Tag Archives: MBS

Is There a Bipartisan Fix for Fannie and Freddie?

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The Hill published my latest column, Congress May Have Finally Found a Bipartisan Fix to Fannie and Freddie. It reads,

It is welcome news to hear that Sens. Bob Corker (R-Tenn.) and Mark Warner (D-Va.) are looking to craft a bipartisan solution to the problem of Fannie Mae and Freddie Mac. The two massive mortgage companies have been in conservatorship since 2008 when they were on the verge of failing. At that time, nobody, just nobody, believed that they would still be in conservatorship nearly a decade later.

But here we are. Resolving this situation is of great importance to the financial well-being of the nation. These two companies guarantee trillions of dollars worth of mortgages and operate like black boxes, run by employees who don’t have a clear mission from their multiple masters in government.

This is the recipe for some kind of crisis.Maybe they will not underwrite their mortgage-backed securities properly. Maybe they will undertake a risky hedging strategy. We just don’t know, but there is reason to think that gargantuan organizations that have been in limbo for ten years may have developed all sorts of operational pathologies.

There have been a couple of serious attempts in the Senate to craft a long-term solution to this problem, but it was not a high priority for the Obama Administration and does not yet appear to be a high priority for the Trump Administration. Deep ideological divisions over the appropriate role of the government in the mortgage have also stymied progress on reform.

Rep. Jeb Hensarling (R-Texas), chairman of the House Financial Services Committee, leads a faction that wants to dramatically reduce the role of the government in the mortgage market. Sen. Elizabeth Warren (D-Mass.) leads a faction that wants to ensure that the government plays an active role in making homeownership, and housing more generally, more affordable to low- and moderate-income households. At this point, it is not clear whether a sufficiently broad coalition could be cobbled together to overcome the opposition to a compromise at the two ends of the spectrum.

2017 presents an opportunity to push reform forward, however. The terms of the conservatorship were changed in 2012 to require that the Fannie and Freddie reduce their capital cushion to zero by the end of this year. That means that if Fannie or Freddie has even one bad quarter and suffers losses, something that is bound to happen sooner or later, they would technically require a bailout from Treasury.

Now, such a bailout would not be such a terrible thing from a policy perspective as Fannie and Freddie have paid tens of billions of dollars more to the Treasury than they received in the bailout. But politically, a second bailout of Fannie or Freddie would be toxic for those who authorize it.

Some are arguing that we should kick the can down the housing finance reform road once again, by allowing Fannie and Freddie to retain some of their capital to protect them from such a scenario. But Corker and Warner seem to want to use the Dec. 31, 2017 end date to focus minds in Congress. They, along with some other colleagues, have warned Fannie and Freddie’s conservator, Federal Housing Finance Agency Director Mel Watt, not to increase the capital cushion for the two companies. They claim that it is Congress’ prerogative to make this call.

The conventional wisdom is that the stars have not aligned to make housing finance reform politically viable in the short term. The conventional wisdom is probably right because the housing finance system is working well enough for now. Mortgage rates are very low and while access to credit is a bit tight, it is not so tight that it is making headlines. So perhaps Senators Corker and Warner are right to use the fear factor of future bailouts as a goad to action.

Housing finance reform requires statesmanship because there are no short-term gains that will accrue to the politicians that lead it. And the long-term gains will be very diffuse – nobody will praise them for the crises that were averted by their actions to create a housing finance system fit for the 21st century. But this work is of great importance and far-thinking leaders on both sides of the aisle should support a solution that takes Fannie and Freddie out of the limbo of conservatorship.

It will require compromise and an acceptance of the fact that the perfect is the enemy of the good. But if compromise is reached, it may help to avoid another catastrophe that will be measured in the hundreds of billions of dollars. And it will ensure that we have a mortgage market that meets the needs of America’s families.

Housing Booms and Busts

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Patricia McCoy and Susan Wachter have posted Why Cyclicality Matter to Access to Mortgage Credit to SSRN. The paper is now particularly relevant because of President Trump’s plan to roll back Dodd-Frank’s regulation of the financial markets, including the mortgage market. While McCoy and Wachter do not claim that Dodd-Frank solves the problem of cyclicality in the mortgage market, they do highlight how it reduces some of the worst excesses in that market. They make a persuasive case that more work needs to be done to reduce mortgage market cyclicality.

