Under Construction: Housing Finance Reform

From the moment the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorship in September 2008, the topic of GSE reform has been the subject of heated policy debates everywhere from inside the Capitol rotunda to around countless industry water coolers. Although it’s remained a popular hot topic in industry and government circles during the ensuing decade, questions of GSE reform—how to manage it, what needs to change, or whether it’s even necessary in the first place—have been seeing renewed prominence in the months since the November elections.

The status quo, suggests Tim Rood, Chairman of the Collingwood Group, is not tenable. “The GSEs are in such a tenuous position, and therefore so is the housing market, because if you have another credit event—which you’re likely to have—the taxpayers are in a first-loss position.”

Such a complex problem, which affects so many different facets of a complex industry, unsurprisingly lends itself to a multitude of possible solutions and viewpoints. In February 2019, Sen. Mike Crapo, Chairman of the Senate Banking Committee, introduced a five-point outline designed to help create a more sustainable housing finance system. His proposal included: private companies as guarantors for the timely repayment of principal and interest to investors of eligible mortgages that are securitized through a platform operated by Ginnie Mae changing the Federal Housing Finance Agency’s (FHFA’s) structure to run it as a bipartisan board of directors instead of a single director to charter, regulate, and supervise the guarantors utilizing Ginnie Mae to guarantee timely repayment of principal and interest on securities that receive credit enhancement from guarantors that are approved and regulated by the FHFA putting a cap on the percentage of all outstanding guaranteed eligible mortgages that a guarantor is permitted within a stipulated timeline as well as ensuring a timeline within which all guarantors are required to be fully capitalized after the enactment of the legislation replacing the current affordable housing goals and duty-to-serve requirements with a new Market Access Fund which will provide grants, loans, and credit enhancements to address the homeownership and rental housing needs of the underserved and low-income communities.

In a statement at the time, Crapo said, “We must expeditiously fix our flawed housing finance system. My priorities are to establish stronger levels of taxpayer protection, preserve the 30-year fixed rate mortgage, increase competition among mortgage guarantors, and promote access to affordable housing.”

Treasury Secretary Mnuchin supported the plan, saying, “Protecting American taxpayers by ensuring the safety and stability of the United States housing finance system is a priority for the Treasury Department. The outline for housing reform legislation released by Chairman Crapo is a productive first step toward that goal, and I applaud him for his efforts.”

Crapo’s plan came only weeks after Politico reported that FHFA Acting Director Joseph Otting reportedly told staffers that the agency would be announcing plans to remove the GSEs from conservatorship soon. The White House swiftly walked those remarks back, with White House Spokeswoman Lindsay Walters releasing a statement that read, “The White House expects to announce a framework for the development of a policy for comprehensive housing finance reform shortly. At this time, no decisions have been made on any reform plan. As part of the process, however, the administration will work with Congress to formulate a plan that fully addresses the risks to taxpayers presented by the current housing finance system and that improves the ability of creditworthy Americans to buy a home.

THE CASE FOR THE CURRENT SYSTEM

Unsurprisingly, the topic again came up during the Congressional confirmation hearings for new FHFA Director Mark Calabria in February. When it comes to any potential GSE reforms, Calabria said that his role as Director of FHFA would be to “carry out the clear intent of Congress, not impose my own vision.”

Just because GSE reform is a topic that inspires debate, that doesn’t mean it’s a given that broad reforms of the existing system are a universal desire among those who interact with or within that system.

“The GSEs are doing a good job ensuring broad access to long-term fixed-rate lending while pushing off the lion’s share of the credit risk into the private market,” said Jim Parrott, Owner, Falling Creek Advisors and a Nonresident Fellow at the Urban Institute. However, Parrott points out that the current system still remains beholden to a privately owned ‘too big to fail’ duopoly, “which doesn’t pose a systemic risk only because they have been put into conservatorship.” He added, “We need to be clearer about the role we want private capital to play in the system and what role we want the government to play in the system—as right now the roles are utterly conflated.”

