Bringing Housing Finance Reform over the Finish Line

photo by LarryWeisenberg

Mike Milkin at Milkin Institute Global Conference

The Milkin Institute have released Bringing Housing Finance Reform over the Finish Line. It opens,

The housing finance reform debate has once again gained momentum with the goal of those involved to move forward with bipartisan legislation in 2018 that results in a safe, sound, and enduring housing finance system.

While there is no shortage of content on the topic, two different conceptual approaches to reforming the secondary mortgage market structure are motivating legislative discussions. The first is a model in which multiple guarantor firms purchase mortgages from originators and aggregators and then bundle them into mortgage-backed securities (MBS) backed by a secondary federal guarantee that pays out only after private capital arranged by each guarantor takes considerable losses (the multiple-guarantor model). This approach incorporates several elements from the 2014 Johnson-Crapo Bill and a subsequent plan developed by the Mortgage Bankers Association. Fannie Mae and Freddie Mac—the government-sponsored enterprises (GSEs)—would continue as guarantors, but would face new competition and would no longer enjoy a government guarantee of their corporate debt or other government privileges and protections.

The second housing finance reform plan is based on a multiple-issuer, insurance-based model originally proposed by Ed DeMarco and Michael Bright at the Milken Institute, and builds on the existing Ginnie Mae system (the DeMarco/Bright model). In this model, Ginnie Mae would provide a full faith and credit wrap on MBS issued by approved issuers and backed by loan pools that are credit-enhanced either by (i) a government program such as the Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA), or (ii) Federal Housing Finance Agency (FHFA)- approved private credit enhancers that arrange for the required amounts of private capital to take on housing credit risk ahead of the government guarantee. Fannie Mae and Freddie Mac would be passed through receivership and reconstituted as credit enhancement entities mutually owned by their seller/servicers.

While the multiple guarantor and DeMarco/Bright models differ in many ways, they share important common features; both address key elements of housing finance reform that any effective legislation must embrace. In the remainder of this paper, we first identify these key reform elements. We then assess some common features of the two models that satisfy or advance these elements. The final section delves more deeply into the operational challenges of translating into legislative language specific reform elements that are shared by or unique to one of the two models. Getting housing finance reform right requires staying true to high-level critical reform elements while ensuring that technical legislative requirements make economic and operational sense.  (2-3, footnotes omitted)

The report does a good job of outlining areas of broad (not universal, just broad) agreement on housing finance reform, including

  • The private sector must be the primary source of mortgage credit and bear the primary burden for credit losses.
  • There must be an explicit federal backstop after private capital.
  • Credit must remain available in times of market stress.
  • Private firms benefiting from access to a government backstop must be subject to strong oversight. (4-5)

We are still far from having a legislative fix to the housing finance system, but it is helpful to have reports like this to focus us on where there is broad agreement so that legislators can tackle the areas where the differences remain.

Kroll: Non-Banks A Non-Systemic Risk

Kroll Bond Rating Agency released a Commentary on Capital Requirements for Non-Bank Mortgage Companies. I may be missing something, but this just seems to be a love letter to the securitization industry. The Commentary opens,

Federal and state regulators are currently considering the imposition of capital requirements and other prudential rules on various classes of non-bank financial institutions, including insurers and mortgage servicers. This report examines some of the issues involving non-bank financial companies with a focus on non-bank loan mortgage originators and/or servicers (“seller/servicers”) in the context of the evolving discussion among regulators and researchers toward developing “appropriate” regulation and supervision like that traditionally applied to insured depository institutions (IDIs).

We believe that regulatory efforts to impose capital requirements on non-bank financial institutions such as mortgage loan seller/servicers need to consider the following factors:

• First, most non-bank financial companies operating in the mortgage space have significantly higher levels of tangible capital and lower risk-weighted assets than do IDIs, especially when considering that much of the asset base of a seller/servicer is collateralized and that the mortgages which they service typically are owned by third parties, in most cases institutional investors. The chief sources of risk for seller/servicers are operational and legal, not credit or market risk.

• Second, the recent call by state and federal regulators for capital requirements for non-bank mortgage companies somewhat ignores the real point of the 2007-2009 financial crisis, namely the vulnerability of IDIs and non-banks which perform bank-like functions to a sudden decline in investor confidence and a related drop in market liquidity.

• Third, since non-banks in the US are already dependent upon the commercial banking system for short-term funding and are effectively prohibited from capitalizing their asset and maturity transformation activities in the short-term debt capital markets (e.g., commercial paper), it is unclear why capital requirements for non-banks are appropriate.

We believe that large non-bank companies and particularly seller/servicers in the mortgage sector do not require formal capital requirements and other types of prudential regulation. In our view, the real issue behind the 2007-2009 financial crisis involved securities fraud and the resulting withdrawal of investor liquidity behind various classes of securities issued by off balance sheet vehicles, not a lack of capital in either IDIs or non-bank firms. (1, footnotes omitted)

First of all, it is not clear to me why Kroll is conflating mortgage originators with seller/servicers in this analysis. I think that Kroll is right that seller/servicers predominantly face operational risk, and whatever credit risk they might face (unless they own mortgages that they service) is quite low. But mortgage originators are a different story completely. If they fund themselves from the short-term commercial paper market they are subject to runs much like an uninsured bank would be. See generally Gary Gorton, Slapped by the Invisible Hand (2009). One would expect that regulators would prescribe different capital levels for different types of non-banks — and could conceivably exempt some seller/servicers completely.

Second, Kroll writes that the financial crisis was caused by “the vulnerability of IDIs and non-banks which perform bank-like functions to a sudden decline in investor confidence and a related drop in market liquidity.” But capital requirements go directly to investor confidence in individual firms as well as in an entire sector.

Third, Kroll’s analysis is heavily dependent on describing the troubles of IDIs. Yes, big banks were at the heart of the problems of the financial crisis, but that does not mean that non-banks should get a free pass on regulation, one that will allow them to grow to be the 800 pound gorillas of the next crisis.

Finally, Kroll writes,

One of the most widely held views espoused by US regulators is that non-bank financial firms caused the subprime crisis. A better way to state the reality is that the non-bank firms were involved in subprime mortgage origination and sales because the largest commercial banks and their partners such as Fannie Mae and Freddie Mac had a monopoly position in the prime mortgage space. Large banks and the GSEs made the whole subprime market work by being willing to buy the senior tranches of subprime deals. (7)

I am not sure how to best characterize that argument, but it is of the ilk of “The Devil made me do it” or “Everyone else was doing it” or “I was just a small fry — much bigger companies than mine were doing it.” This is really not an argument against regulation — if anything it is a call for regulation. If appropriate incentives do not align without regulation, then that is just when the government should step in.