The abstract reads,

Virtually no attention has been paid to the problem of cyclicality in debates over access to mortgage credit, despite its importance as a driver of tight credit. Housing markets are prone to booms accompanied by bubbles in mortgage credit in which lenders cut underwriting standards, leading to elevated loan defaults. During downturns, these cycles artificially impede access to mortgage credit for underserved communities. During upswings, these cycles make homeownership unnecessarily precarious for many who attain it. This volatility exacerbates wealth and income disparities by ethnicity and race.

The boom-bust cycle must be addressed in order to assure healthy and sustainable access to credit for creditworthy borrowers. While the inherent cyclicality of the housing finance market cannot be fully eliminated, it can be mitigated to some extent. Mitigation is possible because housing market cycles are financed by and fueled by debt. Policymakers have begun to develop a suite of countercyclical tools to help iron out the peaks and troughs of the residential mortgage market. In this article, we discuss why access to credit is intrinsically linked to cyclicality and canvass possible techniques to modulate the extremes in those cycles.

McCoy and Wachter’s conclusions are worth heeding:

If homeownership is to attain solid footing, mitigating the cyclicality in the housing finance system will be imperative. That will require rooting out procyclical practices and requirements that fuel booms and busts. In their place, countercyclical measures must be instituted to modulate the highs and lows in the lending cycle. In the process, the goal is not to maximize homeownership per se; rather, it is to ensure that residential mortgages are made on safe and affordable terms.

*     *     *

Taming procyclicality in industry practices in housing finance is much farther behind and will require significantly more work. There is no easy fix for the procyclical effect of mortgage appraisals because appraisals are based on neighboring comparables. Similarly, procyclicality will require serious attention if the private-label securitization market returns. While the Dodd-Frank Act made modest reforms designed at curbing inflation of credit ratings, the issuer-pays system that drives grade inflation remains in place. Similarly, underpricing the risk of MBS and CDS will continue to be a problem in the absence of an effective short-selling mechanism and the effective identification of market-wide leverage. (34-35)

McCoy and Wachter offer a thoughtful overview of the risks that mortgage market cyclicality poses, but I am not optimistic that it will get a hearing in today’s Washington.  Maybe it will after the next bust.

Mortgage Bankers and GSE Reform

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The Mortgage Bankers Association has released GSE Reform Principles and Guardrails. It opens,

This paper serves as an introduction to MBA’s recommended approach to GSE reform. Its purpose is to outline what MBA views as the key components of an end state, the principles that MBA believes should be incorporated in any future system, the “guardrails” we believe are necessary in our end state, as well as emphasize the need to ensure a smooth transition to the new secondary mortgage market. (1)

While there is very little that is new in this document, it is useful, nonetheless, as a statement of the industry’s position. The MBA has promulgated the following principles for housing finance reform:

  • The 30-year, fixed-rate, pre-payable single-family mortgage and longterm financing for multifamily mortgages should be preserved.
  • A deep, liquid TBA market for conventional single-family loans must be maintained. Eligible MBS backed by a well-defined pool of single-family mortgages or multifamily mortgages should receive an explicit government guarantee, funded by appropriately priced insurance premiums, to attract global capital and preserve liquidity during times of stress. The government guarantee should attach to the eligible MBS only, not to the guarantors or their debt.
  • The availability of affordable housing, both owned and rented, is vitally important; these needs should be addressed along a continuum, incorporating both single- and multifamily approaches for homeowners and renters.
  • The end-state system should facilitate equitable, transparent and direct access to secondary market programs for lenders of all sizes and business models.
  • A robust, innovative and purely private market should be able to co-exist alongside the government-backed market.
  • Existing multifamily financing executions should be preserved, and new options should be permitted.
  • The end-state system should rely on strong, transparent regulation and private capital (including primary-market credit enhancement such as mortgage insurance [MI] and lender recourse, or other available forms of credit risk transfer) primarily assuming most of the risk.
  • While the system will primarily rely on private capital, there should be a provision for a deeper level of government support in the event of a systemic crisis.
  • There should be a “bright line” between the primary and secondary mortgage markets, applying to both allowable activities and scope of regulation.
  • Transition risks to the new end-state model should be minimized, with special attention given to avoiding any operational disruptions. (3-4)

