Simplifying GSE Reform A Roundtable Discussion

Transcription

1 Simplifying GSE Reform A Roundtable Discussion Andrew Davidson & Co., Inc. (AD&Co) held a roundtable discussion on housing finance reform at the Willard Hotel in Washington, DC on April 8, Andrew Davidson prepared a series of memos to serve as the starting point for the discussion. More than 80 people representing a broad swath of the housing finance system attended the roundtable and participated in the discussions. After the meeting, AD&Co developed a revised proposal taking into account what we learned from the discussions. This note summarizes the memos, the discussion and AD&Co s proposals for reform. The starting point for the discussion, as expressed in the memos, was the recognition of the crucial role that Fannie Mae and Freddie Mac play in our current system and how difficult it may be to replace them. The two entities currently provide guarantees on approximate $5 trillion of mortgages. During 2014, they facilitated the origination of nearly three quarters of a trillion dollars of mortgages through their guarantee programs. The importance of these companies to our current system is not just in the raw numbers but also in the breadth of business processes including origination, servicing, flow of funds and investing that are built around the current operations of the Government Sponsored Enterprises (GSEs). Total Guarantees 2014 Purchases Fannie Mae $3.1 Trillion $435 Billion Freddie Mac $1.9 Trillion $290 Billion Total $5.0 Trillion $725 Billion The goal of the roundtable discussion was to look at the current functions of Fannie Mae and Freddie Mac and determine how much of the existing system can be preserved, and at the same time, find a way to address the conflicts and flaws of the current GSE charters. The roundtable discussion was split into several topics. Individual panelists were asked to start the discussion of each topic and then all participants were invited to add their views. As the meeting was off-the-record panelist comments are presented without attribution. Opening Comments Corker-Warner and Johnson-Crapo legislation have done much to increase awareness of governmentsponsored enterprise (GSE) reform and the recent success of credit-risk transfer (CRT) deals has shown that a new form of risk sharing is possible. The ideological spectrum on the question of GSE reform spans a relatively wide gamut, however. According to most experts, replacing the GSEs is unrealistic; reforming them is more appropriate. But reform requires satisfying a broad array of constituencies. We need to find ways to reform GSEs for the long term; keeping the functions that are extremely useful, while reforming the aspects that have created obvious conflicts in the past. The challenge is to find a solution that meets the competing goals of different constituents. President Obama has expressed his opinion on GSE reform every year over the past three years, most recently in January His key ideas are to bring in private capital and end reliance on the May 28,

2 government, while preserving crucial elements of the current system such as the 30-year fixed-rate mortgage and the to-be-announced (TBA) market. The issue of fixing the GSEs is complex and it is important not to exclude segments of the population from the credit markets. Even with a vision of ideal housing reform, it is essential to plan a transition from the current situation to the desired end. Priorities include broad access to credit and making credit affordable. There is a widely held concern that credit should be available to low- and middle-income communities. Government Bond Wrap Should the Government National Mortgage Association s (GNMA aka Ginnie Mae) structure of credit-risk sharing be applied to GSE reform? To date, Ginnie Mae has been highly successful, as it applies an additional layer of protection to the taxpayer. Ginnie Mae s single-security approach has worked well; the full faith and credit of the US promotes efficiency in the MBS market and brings in foreign investors who will purchase US securities. One panelist explained that in the Ginnie Mae system issuers retain significant risk on the loans that they securitize. Investors are very comfortable with how these securities work. One way for the Federal National Mortgage Association (FNMA aka Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC aka Freddie Mac) to survive would be by adopting a model similar to Ginnie Mae s (with an explicit government guarantee). One response to the concern that the government will end up taking over the housing sector is that the FDIC has not taken over the banking sector. Ginnie Mae s production volume was low in the years before the financial crisis. However, following the crisis, that volume increased dramatically. Also, the production of new GNMA securities has become less concentrated among the major issuers over recent years. The mechanics of the GNMA system and the pricing make it practical for small issuers to use the GNMA system. There are now about 460 GNMA issuers. In the past, GNMA securitization was concentrated in Federal Housing Administration (FHA) loans to low- and moderate-income borrowers. Today, a greater share comes from the US Department of Veteran s Affairs (VA) loans. Another panelist emphasized that a government guarantee does a lot to help a pass-through market work. Greater homogeneity helps liquidity. One impressive aspect of the GNMA contract is the FHA guarantee. Another is that it creates a valuable servicing strip that GNMA can take away from a servicer if it performs poorly. GSE reform should maximize the amount of cushion to absorb losses before the government (taxpayers) bears any loss. A good way to think of the government s exposure in such a case is to compare it to the exposure on a super-senior tranche. A third panelist asserted that GSE reform should not mess with the TBA market because it works well as it is and it is very important for housing market. Keeping the 30-year mortgage is important. The optimal result is that agency MBS should be a rates product and not a credit product (i.e., there should be a government guarantee so that investors do not have to worry about credit and instead will focus exclusively on prepayment/interest-rate risk). May 28,

