https://timhoward717.files.wordpress.com/2015/03/rosner-2.pdf
The Future of the U.S. Housing Finance System: Bringing the U.S. Residential Mortgage Finance System into the 21st Century Joshua Rosner Graham Fisher & Co. March 18, 2015 2 Summary Points • Problem wasn’t structure of GSE • Conservatorship has not been handled according to requirements in the Housing and Economic Recovery Act. • The legislative and administrative proposals for mortgage finance are unworkable and poor options. 3 For Two Decades We Knew What to Do • There is nothing specifically wrong with the existence of entities whose purpose is to support liquidity in the secondary mortgage market. In fact, there is a substantial need for such a function to exist. • We have long known how to properly regulate the GSEs but we failed to do it in the last meaningful reform effort preceding the crisis (1992). – Historically, unlike Freddie Mac, who generally securitized their mortgages, Fannie tended to portfolio them. – This exposed Fannie to interest rate risk and, between 1978 & 1984, as rates rose, they had a negative net worth on a mark to market basis. – While GSE capital requirements were not as rigorous as other institutions they were able to access markets because of an implied government guarantee. – Still, during that time, underwriting standards were generally strong. • The problem was the use of these quasi-private/quasi-public institutions as tools of social policy for the purpose of delivering housing subsidies to the public through a perverse off-balance-sheet scheme that was arbitraged by private market participants. The problem was not inherent to the GSEs themselves. 4 GSEs – No Controversy Until S&L Crisis – In 1989, as a result of the failure of the S&L industry the government began to reconsider the oversight of the GSEs. • The House Ways & Means Committee held the first comprehensive GSE oversight hearing in 30 years and required reports by departments and federal agencies. • In 1991 the US Treasury Report noted: – “Financial safety and soundness regulation of GSEs must be the primary statutory goal of regulators, or regulatory conflict in the existing structure may compromise effective safety and soundness regulation. – In times of economic stress, a regulator with unclear or dual statutory objectives (safety and soundness versus promotion of another public policy goal) may decide to subordinate its safety and soundness responsibility in favor of the achievement of other public policy goals… – …unless a regulator has an explicit primary statutory mission to ensure safety and soundness, the Government may be exposed to excessive risk”; – “the regulator must have sufficient stature to avoid capture by the GSEs or special interests. – To be effective and avoid capture, the regulator must have strong statutory powers and highly qualified staff.” 5 GSE Reform Acts: 1992 & 2008 1992: Rather than creating a world class regulatory regime, the1992 Act created a neutered safety & soundness standard with a weak primary regulator. This is detailed in great length in Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon. • OFHEO didn’t have free reign to raise & lower capital requirements as appropriate; • The capital standards were defined by Congress, were a static snapshot of an evolving market, took a decade to implement and were interfered with by lobbying and Congress; • GSE mortgage securities received lower relative risk weightings than private mortgages even though GSE capital standards were lower than other financial firms’. • The regulator had no explicit authority over enterprise leverage or portfolio growth • Safety and soundness received no priority over housing goals and public mission; • Regulator had no “bright line language” to prevent mission creep; • The regulator was neutered by the politics of appropriation; • The 1992 Act left in place a $2.25 billion line of credit for the GSEs. While nominal these lines, nonetheless, supported an implicit government guarantee. • With the President selecting half the members of the GSEs boards, they were political. 2008: While the 2008 Act (HERA) addressed most of the problems embedded in the 1992 Act it was too late prevent the subprime market contagion, which began in 2006, from imperiling the GSEs solvency. 