This set of principles reflect the bipartisan consensus that had been developing around the Johnson-Crapo and Corker-Warner housing reform bills. The ten trillion dollar question, of course, is whether the Trump Administration and Congressional leaders like Jeb Hensarling (R-TX), the Chair of the House Banking Committee, are going to go along with the mortgage finance industry on this or whether they will push for a system with far less government involvement than is contemplated by the MBA.

Taking up Housing Finance Reform

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photo by Elliot P.

I am going to be a regular contributor to The Hill, the political website.  Here is my first column, It’s Time to Take Housing Finance Reform Through The 21st Century:

Fannie Mae and Freddie Mac, the two mortgage giants under the control of the federal government, have more than 45 percent of the share of the $10 trillion of mortgage debt outstanding. Ginnie Mae, a government agency that securitizes Federal Housing Administration (FHA) and Veterans Affairs (VA) mortgages, has another 16 percent.

These three entities together have a 98 percent share of the market for new residential mortgage-backed securities. This government domination of the mortgage market is not tenable and is, in fact, dangerous to the long-term health of the housing market, not to mention the federal budget.

No one ever intended for the federal government to be the primary supplier of mortgage credit. This places a lot of credit risk in the government’s lap. If things go south, taxpayers will be on the hook for another big bailout.

It is time to implement a housing finance reform plan that will last through the 21st century, one that appropriately allocates risk away from taxpayers, ensures liquidity during crises, and provides access to the housing markets to those who can consistently make their monthly mortgage payments.

The stakes for housing finance reform today are as high as they were in the 1930s when the housing market was in its greatest distress. It seems, however, that there was a greater clarity of purpose back then as to how the housing markets should function. There was a broadly held view that the government should encourage sustainable homeownership for a broad swath of households and the FHA and other government entities did just that.

But the Obama Administration and Congress have not been able to find a path through their fundamental policy disputes about the appropriate role of Fannie and Freddie in the housing market. The center of gravity of that debate has shifted, however, since the election. While President-elect Donald Trump has not made his views on housing finance reform broadly known, it is likely that meaningful reform will have a chance in 2017.

Even if reform is more likely now, just about everything is contested when it comes to Fannie and Freddie. Coming to a compromise on responses to three types of market failures could, however, lead the way to a reform plan that could actually get enacted.

Even way before the financial crisis, housing policy analysts bemoaned the fact that Fannie and Freddie’s business model “privatizing gains and socialized losses.” The financial crisis confirmed that judgment. Some, including House Financial Services Committee Chairman Jeb Hensarling (R-Texas), have concluded that the only way to address this failing is to completely remove the federal government from housing finance (allowing, however, a limited role for the FHA).

The virtue of Hensarling’s Protecting American Taxpayers and Homeowners Act (PATH) Act of 2013 is that it allocates credit risk to the private sector, where it belongs. Generally, government should not intervene in the mortgage markets unless there is a market failure, some inefficient allocation of credit.

But the PATH Act fails to grapple with the fact that the private sector does not appear to have the capacity to handle all of that risk, particularly on the terms that Americans have come to expect. This lack of capacity is a form of market failure. The ever-popular 30-year fixed-rate mortgage, for instance, would almost certainly become an expensive niche product without government involvement in the mortgage market.

The bipartisan Housing Finance Reform and Taxpayer Protection Act of 2014, or the Johnson-Crapo bill, reflects a more realistic view of how the secondary mortgage market functions. It would phase out Fannie and Freddie and replace it with a government-owned company that would provide the infrastructure for securitization. This alternative would also leave credit risk in the hands of the private sector, but just to the extent that it could be appropriately absorbed.

Whether we admit it or not, we all know that the federal government will step in if a crisis in the mortgage market gets bad enough. This makes sense because frozen credit markets are a type of market failure. It is best to set up the appropriate infrastructure now to deal with such a possibility, instead of relying on the gun-to-the-head approach that led to the Fannie and Freddie bailout legislation in 2008.