3 Another panelist presented an analysis of what the TBA market would look like without a government wrap. Investors would have to differentiate among the different guarantees from different entities based on their credit quality, ultimately leading to a specified pool market if one guarantor started to falter. The TBA sector would be reduced to bonds that carry a guarantee from the distressed guarantor. It is possible to create a TBA market for private-label MBS if standardization improves. How Many Guarantor Programs Should There Be? Will There Be? In thinking through alternatives, one must consider whether or not a new system will work as intended. For example, several of the alternative proposals for the GSEs focus on replacing the guarantor role of the GSEs with competitive firms. In this regard, it is important to think about the likely success of this approach. Will market players arise to fill the gap of shrinking GSEs? Will they reach the scale necessary to be efficient? How many such firms will survive? What happens if we end up with only one or two guarantors because of the substantial benefits to scale? Additional secondary market competition is desirable firms should compete on product, service, and price. Moving to a single security eliminates the need to be big for the sake of being big. Fannie Mae felt it had to be bigger than Freddie Mac for liquidity. One panelist noted that having competition would not necessarily result in the overall price becoming too low competition could occur in terms of differences in views on LLPAs for different characteristics while leaving the average cost relatively close. How many guarantors do we need? The mortgage industry (MI) has seven. If the market allows new players to join in, it would enhance competition. The key is to get more private capital into GSEs through MI and lender recourse. Another panelist advocated more competition with more regulation, creating an environment where others can enter the market and break the current duopoly. The role of the GSE should be to promote the flow of capital from the borrower to the capital markets this will de-risk the GSEs. A transition plan is needed to determine how this will work and to test new approaches. Currently, there are three guarantor loan programs: Ginnie, Fannie, and Freddie. The plan for a Fannie/Freddie single security would reduce the number to two. How many seller/servicer guides do we want to have? Competition is a good thing in the abstract, but what happens if it turns out that there are natural monopolies in different aspects of the system that should be allowed to operate as monopolies? Housing Goals As Government Sponsored Enterprises, Fannie Mae and Freddie Mac had economic advantages stemming from their implied guarantee and limited competition. In exchange for these advantages, the GSEs were required to support affordable housing and broadly serve the US housing markets. If loan guarantors under a new system lose these advantages, can they be required to provide the same support to the market? May 28,

