More GSE Reform Proposals Offered. Reduced Loan Limits Inevitable

The House Capital Markets Subcommittee held a hearing on Wednesday on reforming Fannie Mae and Freddie Mac.  Testimony came from representatives of three conservative "think tanks" and a single progressive one.  The first three speakers presented outlines for reform that had the common theme of privatization and many similar specifics.  The fourth advocated for continued government involvement and devoted much of her testimony to contradicting premises of her fellow panelists.

Mark A. Calabria, Ph.D., director of Financial Regulation Studies at the Cato Institute said the need for reform of the two government sponsored entities (GSEs) is beyond dispute and  there will be divisions over the substance of such reform but there are steps which Congress and the Administration must take immediately to protect the taxpayer and "reduce the perverse incentives that permeate our financial system."

Calabria and Anthony Randazzo, director of economic research at the Reason Foundation both urged the government to act quickly to change the role of the Federal Housing Finance Administration (FHFA) from conservator of the GSEs to receiver which would allow losses to be imposed upon the GSEs' debt holders rather than the taxpayers.  Such a receivership would not end the GSEs as the Housing and Economic Recovery Act (HERA) specifically prohibits FHFA from immediately terminating the enterprises' charters and would give Congress sufficient time to deliberate reform.

Placing the GSEs in receivership would help to lessen the perception that certain entities are too big to fail.  "If we are unwilling to take Fannie Mae into a receivership," Calabria said, "then most market participants will conclude that we would also be unwilling to take Citibank or Goldman Sachs into a receivership."

Another objection to receivership is that it would impose losses on creditors, most of which are also financial institutions and this might cause some to fail or experience financial stress but he foresees few resulting bank or thrift failures as they hold MBS.  Subordinate debt would likely be wiped out so Money Market Mutual Funds might incur significant losses as would foreign banks.

One inevitable element of this transition should be a gradual step-wise reduction in the maximum loan limits for the GSEs and FHA.  This would shift higher mortgage costs as well as the reduction in potential tax burden to higher income households.  The current "jumbo" loan market - loans above $729K - is approximately $90 billion.  Reducing the loan limit to $500K would increase the size of the jumbo market to around $180 billion, an amount that insured depositories with excess reserves of over $1 trillion and an aggregate equity to asset ratio of over 11 percent should have no trouble absorbing.  Moving more of the mortgage sector to banks would also put some capital behind the market which at present does not exist. This step seems inevitable.

Calabria suggested other immediate changes in preparation for more comprehensive GSE Reform. 

• Transition all GSE employees to the government pay scale as quickly as possible.
• Congress should examine the agreements reached between the GSEs and banks in regard to loan repurchases and GAO should audit them. Funds recovered should be used for off-setting taxpayer assistance to the GSEs
• Congress should establish a "recoupment fee" on all mortgages purchased by the GSEs. A 1 percentage point per unpaid principal balance of loans purchased would raise at least $5 billion annually and would have the additional advantage of reducing the competitive advantage of the GSEs.
• Whole mortgage loans currently require a 50 percent risk-weighting under Basel II while GSE debt only requires a 20 percent. The result is that the overall system holds only about 40 percent of the equity behind the mortgage market as it would otherwise. Congress should gradually eliminate the preferential treatment of the GSEs by bank capital standards; this would require the banking system to increase capital by approximately $24 billion.
• Going forward the GSEs should be limited to purchasing only those mortgages that meet the eventual definition of a qualified residential mortgage under the Dodd-Frank Act and should be immediately be allowed to purchase only mortgages for primary residences, with a maximum LTV of 90 percent and a credit quality indicating a projected delinquency rate of less than 5 percent.
• The scheduled reduction of GSE retained portfolios should be accelerated and the portfolios limited to mortgage-related investments with minor provision for cash and treasuries.

Randazzo's list of 10 intermediate actions contained many of the same suggestions but also urged a 20 percent minimum downpayment for GSE mortgages and an end to all affordable housing goals.