Republicans and Democrats alike have placed homeownership at the center of their housing policy platforms for a long time. Homeownership represents stability, independence and engagement with community. It is also a path to financial security and wealth accumulation for many.

In the past, housing policy has overemphasized the importance of access to credit. This has led to poor mortgage underwriting. When the private sector also engaged in loose underwriting, we got into really big trouble. Federal housing policy should emphasize access to sustainable credit.

A reform plan should ensure that those who are likely to make their mortgage payment month-in, month-out can access the mortgage markets. If such borrowers are not able to access the mortgage market, it is appropriate for the federal government to correct that market failure as well. The FHA is the natural candidate to take the lead on this.

Housing finance reform went nowhere over the last eight years, so we should not assume it will have an easy time of it in 2017. But if we develop a reform agenda that is designed to correct predictable market failures, we can build a housing finance system that supports a healthy housing market for the rest of the century, and perhaps beyond.

Subprime v. Non-Prime

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The Kroll Bond Rating Agency has issued an RMBS Research report, Credit Evolution: Non-Prime Isn’t Yesterday’s Subprime. It opens,

Following the private label RMBS market’s peak in 2007 and the ensuing credit crisis, non-agency securitizations of newly originated collateral have focused almost exclusively on prime jumbo loans. This is not surprising given the poor performance of loosely underwritten residential mortgage loans that characterized certain vintages leading up to the crisis. While legacy prime, in absolute terms, performed better than Alt-A and subprime collateral, it was apparent that origination practices had a significant impact on subsequent loan performance across product types.

Many consumers were caught in the ensuing waves of defaults, which marred their borrowing records in a manner that has either barred them from accessing housing credit, or at best made it extremely challenging to obtain a home loan. Others that managed to meet their obligations have been unable to qualify for new loans in the post-crisis era due to tighter credit standards that have been influenced by regulation.

The private label securitization market has not met the needs of these consumers for a number of reasons, including, but not limited to, reputational concerns in the aftermath of the crisis, regulatory costs, investor appetite, and the time needed for borrowers to repair their credit. The tide appears to be turning quickly, however, and Kroll Bond Rating Agency (KBRA) has observed the re-emergence of more than a dozen non-prime mortgage origination programs that intend to use securitization as a funding source. Of these, KBRA is aware of at least four securitization sponsors that have accessed the PLS market across nine issuances, two of which include rated offerings.

Thus far, KBRA has observed that today’s non-prime programs are not a simple rebranding of pre-crisis subprime origination, nor do they signal a return to the documentation excesses associated with “liar loans”. While the asset class is meant to serve those with less pristine credit, and can even have characteristics reminiscent of legacy Alt-A, it is expansive, and underwriting practices have been heavily influenced by today’s consumer-focused regulatory environment and government-sponsored entity (GSE) origination guidelines. In evaluating these new non-prime programs, KBRA believes market participants should consider the following factors:

■ Loans originated under sound compliance with Ability-To-Repay (ATR) rules should outperform 2005-2007 vintage loans with similar credit parameters, including LTV and borrower FICO scores. The ATR rules have resulted in strengthened underwriting, which should bode well for originations across the MBS space. This is particularly true of non-prime loans, where differences in origination practices can have a greater influence on future loan performance.

■ Loans that fail to adhere to GSE guidelines regarding the seasoning of credit dispositions (e.g. bankruptcy, foreclosure, etc.) on a borrower’s credit history should be viewed as having increased credit risk relative to those with similar credit profiles that lack recent disposition activity. This relationship likely depends on, among other things, equity position, current FICO score, and the likelihood that any life events relating to the prior credit issue remain unresolved.

■ Alternative documentation programs need to viewed with skepticism as they relate to the ATR rules, particularly those that serve borrowers with sub-prime credit histories. Although many programs will meet technical requirements for income verification, it is also important to demonstrate good faith in determining a borrower’s ability-to-repay. Failure to do so may not only result in poor credit performance, but increased risk of assignee liability.

