GSE Reform and Securitized Mortgage Finance

Originally published in the December 2010 issue of Asset Securitization Report

There is a reasonable chance that the incoming Congress will finally attempt to tackle the contentious issue of GSE reform. However, radical changes to the GSEs (with some discussion of eliminating them entirely) have the potential to seriously disrupt the mortgage and housing markets.  Despite their depleted financial condition, they remain entrenched in housing finance, as more than two-thirds of MBS are being issued through Fannie Mae and Freddie Mac.

Despite calls by politicians and columnists suggesting that the GSEs can be replaced by the “private markets,” there is currently no private issuance mechanism that can immediately assume their role. Private-label issuance since the end of 2007 has been minuscule, resulting in opaque pricing and subordination levels for new transactions. A back-of-the-envelope analysis implies that private-label execution would translate to primary conforming mortgage rates hundreds of basis points higher than current posted levels. The collective balance sheet of the U.S. banking system is also not large enough to finance the housing market on its own.

In this light, it’s unrealistic to believe that the GSEs could be dissolved without severe consequences to both housing and the economy. Assuming a rational debate ensues, I can envision some potential forms that the “reformed” GSEs could take. In all cases, the GSEs would not hold more than token retained portfolios and be strictly proscribed from political activities. One option would continue current pooling and distribution practices, but with GSEs that only issue loan guarantees. While this would be minimally disruptive, it would not reduce taxpayers’ exposure to losses on housing credit which, according to a recent report from the FHFA, accounted for roughly three-quarters of the GSEs’ “capital reductions” since 2008.

An alternative would dust off an old concept to create a new securitization scheme. This arrangement would utilize structures similar to the private-label deals issued by the GSEs through their whole loan shelves in the late ‘90s and early ‘00s. (The deals were issued using FNW and FSPC tickers.) Those transactions were structured like private-label whole loan deals; the difference was that the senior bonds were wrapped by Fannie or Freddie, with the wrap cost paid out of the senior bond’s coupon.

Senior passthroughs off transactions utilizing similar structuring techniques could replace passthrough pools as the primary vehicles for GSE-backed mortgage securitizations. A few alterations to the structures would be necessary in order for them to trade with comparable liquidity to passthrough pools. (For example, the structures could not employ a shifting-interest mechanism, which directs early principal payments to the seniors; it effectively leverages the seniors and makes them less fungible.) If structuring rules and delivery requirements are standardized by SIFMA, the seniors could be traded and settled in the same fashion as pools in the TBA market and, given the GSEs’ backing, would trade fairly well.

Such an arrangement would maintain continuity in housing finance while significantly reducing taxpayer exposure to mortgage credit, since the bulk of credit risk is passed into the capital markets through the deals’ subordinate tranches. It would also leave the FHA as the primary provider of “affordable” mortgage credit. The potential lack of rating agency involvement due to Dodd-Frank’s revocation of the rating agencies’ “expert advice” exemption could be surmounted by using simple structures for which the issuers outline enhancement levels and cash-flow priorities rather than “ratings.”

Sweeping changes such as those outlined above will be difficult to legislate, as few congressional aides have experience in structured mortgage finance. In any case, the active participation of the securities industry in the reform process will be necessary to properly institute such far-reaching reforms.