6 Both Private Markets & GSEs Caused Crisis While many Democrats blame weak regulation of private markets and unbridled greed, many Republicans blame government policies that attempted to deliver social subsidies through the offbalance sheet, quasi-public and quasi-private, Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac. Attempts to assign blame have prevented policy-makers from embracing the structural mortgage finance reforms that would address weaknesses which brought the economy to the precipice of collapse and have therefore failed to reduce these economic, market, social or political risks. What Washington seems not to understand is precisely what many private citizens understand, that these are not mutually exclusive explanations. In fact, it was the interplay between poorly considered government policies, weak regulatory oversight, the lobbying power of industry players, unrestrained profit seeking behaviors of issuers of private label mortgage backed securities, structural changes in the business and oversight of the GSEs and a lack of prudent economic activities of borrower “…we excused and even embraced an ethic of greed…we encouraged a winner-take-all, anything-goes environment …instead of establishing a 21st century regulatory framework, we simply dismantled the old one.” – Barack Obama 7 GSEs Seasoned Market but Were not the only Culprits 1993, Clinton administration decided that among the “available Federal resources”, “capital investments for housing and community development” could be driven “through Fannie Mae, Freddie Mac, FHA, and HUD/USDA programs” – “National Homeownership Strategy”: goal was “reaching all-time high national homeownership levels by the end of the century” – “Can be done almost entirely off-budget-through creative leadership and partnerships HUD, FHA, Fannie Mae, Freddie Mac, FHLBS, CDFls, the private mortgage and insurance companies, and the banks and thrifts”. – It could be achieved by “making homeownership more affordable, expanding creative financing, simplifying the home buying process, reducing transaction costs, changing conventional methods of design and building less expensive houses, among other means” – It was unprecedented for regulators to partner this closely with those that they have been charged to regulate. – “National Partners in Homeownership”: HUD, Federal Deposit Insurance Company, Fannie Mae, Freddie Mac, the Mortgage Bankers Association, the American Institute of Architects, America’s Community Bankers, the U.S. Dept. of Treasury and the National Association of Realtors. 8 GSEs Seasoned Market but Were not the only Culprits 1998 risks were understood, stated but ignored: • In an internal memorandum from Secretary of the Treasury Robert Rubin regarding “increasing lending to the most ‘at risk’ borrowers”: – “Lowering the down payment requirement is likely to reduce saving among low-income people who would like to be home owners”; – “We may not want to encourage poor people especially those who cannot save, to purchase their homes. In an economic downturn, these home owners may be more vulnerable and more likely to lose their homes”; and – “It is not clear that home ownership causes the effects attributed to homeowners”. 9 GSEs Seasoned Market but Were not the only Culprits In 2001, lobbying by Federal Reserve, banks and investment banks led the Basel Committee to determine that “AAA” and “AA” rated private label securities should carry the same risk weightings as correspondingly rated GSE products. • As a result the PLS market took off – Investment banks and their third-party mortgage origination partners created more and more risky products, including many negative amortization products – Credit rating agencies conflicted analysis of MBS led to development of derivative CDO market – Strong investor demand for these relatively higher yielding debt securities led to PLS issuers taking significant market share from the GSEs. – Negative amortization and hybrid products emerged to take advantage of falling interest rates to refinance existing homebuyers, to encourage cash out refinancing and to encourage speculation in second homes and investment properties. • For the first few years, the GSEs avoided direct and aggressive competition with the looser standards of these lenders and instead, increasingly used their portfolios to become the largest purchasers of private label securities. By 2004, Freddie Mac decided to expand its direct exposure to Alt-A lending. 10 Why did Fannie & Freddie Fail? • Their failures had nothing to do with their core activities or specifically the TBA market. • Improper use of portfolios: – GSEs employed the lower costs of funds to increase on-balance sheet leverage through the purchase of each others’ securities and investment-grade rated private label securities; – Such use of their portfolios increased risk and pro-cyclicality. • Weak Capital Standards: – In the wake of the S&L crisis, as Congress was designing a new regulator and new oversight regime, for the GSEs, Fannie Mae successfully lobbied for and received the weak capital requirements embedded in the 1992 Act. • Expanding Credit Box without Safeguards: – By 2000 “expanded their purchases to include “Alt-A,” A-minus, and subprime mortgages, in addition to private-label mortgage securities”; – By 2007, seven private mortgage insurers with combined capital base of $40 billion insured about 17% (roughly $400BB) of GSEs’ book. Nobody questioned the ability to absorb first loss exposures. • Improper pricing of guarantee fees: – Between 2003 and 2007, to retain market share, GSEs offered significant discounts on G-fees for large volume customers. Pricing diverged from risk; – Guarantee fees didn’t reflect underlying, loan-level, mortgage credit risk. 11 Legislative Attempts To Date • In considering reform proposals it is an imperative to ask: – Is it an improvement? – Does it protect the public? – Does it improve market discipline? – Does it reduce systemic risks posed by central players? – Does it create a strong divide between the utility-like function of the secondary mortgage market and the primary (private) mortgage origination market? • The answers are clear: “No!”