■ Investor programs underwritten with reliance on expected rental income and limited documentation may pose more risk relative to fully documented investor loans where the borrower’s income and debt profile are considered, all else equal. (1, footnotes omitted)

I think KBRS is documenting a positive trend: looser credit for those with less-than-prime credit is overdue. I also think that KBRS’ concerns about the development of the non-prime market should be heeded — ensuring that borrowers have the ability to repay their mortgages should be job No. 1 for originators (although it seems ridiculous that one would have to say that). We want a mortgage market that serves everyone who is capable of making their mortgage payments for the long term. These developments in the non-prime market are most welcome and a bit overdue.

Fannie & Freddie G-Fee Equilibrium

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The Federal Housing Finance Agency’s Division of Housing Mission & Goals has issued its report on Fannie Mae and Freddie Mac Single-Family Guarantee Fees in 2015. Guarantee fees (also known as g-fees) are another one of those incredibly technical subjects that actually have a major impact on the housing market. The g-fee is baked into the cost of the mortgage, so the higher the g-fee, the higher the mortgage’s Annual Percentage Rate. Consumer groups and housing trade associations have called upon the FHFA to lower the g-fee to make mortgage credit even cheaper that it is now. This report gives reason to think that the FHFA won’t do that.

The report provides some background on guarantee fees, for the uninitiated:

Guarantee fees are intended to cover the credit risk and other costs that Fannie Mae and Freddie Mac incur when they acquire single-family loans from lenders. Loans are acquired through two methods. A lender may exchange a group of loans for a Fannie Mae or Freddie Mac guaranteed mortgage-backed security (MBS), which may then be sold by the lender into the secondary market to recoup funds to make more loans to borrowers. Alternatively, a lender may deliver loans to an Enterprise in return for a cash payment. Larger lenders tend to exchange loans for MBS, while smaller lenders tend to sell loans for cash and these loans are later bundled by the Enterprises into MBS.

While the private holders of MBS assume market risk (the risk that the price of the security may fall due to changes in interest rates), the Enterprises assume the credit risk on the loans. The Enterprises charge a guarantee fee in exchange for providing this guarantee, which covers administrative costs, projected credit losses from borrower defaults over the life of the loans, and the cost of holding capital to protect against projected credit losses that could occur during stressful macroeconomic conditions. Investors are willing to pay a higher price for Enterprise MBS due to their guarantee of principal and interest. The higher value of the MBS leads to lower interest rates for borrowers.

There are two types of guarantee fees: ongoing and upfront. Ongoing fees are collected each month over the life of a loan. Upfront fees are one-time payments made by lenders upon loan delivery to an Enterprise. Fannie Mae refers to upfront fees as “loan level pricing adjustments,” while Freddie Mac refers to them as “delivery fees.” Both ongoing and upfront fees compensate the Enterprises for the costs of providing the guarantee. Ongoing fees are based primarily on the product type, such as a 30-year fixed rate or a 15-year fixed rate loan. Upfront fees are used to price for specific risk attributes such as the loan-to-value ratio (LTV) and credit score.

Ongoing fees are set by the Enterprises with lenders that exchange loans for MBS, while those fees are embedded in the price offered to lenders that sell loans for cash. In contrast to ongoing fees, the upfront fees are publicly posted on each Enterprise’s website. Upfront fees are paid by the lender at the time of loan delivery to an Enterprise, and those charges are typically rolled into a borrower’s interest rate in the same manner as ongoing fees.

Under the existing protocols of the Enterprises’ conservatorships, FHFA requires that each Enterprise seek FHFA approval for any proposed change in upfront fees. The upfront fees assessed by the two Enterprises generally are in alignment. (2-3)

The report finds that “The average single-family guarantee fee increased by two basis points in 2015 to 59 basis points. This stability is consistent with FHFA’s April 2015 determination that the fees adequately reflected the credit risk of new acquisitions after years of sharp fee increases. During the five year period from 2011 to 2015, fees had more than doubled from 26 basis points to 59 basis points.” (1)

At bottom, your position on the right g-fee level reflects your views about the appropriate role of the government in the housing finance market. If you favor lowering the g-fee, you want to further subsidize homeownership  through cheaper mortgage credit, but you risk a taxpayer bailout.

If you favor raising it, you want to to reduce the government’s footprint in the housing finance market, but you risk rationing credit to those who could use it responsibly.