Michael Bright, President and CEO, Structured Finance Industry Group, previously served as the EVP and COO of Ginnie Mae, where he worked to advance a “commitment to modernization.” He also threw his name into the GSE reform fray in September 2016, when Bright and former FHFA Acting Director Ed DeMarco co-authored a paper entitled “Toward a New Secondary Mortgage Market.” The paper proposed broad GSE reforms that would “end the conservatorships, reconstitute Fannie Mae and Freddie Mac as lender-owned mutuals, and build on the credit risk transfer (CRT) initiative to create a private market for mortgage credit risk while preserving a government-guaranteed rates market for mortgage-backed securities.” In addition, Bright and DeMarco proposed removing Ginnie Mae from the Department of Housing and Urban Development (HUD) and converting it into a standalone government corporation like FDIC, “with authority over its own budget, hiring, and compensation.”

With the current subsidized system allowing Fannie and Freddie to issue debt at Treasury rates in order to buy delinquent loans out of pools, and with the Federal Reserve then buying most of the product they issue, Bright told DS News that the paramount strength of the current system is that it is very good at making mortgages cheap. However, that doesn’t mean it’s without its flaws.

“It’d be nice to get to a place where these rates can be low, but not quite as subsidized, where the market can stand on its own two feet,” Bright said. “The idea of countercyclicality is supposed to be that when things are bad, the government steps in, and then when things are good, the government backs away.” However, Bright observed that Washington sometimes only follows part of that protocol. “When things are bad, the government steps in … and then the government stays in,” he joked. “We haven’t figured out that part of the cyclicality agenda yet, but we’ll see.”

Collingwood’s Rood also credits the GSEs for leading in the field of technological innovations, “creating new tools to drive efficiencies, mitigate risk, and offload risk for lenders at a time where they would probably struggle to make those investments themselves.” He added that the GSEs are also doing this work “when they have no financial incentive to do so.”

Rood added that both Fannie and Freddie are doing “a good, thoughtful job” of making the servicing of GSE loans less expensive and less risky. “They’re automating many of the claims-related activities, which generally carried a lot of tail risk because you could find yourself liable for bad claims at some point in the future.”

10 YEARS OF CHANGE

Of course, it would be a mistake to view the notion of housing finance reform as a binary—either a huge, all-encompassing reform bill is passed or it isn’t. As those DS News spoke to pointed out, that ignores all the ways that the system has course-corrected over the years since the crisis, in big ways and small.

Rood said that the GSEs as they exist now are “far more prescriptive, and there are tools now available to servicers to help them with loss mitigation, foreclosure prevention, and default management. Most of those tools didn’t exist in the past, so it makes it all more predictable, more rote, and less risky. The tools the GSEs have put out there have helped manage the costs of servicing delinquent or defaulted borrowers.”

“Since the companies were taken to conservatorship, Congress has performed a lot of oversight and a lot of big idea creation,” Bright said. “There hasn’t been some major big-bang legislative effort that’s passed into law. Congress has also played an oversight function, and has undone some things that the FHFA has done here and there, or encouraged the FHFA to do more. Meanwhile, the FHFA and the enterprises—who know the details of their business better than a member of Congress does, by definition—are experimenting within the system.” Bright posited that, while there hasn’t been a single large-scale piece of reform legislation passed, “eventually, a law will be signed that codifies many of these ideas.” Until then, housing finance reform will likely remain an evolutionary process.

That more measured approach is one that has no shortage of supporters. In early March, several industry groups sent a letter to the FHFA urging it to take a cautious approach to reforms going forward, recommending that the agency leverage and build upon the current structures of the GSEs. The letter also urged that a commitment to facilitating more affordable housing remain paramount throughout the process.

