco said the major housing finance reform bills in the House and Senate share key similarities: “winding down Fannie Mae and Freddie Mac, building a common securitization infrastructure and drawing private capital back into the marketplace while reducing taxpayer involvement.”

DeMarco added, “We should build on these similarities, making them the cornerstone features of final legislation.” Prolonging the GSEs’ conservatorship, he warned, “will continue to distort the market and place taxpayers at risk.”

David Reiss, research director of the Center for Urban Business Entrepreneurship at the Brooklyn Law School, lauded the common securitization project. But Reiss worried the former FHFA head is too optimistic about the state of Fannie and Freddie.

“The GSEs have been in a state of limbo for far too long,” said Reiss. “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.”