4 One unsolved issue of the proposed Johnson-Crapo legislation is housing goals; access to credit markets needs to extend to the primary market. One panelist said, as this is a policy question, the market should be agnostic to housing goals. More important should be the flow of information to investors so they can make informed decisions as to how they want to participate, or not participate, in the market, or how they would like to price different forms of housing goals. Predictability and transparency are key to pricing. While another panelist said there should not be a government guarantee without providing equal access to credit to all those who qualify (this is the strongest argument for why there ought to be a government role, after all). Access goals argue against more guarantors and for a more consolidated market. One panelist argued that the system should not push consumers solely into FHA loans as an access product, especially in light of the long-term demographic changes that are underway in the US. This would lead to the FHA becoming overwhelmingly focused on minority borrowers, the fastest growing segment of homeowners as baby boomers age out. One example of an alternative approach would be the use of a Flex Fee (insurance premium) to enhance the trust fund, thereby providing resources to the neediest. Capital and Eligible Loans An important consideration in restructuring the GSEs is to establish a capital rule that will protect tax payers from losses while allowing the system to function effectively. The recent credit risk sharing transactions from the GSEs may provide a good source of insight into the risk of GSE loans. (See the Appendix for a graphical analysis of the risk of a recent transaction.) Mixing market transactions and insurance into a capital framework is a challenging exercise. Many proposals also require that guarantor firms fail, before a government guarantee is triggered. What happens if several guarantors fail at once? Will the government need to step in to support them? How can the government ensure funding for new loans during a financial crisis, without encouraging irresponsible behavior in a strong market? If the failure is due to macroeconomic events, is it necessary to punish the firm? What is the best way for the government to play a countercyclical role? The amount of capital required depends on the types of loans and their level of risk. One speaker asserts that 4% capital is enough for most current types of loans. Capital of 10% should not be needed unless there is change or innovation. Four percent on $1 trillion is $40 billion. Thus, $1 trillion of mortgage production per year should require $40 billion of capital per year. If new production half of this then the new capital required per year is only $20 billion. One source for building up a capital cushion are g-fees, especially the excess g-fee, the portion of currently charged g-fees which are not required by risksharing transactions. May 28,

5 There are some things everyone seems to agree on: a. The proper pricing of capital is key. b. We need a 30-year fixed-rate mortgage. c. We need to support the TBA market. d. There s a need for insurance. e. There s a need for private capital upfront. Another panelist asserted that focus of the GSEs should be on the most vanilla loans; jumbo, subprime, and Alt-A rated loans should all go to the private-label (PLMBS) market. One panelist proposed that catastrophic rescues could be tied to vintages to allow the market to continue to move forward. Another panelist proposed the use of convertible bonds (which would start out as MBS, and convert to equity in the event of catastrophic failure). What Legislation Is Required? What s Possible? While much GSE reform has taken place under the direction of FHFA and more is planned, some steps would require legislation. What are the minimum requirements for legislation? How likely is it that Congress will take up the issue? What are the prospects for passing reform? Are incremental bills possible? One speaker suggested bringing private-sector pricing into the housing-finance equation. One proposal would be to expand Ginnie s role and to apply a vintage approach. The government would take a pari passu share of losses and would piggyback with private sector pricing of the guarantee. Another speaker asserted that one purpose of legislation should be to provide a roadmap a clear path. Implementation of GSE reform will involve so many people and take so long that detailed legislation will be necessary to achieve the intended results. Lawmakers should resist the tendency to under-legislate. Legislation will need to address many key issues: Full faith and credit government guarantee for the security. How much of a g-fee should there be? What are the requirements for obtaining a government guarantee? What regulatory oversight should be required for providers of private capital? Which regulator is in charge and what powers does it have? What authority would there be in times of economic stress? Do we need any self-regulatory organizations? What should be subsidized in support of public policy goals? Another speaker cautions that there is a danger of talking too much and doing nothing. GSE reform will not come from a perpetual conversation. The same issues are being debated today that were being debated a year ago. Three goals that require legislation are: (a) transferring the government guarantee to the securities from the entities; (b) ending conservatorships, and (c) permanently funding the housing trust fund. Other key policy objectives can probably be achieved without legislation. A different speaker agrees that GSE May 28,