Alex Pollock, resident fellow of the American Enterprise Institute suggests that an ultimate aim for the GSEs would be to divide them into a "bad" bank which would be put into a liquidating trust, a "good" bank which should be privatized and the remaining governmental activities of delivering subsidies and non-market loans merged into the Department of Housing and Urban Development (HUD) and a five-year sunset be set for the GSE charters.  He echoed earlier suggestions of reducing conforming loan levels and prohibiting double leveraging of the GSEs by banks and suggested additional intermediate steps while awaiting permanent reform.

• Enable covered bonds as an alternate long-term mortgage funding option. Legislation is required to protect the covered bond holders' rights to the relevant collateral, but with covered bonds the issuing bank will have 100 percent "skin in the game."
• Bring GSE capital requirements up to those of national banks.
• Mandate the run-off of the GSEs' investment portfolios.
• Account for GSE debt on the government's books.
• Prohibit future lobbying by the GSEs
• Eliminate all GSE affordable housing goals and transfer any such goals to HUD.
• Require a one-page mortgage disclosure form for all GSE-guaranteed loans.
• Consider requiring GSE approval for the addition of second liens.
• Remove taxpayer guarantee of GSE subordinated debt.

Sarah Wartell, Executive Vice President, Center for American Progress said a new housing finance system should be based on five principles;

• Liquidity. Investors must have the confidence to deliver mortgage credit for both ownership and rental options in every community, through large and small lenders, and regardless of economic conditions.
• Financial stability. Mortgage lending in inherently pro-cyclical sources of countercyclical liquidity are required so to stabilize the markets and economy.
• Transparency and standardization. Underwriting and documentation standards must be clear and consistent so consumers, investors, and regulators can accurately assess and price risk and institutions can be held accountable for maintaining an appropriate level of capital.
• Access to reasonably priced financing for both homeownership and rental housing.
• Support for the best interests of borrowers and consumers and protection from predatory practices.

Wartell said that "taking some of the steps recommended by other panelists would serve the goals of our system badly."  Restoring a private market system will take time.  There has been only one private label securitization deal since the beginning of the financial crisis three years ago and it consisted entirely of 5-year jumbo ARMS of extremely high quality.  "It is hard to imagine private-label securitization coming to a scale to take any significant part of the conventional market in the near future."  She cited as reasons the current incomplete rulemaking surrounding Dodd-Frank, the lack of investor confidence in private label securities, the need to look at servicing standards, and the comparative pricing advantage of GSE-backed lending.

There should not be an either/or choice between the status quo and radical privatization, she said.  A third option would be a limited government guarantee of MBS.  Private investors could pay into an insurance fund along the lines of the FDIC fund to protect taxpayers.

The Center supports a reduction in loan limits so as to focus the government backstop on the lower part of the market but not until the private market is positioned to take over the higher end.  To reduce limits too soon will hamper the ability to sell and ultimately the value of homes.  "In such a fragile economy, policy-induced home price declines seem unwise."

Wartell said she shares the goal of reducing taxpayer losses but fears some of the proposals presented at the hearing would have the opposite effect.  Shutting down the GSEs just as their assets are improving and losses are declining would cut off future dividends under the preferred stockholder program and the proposal to rapidly liquidate the GSE portfolios could also have the unintended effect of depressing the market and reducing recoveries for taxpayers while benefitting investors.  Selling assets gradually as now intended is more likely to maximize recoveries.

It is difficult to foresee what the housing market might look like under a system without government participation Wartell said.  In the event that private forces are able to finance the $10 trillion plus of mortgage debt, it is difficult to see how their obligations would not be considered systemically important.  Instead of a purely private market, we might "create a new set of implicit, unmonitored, and unpriced government guarantees."

The Obama administration will unveil its proposals for changes to housing finance giants Fannie Mae and Freddie Mac on Friday.