Addressed to FHFA Acting Director Joseph Otting, the letter stated, in part, that “any efforts to meaningfully change the GSEs’ market presence must be undertaken carefully, with vigilant monitoring and frequent recalibration (if necessary) to avoid disruptions to the flow of mortgage credit into the singlefamily and multifamily real estate markets. Efforts to reduce the GSEs’ footprint should not move forward unless there is compelling evidence that the private market is able to assume an expanded role.”

A MOVE TOWARD CONSOLIDATION

One major change on the near horizon, of course, is the impending launch of the GSEs’ universal mortgage-backed security. First announced in March 2018, the universal mortgage-backed security (UMBS) are set to launch on June 3, 2019. The common securities will replace the Enterprises’ current offerings of To-Be-Announced-eligible mortgage backed securities. The UMBS will be issued through the Enterprises’ joint venture, Common Securitization Solutions (CSS), using the Common Securitization Platform (CSP).

At the time of the announcement, the FHFA explained that, after the June 2019 launch, CSP and CSS “will expand to include the administration of multi-class securities and commingled Enterprise UMBS and the production of UMBS disclosures.” CSS and CSP will thereafter begin performing bond administration functions for close to 900,000 securities backed by nearly 26 million loans.

“The UMBS and CSP, that’s a bit of a rabbit hole,” Bright told DS News. “I think that the jury’s very much out on that. Continuing to evolve the GSEs’ role so that they’re not systemic holders of all those credit risks is important, but they need to have a more unified set of rules, technology, and architecture for managing the distribution of credit risk in an efficient manner.”

“The development of the platform and credit-risk-transfer process are both critical building blocks for a system like the one I’ve described,” Parrott said. “Right now we’re overly dependent on the GSEs for both their assumption of credit risk and their management of the securitization infrastructure. In order to free the system from its dependence on a TBTF duopoly, you have to address both. The CRT helps address the credit-risk concentration and the CSP helps address our reliance on them for the securitization infrastructure. However, both need to be expanded for this transition to work. The CRT needs to be made more durable by attracting more institution-based capital into the deals, institutions that will be there even when the markets get choppy. The CSP needs to be expanded to allow others to use it, so it is a tool to reduce barriers to entry rather than yet another barrier to entry.”

WHERE DO WE GO FROM HERE?

Parrott recently wrote a piece for the Urban Institute’s Housing Finance Policy Center entitled “Clarifying the Choices in Housing Finance Reform.” In it, he walked readers through the history of the housing finance system prior to the conservatorships and provided a detailed examination of three prominent recent reform proposals:

»» MBA Proposal: Suggests turning Freddie and Fannie into privately owned utilities “with regulated rates of return and opening them up to the threat of competition from newly chartered guarantors.”

»» The “Promising Road” Proposal: Coauthored by Parrott, this plan would utilize a common securitization platform and combine Freddie and Fannie into “a single government corporation that issues government-backed securities, sells off all the non-catastrophic credit risk on those securities, and guarantees interest rate investors the timely payment of principal and interest on their investments.”

»» Bright and DeMarco’s Proposal: Leverages and expands existing Ginnie Mae infrastructure to allow Ginnie Mae–approved issuers to get credit enhancement from private and government institutions, while also allowing Ginnie Mae to issue securities. Fannie and Freddie would “compete over the management of non-catastrophic credit risk.”

All three of these plans share some common elements: a government corporation overseeing securitization and guaranty of MBS, while allowing for more competition and a larger role for the private market.

Bright told DS News that his and DeMarco’s proposal to disaggregate the functions of issuer and guarantor was, on some level, intentionally provocative. Since Fannie and Freddie buy delinquent loans “in a subsidized way because they issue debt that trades basically flat to Treasury debt,” Bright explained that “no new company could ever come in and compete with that because they wouldn’t be able to replicate the funding cost of being the issuer.” If you disaggregate those functions, however, you could “open up a pathway to competition.”