From this report, it looks like today’s FHFA thinks that it has the balance between those two views in some kind of equilibrium.

Investing in Mortgage-Backed Securities

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US News & World Report quoted me in Why Investors Own Private Mortgage-Backed Securities. It opens,

Private-label, or non-agency backed mortgage securities, got a black eye a few years ago when they were blamed for bringing on the financial crisis. But they still exist and can be found in many fixed-income mutual funds and real estate investment trusts.

So who should own them – and who should stay away?

Many experts say they’re safer now and are worthy of a small part of the ordinary investor’s portfolio. Some funds holding non-agency securities yield upward of 10 percent.

“The current landscape is favorable for non-agency securities,” says Jason Callan, head of structured products at Columbia Threadneedle Investments in Minneapolis, pointing to factors that have reduced risks.

“The amount of delinquent borrowers is now at a post-crisis low, U.S. consumers continue to perform quite well from a credit perspective, and risk premiums are very attractive relative to the fundamental outlook for housing and the economy,” he says. “Home prices have appreciated nationwide by 5 to 6 percent over the last three years.”

Mortgage-backed securities are like bonds that give their owners rights to share in interest and principal received from homeowners’ mortgage payments.

The most common are agency-backed securities like Ginnie Maes guaranteed by the Federal Housing Administration, or securities from government-authorized companies like Fannie Mae and Freddie Mac.

The agency securities carry an implicit or explicit guarantee that the promised principal and interest income will be paid even if homeowners default on their loans. Ginnie Mae obligations, for instance, can be made up with federal tax revenues if necessary. Agency securities are considered safe holdings with better yields than alternatives like U.S. Treasurys.

The non-agency securities are issued by financial firms and carry no such guarantee. Trillions of dollars worth were issued in the build up to the financial crisis. Many contained mortgages granted to high-risk homeowners who had no income, poor credit or no home equity. Because risky borrowers are charged higher mortgage rates, private-label mortgage securities appealed to investors seeking higher yields than they could get from other holdings. When housing prices collapsed, a tidal wave of borrower defaults torpedoed the private-label securities, triggering the financial crisis.

Not many private-label securities have been issued in the years since, and they accounted for just 4 percent of mortgage securities issued in 2015, according to Freddie Mac. But those that are created are considered safer than the old ones because today’s borrowers must meet stiffer standards. Also, many of the non-agency securities created a decade or more ago continue to be traded and are viewed as safer because market conditions like home prices have improved.

Investors can buy these securities through bond brokers, but the most common way to participate in this market is with mutual funds or with REITs that own mortgages rather than actual real estate.

Though safer than before, non-agency securities are still risky because, unlike agency-backed securities, they can incur losses if homeowners stop making their payments. This credit risk comes atop the “prepayment” and “interest rate” risks found in agency-backed mortgage securities. Prepayment risk is when interest earnings stop because homeowners have refinanced. Interest rate risk means a security loses value because newer ones offer higher yields, making the older, stingier ones less attractive to investors.

“With non-agencies, you own the credit risk of the underlying mortgages,” Callan says, “whereas with agencies the (payments) are government guaranteed.”

Another risk of non-agency securities: different ones created from the same pool of loans are not necessarily equal. Typically, the pool is sliced into “tranches” like a loaf of bread, with each slice carrying different features. The safest have first dibs on interest and principal earnings, or are the last in the pool to default if payments dry up. In exchange for safety, these pay the least. At the other extreme are tranches that pay the most but are the first to lose out when income stops flowing.

Still, despite the risks, many experts say non-agency securities are safer than they used to be.

“Since the financial crisis, issuers have been much more careful in choosing the collateral that goes into a non-agency MBS, sticking to plain vanilla mortgage products and borrowers with good credit profiles,” says David Reiss, a Brooklyn Law School professor who studies the mortgage market.

“It seems like the Wild West days of the mortgage market in the early 2000s won’t be returning for quite some time because issuers and investors are gun shy after the Subprime Crisis,” Reiss says. “The regulations implemented by Dodd-Frank, such as the qualified residential mortgage rule, also tamp down on excesses in the mortgage markets.”