6 legislation is unlikely in the near term, including after the next Presidential election. The Federal Home Loan Bank System is also an important aspect of the housing-finance landscape that needs to be considered when altering the GSEs. For example, changing from stock companies to mutual could change key dynamics. One speaker suggested that Fannie and Freddie should be required to purchase guarantees from GNMA for six basis points. That would be a way to solidify the explicit guarantee on their MBS. Another speaker remarked that conditions now may be ideal for getting GSE reform legislation. However, as the GSE accumulate a longer track record of being profitable, it becomes harder to argue for major change. Governance of GSE Functions Government control and privatization are forms of governance for the GSE functions. Mutual insurance companies and utilities are alternative forms of governance that may be useful. What are the relative merits of each type of governance for each of the current functions of the GSEs? Which functions should be kept together and which are best put into separate entities? One speaker outlined the uses of mutualization, which is a form of cooperative ownership of the GSEs, and gave examples such as trade associations and joint ventures. Housing coops are underappreciated and have the following characteristics: a) stakeholder interests are aligned; b) there may be less access to capital markets but the cooperative entity has longer-term capital; and c) they are useful for setting underwriting and aggregating standards. Another speaker observed that we are moving away from having hybrid companies (governmentprivate) to having a hybrid system. However, some large lenders would not like the government to have complete control over the seller/servicer guides, the credit box, and the representations and warranties. May 28,

7 GSE Bingo To facilitate the discussion of the role of the GSEs, Andy Davidson developed a framework he called GSE Bingo. GSE Bingo is a two-dimensional board labeled with a list of the current functions on the vertical axis and a list of potential governance structures for those functions (such as government, GSE, private sector, mutual) and a set of circular game pieces to discuss different potential options. GSE refers to the pre-2007 structure of private ownership of chartered enterprise which benefits from an implicit guarantee. Bond refers to selling the risk in the bond market, with the rating agencies playing a major role in the investing process. Private refers to private competitive companies, including insurance companies, banks and other financial firms. Mutual refers to one or more mutual insurance companies, supported by member capital and reinsurance, and is one possible governance structure for the GSEs. Utility refers to a government-regulated monopoly. Regulate refers to government oversight of a function performed by others. Government refers to government providing that function directly. May 28,

8 Key points raised during this session were: 1. G-fees should be added to the discussion (and hence to the board) and one hand and one set of eyes should not be setting the fees. 2. A mutual organization charging a higher than needed g-fee is not as bad as a privately owned actor that will earn unfair profits; the mutuals profits can be reinvested in the system, used to increase the capital buffer, etc. 3. The important question is how mutuals are governed as there are plenty of ways for this to go wrong. Governance has to be thought about carefully. 4. The trade-off with mutual is that they are not the most innovative form of firm and tend to engage in mean-reverting behavior. Perhaps this is not so bad for certain functions, though. 5. What incentives key decision makers have is key: if a type of firm produces better incentives then it may be better to use that type of entity. But we should be clear on the difference between entity types (one choice) and incentive creation (a different choice). May 28,

9 PROPOSAL Andrew Davidson & Co proposes a four-step program to restructure the GSEs. The proposal can be demonstrated using GSE Bingo. The starting point is the current structure of the conventional market. The method will utilize the credit-bearing capacity of the private-label market and the bond-wrap capabilities of the government market. The ownership of the GSEs will be transformed to reduce the conflicts that mar the existing system. Some of these steps are already underway. May 28,

10 Step 1: Streamline Establish a common security platform (CSP) as a utility and eliminate the debt-funded retained portfolio. Home Loan Bank Advances can be used to provide funding for MBS portfolios in appropriately capitalized institutions. The Fed may purchase MBS as necessary. Home Loan Bank MBS portfolios should also be reduced substantially. This is already in progress. 1. Reduce the retained guaranteed MBS portfolios. 2. Establish plan to hold or sell off non-performing assets. a. Securitize and sell re-performing assets in senior/sub transactions. 3. Establish a common securitization platform a. The platform should include access to GNMA securitization. b. The platform needs to have management by the originators as well as Fannie Mae and Freddie Mac. c. Platform should be capitalized as an independent entity, perhaps as a membership corporation like DTCC. May 28,