. 12 Legislative Attempts To Date • The GSEs, in or out of Conservatorship, are among the largest companies in the world with assets of $5.19 trillion and liabilities of $5.18 trillion. These assets and liabilities, according to HERA must be respected as these institutions are hugely important to the financial markets and cannot be modified willynilly without serious collateral damage to both investors and home borrowers who need to get mortgages delivered to them. • The leading bills in both the House (PATH Act) & Senate (Crapo Johnson) recreate a dangerous system in which: – The line between primary and secondary market players creates the risk of excess liquidity in good times and withdrawal of liquidity in bad times. – Legislators seek to deliver public subsidies through shareholder owned and private companies without appropriate regulation. • The same mortgage industrial complex that captured Washington before is attempting to do so again. • Their approaches are dangerous, create new systemic risks and support several false myths. 13 Legislative Attempts To Date • Imagine a car getting rear-ended by another car as it is stopped at a stoplight. The damage is significant but repairable. • There are two obvious choices: – Bring the car to an auto repair shop and have it fixed (rational economic choice with benefits of limited downtime); – Junk the car (uneconomic choice coupled with downtime while raising funds to offset depreciation and buy a new car). • Crapo Johnson found a third choice – Build a new auto assembly plant to produce a new car. • Moreover, when looking at the “comprehensive reform” proposals one must ask: “Who will own these new entities?” – If you look at Crapo Johnson or the PATH Act, the standard setters and securitization entity would be owned by industry. Whose interests are being served? 14 False Myth #1 – Private Capital can Replace GSEs • To replace the GSEs and attract enough private capital to insure the top 10% of a future market roughly the size of their current books, or roughly $5 trillion, the industry will need to attract close to $500 billion of capital, before even considering the capital risk weighting of assets. • The seizure of shareholder owned companies, without regard for the contractual rights of preferred or equity holders and in violation of capital priority rights promulgated by the FHFA & authorized by HERA substantially reduces the likelihood of substantial private capital. • The PMI industry, which was intended to reduce losses to the GSEs by insuring any portion of an agency mortgage above 80 LTV, remains thinly capitalized with only $8 billion of capital of which $3 billion has been raised since the crisis. • There is currently no private securitization market because neither regulators nor industry participants fixed it or created standards that would revive it. If one looks at the share of agency and non-agency MBS issuance it is clear that private capital is not returning to the market. – While some argue the GSEs guarantee fees need to be increased to allow private capital to compete this is inaccurate. With the average agency mortgage FICO score above 740 there should be plenty of opportunity for private lenders. 15 False Myth #2 – We Need more Competition • A key arguments of those who favor either replacing the GSEs or expanding the number of players supporting the secondary mortgage market is that Fannie and Freddie have duopoly power over the market. – Monopolies, duopolies and oligopolies are all driven by industry fixing pricing, rather than markets. Historically, the GSEs did not compete on price. – Yes, they are the only private secondary market firms tasked exclusively with ensuring ongoing liquidity to the primary markets but they are not the only source of long-term mortgage funding: • Bank balance sheets; • Federal government programs; and, • Private label securitizations (before the crisis) all provided (what was intended to be) stable funding. – Importantly, if we are to strike the proper balance in support of the secondary mortgage market, we should recognize that they provide an essential public service (ongoing availability of secondary mortgage credit) much like the provisioning of water, gas, electricity or sewers that utilities offer. – As is true of these other utilities, increasing the number of competing firms doesn’t improve outcomes. In fact it drives excess liquidity and create disparate execution prices for all but the largest, leading to deterioration in standards. 