Speaking of why he and DeMarco determined that expanding Ginnie Mae’s role made the most sense, Bright said, “The Ginnie Mae security was a platform that had been able to onboard a variety of different types of issuers onto it, and it was globally accepted as a security. The name ‘Ginnie Mae’ is already written into investor guides all over the world.”

Bright said that this viewpoint was only hammered home further during his time at Ginnie Mae. “Fannie, Freddie, the UMBS—whatever new security or new credit wrap Congress could create, there would inherently be a long process of going around and explaining it to central banks in China and Japan and Thailand and Dubai and everywhere, saying, ‘This is how this bond works.’ Whereas with Ginnie, it already has the name recognition, so that also means it has legal recognition.”

Bright further explained that it can be difficult explaining the nuances of the American mortgage market even to policymakers in Washington, but “at least in America, we’re all used to 30-year fixed-rate pre-payable mortgages and stuff like that. In Europe and Asia, you might have to start that discussion more from the ground up.” Ginnie, however, is already a known quantity in those markets. Bright continued, “To try and rebuild all of that global awareness for a totally new bond seemed a bit silly and unnecessarily complex in our view.”

Parrott also put Sen. Crapo’s proposed outline for housing finance reform under the microscope recently, examining the ins and outs in an Urban Institute paper entitled “How Chairman Crapo’s Outline for Housing Finance Reform Can Work.” Crapo’s plan would allow lenders to sell their loans to chartered guarantors, who would then issue securities through Ginnie Mae. Lenders could also securities themselves via Ginnie Mae, and could also sell their loans to a loan aggregator. Under this system, guarantors would issue insurance to cover the credit risk on the lenders’ pools.

Although Parrott’s examination of the Crapo outline did spotlight several issues that still needed to be addressed, including how to integrate existing systems and “what capital and regulatory regime to impose on guarantors to ensure that they are protecting the taxpayers standing behind the system,” Parrott’s write-up nevertheless concluded that the proposal held “significant promise, making it a worthy place to renew the much delayed, but still badly needed, effort to overhaul the housing finance system.”

For all the talk earlier this year of the White House trying to make a move on the GSE reform front, Rood told DS News that he doesn’t see any likely path forward outside of administrative reform, at least not in the foreseeable future. “Most legislation tends to get passed when one of two conditions are present,” Rood said. “Either 1) there’s an emergency and everybody has to rally together against an outside foe or event, or 2) they pass legislation when it doesn’t matter anymore. At that point, people are just tired of talking about it, so it’s less relevant and you’re more likely to see a bipartisan solution passed.”

“To be honest, it’s FHFA with most of the power here,” Parrott said. “Anything Treasury or the White House wants to do, they can only do through an agreement with the regulator and conservator of the GSEs. The FHFA, on the other hand, can move unilaterally, imposing a new capital regime, changing pricing—and with it the amount of cross-subsidy the GSEs provide—the size and nature of their footprint, and so forth.”

As for Bright, have the intervening years— and a stint at Ginnie Mae—altered his view on how best to proceed with these reforms?

“I believe that if we want more than just two companies in this space, it’s going to be hard to get new entrance if they have to be issuer as well because they won’t have a funding advantage,” Bright said. “Some people don’t see it as a problem in the first place. That’s a different level of policy debate. We were basically saying, if you want competition, here’s one way that you probably can get it.”

Bright joked that lenders and servicers may have occasionally had something of a “frenemy” relationship with the GSEs, but that further reforms could help put all the players on more equal footing.

“It would be more of a pure B-to-B dynamic where you have an origination business and then you have a secondary market business,” Bright said. “Fannie and Freddie work hard to innovate for their customers, but they’ve inherently got a lot of weight on their side given the fact that they’re government chartered enterprises. If you’re going to have a system where it’s private actor interacting with private actor, there could be some advantages to having both aspects, both silos, be more pure businesses that are actually competing for each other’s products and innovation.”