11 Step 2: Reinsure Reinsure most of the credit risk via risk sharing transactions using both private companies and creditlinked notes and other structured-finance transactions. These transactions should be treated as REMICs and as good assets for REITs. These transactions not only provide a source of capital to bear credit risk, they also provide an indication of the pricing of these risks in the market. This is also already partially in progress. 1. Establish reinsurance programs for up to 75% of risk on new GSE loans. 2. Establish capital rules that encourage the use of risk sharing. 3. Place high quality assets in trust to cover losses. 4. Encourage the IRS and SEC Establish Risk Sharing Transactions as REMICs and good assets for REITS. May 28,

12 Step 3: Wrap Establish vintage-based wrap of GSE-issued MBS, using GNMA. Vintage-based wrap creates clear capital requirements and allows entities to survive a systemic decline in housing or other economic crisis. Firstloss requirement of the guarantors should be backed by high quality assets that are held for the benefit of MBS investors as first loss coverage prior to government wrap. The government uses portion of wrap fee to support affordable housing activities. This may be achievable within the current law. 1. Establish GNMA F program; that is a GNMA program for pools guaranteed by Fannie Mae and Freddie Mac. 2. GNMA will wrap MBS from cohorts fully protected up to cohort requirement by a trust fund. 3. Cohort requirement would be established by Treasury and FHFA. 4. GSE, via the Preferred Stock Purchase Agreements (PSPAs) would be responsible for any losses above the trust fund. May 28,

13 Step 4: Mutual Insurance Sell GSE loan guarantee assets and business to mutual insurance companies with the originators as members. The mutual would insure losses up to a vintage or cohort limit. The government wrap would cover additional losses, if any. Initially it makes sense to maintain two mutual insurers, but the number could be increased or decreased over time. Mutual insurers offer advantages over alternative governance structures in terms of providing activity based capital and monitoring and alignment of incentives. The mutual would retain duty to serve obligation, via its members. (Another alternative would be a regulated utility.) During conservatorship FHFA and Treasury will explore the pricing, structure and governance of recapitalizing the remaining GSE functions within originator-owned mutuals. They will also develop pro-forma financial statements based upon capital rules and expected regulation. The reason for using mutuals rather than stock companies is that the mortgage guarantee business is likely a natural monopoly. This arises from the need for standardization and due to investor preferences for a large liquid issuer. Single Security and Government standards may create competition, but there is no assurance that they will succeed. The mutual structure accommodates a market structure of very few guarantors. The transformation of Fannie and Freddie into issuer owned mutual insurance companies May 28,

14 provides approach to transitioning to an improved governance structure for these critical functions without creating severe disruption of the housing finance system. Summary This four step process streamline, reinsure, wrap, mutualize provides a clear path for GSE reform. It does not require the creation of any new unknown entities or disrupt the existing system. The one difficult transition, the creation of the common securitization platform, is would no longer be the lynchpin of reform. That development can take place independently of the other changes. Transforming Fannie Mae and Freddie Mac provides a mechanism to create a more stable housing finance system in the long run, without the risk of severe disruption in the short run. While much of the transition can occur administratively, certain steps will required legislation. These include: 1. Establishing risk-sharing transactions as REMICs and good assets for REITS, if not achieved administratively. 2. Amending GSE charters to narrow role and allow mutual ownership by originators, remove all government support for the mutuals other than ability to have eligible loans wrapped by GNMA. 3. Establishing government wrap of mutual-issued MBS. Access to wrap will require that cohort level deductible to be fully collateralized in trust accounts held for the benefit of the guarantor. 4. The government will collect a wrap fee to fund affordable housing; mutuals will have a national duty to serve all qualified borrowers. FHFA and the Administration can start down this path now, and invite Congress to participate as there is greater certainty on what legislation will be required. Acknowledgements We would like to thank all of the participants in the roundtable discussion. The proposal presented here represents the views of Andrew Davidson & Co, and does not necessarily represent the views of the participants in the roundtable individually or collectively. May 28,