16 Housing & Economic Recovery Act (HERA) Solved Most of These Issues • HERA empowered FHFA with authorities to make changes that should be supported by even the staunchest critics of the GSEs. – Treasury’s support of the GSEs is not considered capital nor is it the equivalent of capital. – Today, the GSEs maintain less capital than they did before the crisis. • Even though HERA prevents the funding of affordable housing funds if the GSEs are undercapitalized, FHFA has turned on the funding. – HERA states that an enterprise that is determined to be undercapitalized “shall make no capital distribution if, after making the distribution, the regulated entity would be undercapitalized”. – The primary regulator who appointed itself Conservator, has done nothing to fulfill its statutory obligations to “put the regulated entity in a sound and solvent condition; and… to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity” and has ignored HERA requirements that it: – “Periodically review the amount of core capital maintained by the enterprises… and the minimum capital levels established for such regulated entities”; – “Determine the capital classification of the regulated entities for purposes of this subchapter on not less than a quarterly basis”; and – Instead of meeting these explicit requirements, the Director of FHFA chose to “suspend capital classifications of Fannie Mae and Freddie Mac during the conservatorship”. 17 Treasury Interfering with an Independent Agency’s Execution of Its Mandate • The Director of FHFA appears to be mistaken about his obligations and authorities as demonstrated by his comment, in a recent hearing that the Preferred Stock Purchase Agreements, between FHFA and Treasury, he stated that the agreement with Treasury “trump(s) the law”. • U.S. Treasury has effectively prevented FHFA’s execution of its legal mandate: – FHFA is required to “to take such action as may be necessary to put the regulated entity in a sound and solvent condition”. But when the 2012 Amendment to the PSPA was announced, Michael Stegman, an unconfirmed advisor to Treasury, stated they were “acting upon the commitment made in the Administration’s 2011 White Paper that the GSEs will be wound down and will not be allowed to retain profits, rebuild capital, and return to the market in their prior form”. – FHFA promulgated rules regarding the priority of payments to the capital structure that recognize contracts, market practices and priority of claims that look almost identical to those used by the FDIC’s rules. Still, even though the GSEs are undercapitalized, and should not be making distributions, Treasury has taken $40 billion more, from the GSEs than the GSEs received and has enforced “the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future”. • The net worth sweep may have been used to achieve political ends. – In the summer of 2012, as the net worth sweep was being planned, the administration was battling Republicans in Congress over an increase to the debt ceiling. Treasury noted the sweep of GSE profits would push out the debt-ceiling deadline until September. 18 Is FHFA as Feckless as OFHEO? • Contrary to their oft repeated claims that only Congress can fix the GSEs: – Ensure independence of Conservator and ability to operate effectively. – FHFA should place the restoration of capital ahead of the PSPA. As the sole party to that agreement statutorily charged with the restoration of the GSEs’ capital, it is in the FHFA Director’s power either (a) to stop dividends and to inform the Treasury that now that they have received repayment of all monies provided in support of the GSEs and enter into a new agreement which effectuates the statutorily required process of restoring the GSEs capital or, (b) if he deems the GSEs could not become adequately capitalized according to the capital classifications in HERA, to reorganize the enterprises through receivership by creating a limited life regulated entity (i.e. a good bank) and then selling the capital stock of the LLRE. – Suspend payments to the affordable housing funds which, according to HERA, are disallowed for undercapitalized GSEs. – Negotiate with Treasury to place Treasury’s warrants into the affordable housing fund, ensuring support for affordable housing while contributions are suspended for recapitalization – Such a fund, as already established by HERA, should not only be acceptable to the public but was proposed by Peter Wallison of AEI in draft GSE reform language offered in 2004. As the companies build capital, improving safety & soundness, it will increase the value of the warrants; – Ensure that capital is assessed based on actual issuance. Prior to the 1992 Act the capital requirement on unsecured GSE debt to total capital was 15-to-1 but there was no requirement for capital to be held against the agencies’ MBS. If they are forced to retain capital against MBS outstanding, and buffer capital for the institutions in case of operational or other risks they would have been able to withstand financial crisis. 19 Is FHFA as Feckless as OFHEO? • Contrary to their oft repeated claims that only Congress can fix the GSEs, FHFA should: – Continue development of first loss risk transfer to minimize risk of PMI failures and dispersion of risk; – Raise guarantee-fees to market levels; – Prevent the deterioration of underwriting standards through both private market mechanisms (greater data disclosure, accurately represented and warrantied mortgages with clear, standardized and enforceable putback remedies) and by better regulation – HERA has already mandated the near total elimination of the GSEs portfolios for other than liquidity purposes; • A failure to act will create political problems and may create economic problems as interest rates rise and housing, potentially, weakens. • GSEs have no capital so there will be a political problem as GSEs go back to draw on UST. • As we saw in the 1960’s, as rates rose and bank deposits were withdrawn and placed in Treasuries, there was a reduction in bank willingness to support mortgage lending. • We shouldn’t reinvent a wheel that has driven the secondary market successfully for generations. We should repair it well, just as we recognized the need to do after the S&L crisis. 20 If FHFA Does Its Job, Legislation Becomes Easier • Congress should ensure that the GSEs’ regulator places safety and soundness of these companies as primary. • Replace the current regulatory oversight with a Public Utility Commission responsible for determining allowable rates of return – Any income above that rate of return would go to enhance capital. – Any income above the enhanced capital requirements would be split between dividends and an affordable housing trust fund. – With capped rates of return the GSEs would not have the deep pockets with which to lobby legislators, thus avoiding much of the basis for capture. • Use stringent methods to price guarantees, separate from the GSEs and from political influence. This would create incentives for increased private market, unwrapped issuances on which investors would be forced to retain the risk (eliminating the broad government guarantee); • Sever the government’s sponsorship to end the provisioning of an implied government guarantee; • Ensure that GSEs can function in a counter-cyclical environment, the GSEs are regulated in the same manner as other utilities providing essential public services. “A public utility model offers one possibility for incorporating private ownership. In such a model, the GSE remains a corporation with shareholders but is overseen by a public board. Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders” – Federal Reserve Chairman Ben Bernanke (October 31, 2008) 21 If FHFA Does Its Job, Legislation Becomes Easier • Rather than leave the Treasury line of financial support in place, which only supports market perception of an implied government guarantee, the GSEs should be required to pay an annual commitment fee to Treasury. That fee should be determined by the Financial Stability Oversight Council by reference to market rates for comparable financing and the risk of drawing on that support. – With stringent capital standards that incorporate security level requirements, real transfer of first loss and capital stringent capital standards for PMIs or other first loss holders, this should never be called on. – Such a line would provide a narrow guarantee to allow the ongoing functioning of the TBA market and would be significantly smaller than proposed guarantees in either Crapo Johnson or the PATH Act. – With capital determined both on the institutions and their guaranteed securities, this would be a backstop guarantee of the institutions so that, in crisis, they would still be able to access markets. • Congress should designate the GSEs to be Systemically Important Financial Institutions. – This would create the opportunity for other primary financial regulators to oversee the interplay between the GSEs and other market participants. – It would also create enhanced supervision and expanded regulatory authorities. • Eliminate the Presidential appointments to the GSE boards. “I am skeptical that the ‘break it up and privatize it’ option will prove to be a robust or even viable model of any substantial scale, without some sort of government support or protection. It is difficult to envision a sound, practical, private sector mortgage insurance business of any significant size that does not require large amounts of capital, and consequently generates only a modest return on capital.” – Secretary of the Treasury Henry “Hank” Paulson 22