Senate Witnesses Agree on Vital Components for Mortgage Reform

The panel of four witnesses that appeared before the Senate Banking Committee hearing on the Essential Elements of Housing Finance Reform were largely in agreement regarding the essential outline and goals of that reform.  There was unanimity on the need for access, stability, and transparency and all agreed that any system that emerged should have some mixture of private capital and a catastrophic government guarantee.

Jerome Lienhard II, President and Chief Executive Officer, SunTrust Mortgage said that from the prospective of a regional bank, the necessary reform of the housing finance system must retain the basic "plumbing" of a system that draws in enormous sums of investment capital and provides borrowers with rate certainty.  Reform must bring more private capital into the mortgage market in a principal loss position while maintaining a global market for mortgage-backed securities (MBS) and providing competitive access for small and medium-sized institutions that serve millions of homeowners.

Lienhard said that while his bank has originated and service more than $140 billion in mortgages, it holds only one in six or $30 billion worth on its books.  This is made possible for SunTrust and other regional banks by the existence of the secondary market.

A bank must be able to give the customer basic information on its interest rate and monthly costs up front, information the bank gets from the price of MBS trading in the "To Be Announced" (TBA) market.  The bank can then lock in the rate for up to 90 days and proceed through the lending process, properly qualifying, underwriting, documenting, and closing the loan.  But this all starts with the certainty of how the bank is funding the mortgage without which lenders would have the "chicken or egg" problem of funding risk without knowing its price.

While there is a need to address taxpayer risk, Lienhard said, the securitization platform, the standard-setting on lending and documentation and the servicing requirements are absolutely essential to maintaining a secondary market and we must emerge from housing finance reform with these key functions intact.

Richard Johns, Executive Director of the Structured Finance Industry Group ("SFIG") also stressed the preservation of the TBA market and suggested three sequential stages that any reform effort should follow.   

• A conversion into a common TBA, making Fannie and Freddie MBS fungible and therefore deliverable into a single TBA Market, eliminating current pricing and liquidity inefficiencies in the Agency Market.

• The creation of a single agency security to facilitate the conversion and continued liquidity of legacy securities and promote a deep and liquid new-issue MBS market.

• Establishment of a common securitization platform for the purpose of overseeing and maintaining the standardization of the market for government-guaranteed MBS.

Johns suggested that it should be left to regulators to determine the specific types of representations, warranties, enforcement provisions and recourse to be used in the new system.  He also advocated that government separate any goal of affordable housing from the operation of the secondary market, funding affordable housing through separate legislative mechanisms.  Also, reducing the upper loan limits for government guaranteed loans would ensure that their benefits are directed to the populations most in need of them.

Julia Gordon, speaking on behalf of the Center for American Progress (CAP), said that a consensus of stakeholders appears to be solidifying around the idea of a catastrophic government guarantee behind private capital such as is proposed in S 1217, the Warner-Corker bill rather than the virtual elimination of government involvement proposed in the House legislation called PATH.  Differences center on how to structure putting private capital in a first-loss position.  

CAP, Warner-Corker, and others have called for specialized mono-line institutions or bond guarantors. Other plans envision issuers that lay off the credit risk through structured transactions.  S. 1217 offers a plan through which issuers could toggle between bond guarantors and a purely private capital markets transaction.  The first alternative, Gordon said, is the only structure that meets all the other requirements CAP believes are necessary.  It is far more likely to be regulated and managed effectively for safety and soundness as there will be far fewer bond guarantors than issuers.  The regulator would need extraordinary regulatory capacity or ironclad coordination with banking regulators to evaluate the safety and stability of the many institutions involved in the structured transactions.

Second, bond guarantors are much more efficient at pooling and spreading risks. Structured transactions, to the extent that they cover a single or limited number of pools, cannot allocate risks and reserves across years, regions, lenders, and so on.

Third, investors in structured transactions have proven unwilling to assume risk on anything but the most pristine mortgages and if they are assuming first-loss position their high level of scrutiny will result in higher prices for non-traditional but credit-worthy borrowers.   

Individual deals are much less likely to be able to support a robust TBA market and, although the appeal of a structured transaction is that the money is already there to cover losses, it is much harder to ascertain how the investor institutions are accounting for these assets on their own books and to prevent them exporting risk into the larger financial sector.  Finally, bond guarantors can provide more protection to the taxpayer at less cost.

Gordon said she does not believe the S. 1217 approach of offering both executions will work.  The current bill tilts the playing field toward the pure capital markets approach, since that execution has little by way of regulatory requirements and can more easily meet the capital thresholds through leverage. Moreover, allowing investors to toggle back and forth between executions will likely fragment the market sufficiently to undermine TBA.

Gordon also called for establishment of a Market Access Fund to ensure a new system has the capacity to service borrowers in a "grey zone" between private credit and credit through VA, FHA, and USDA.  This would be funded through a 10 basis point assessment on all securitized mortgages, whether or not an issue receives a federal guarantee.  The fee would be collected by the SEC and used to provide support for developing innovations geared to expanding sustainable homeownership, for unsubsidized affordable rentals, to provide limited credit support and provide grants to encourage development of self-sustaining support services such as housing counseling.  Gordon said estimates suggest this fee would result in approximately $5 billion in revenues by the fifth year of generation.

Mark Zandi, Chief Economist and Co-Founder Moody's Analytics laid out a nearly complete blueprint for revamping the system including the same goals of access and transparency outlined by others but in many cases his recommendations were much more specific. 

To achieve these goals Zandi said the future housing finance system should embody a number of essential elements including a catastrophic government backstop with private investors providing the first loss capital. He refers to this as a hybrid housing finance system.

A substantial amount of first-loss private capital should stand in front of the government's catastrophic backstop.  Losses suffered in the Great Recession should be the benchmark.  Freddie Mac and Fannie Mae (the GSEs) and private mortgage insurers ultimately had a combined loss rate of between 4 and 5 percent.  This, what Zandi called the 100-year flood mark, would be a conservative capitalization rate since regulations will require guaranteed mortgages to be of higher quality than those purchased by the GSEs.

The private capital that will bear risk ahead of the government should come from varied sources. At the loan level private capital should include down payments from borrowers and the capital of any private mortgage insurers attached to the loan. At the MBS level sources should include the capital of the mortgage guarantors, risk retention by mortgage issuers, and the capital put at risk by global investors who take on housing risk from mortgage guarantors.

The system must be overseen by a strong regulator fashioned along the lines of the FDIC which would manage an insurance fund, funded by mortgage borrowers, to pay for any future costs that the government bears backstopping the system.

A common government-run securitization platform which would be used for all non-Ginnie Mae government-guaranteed securities and, although not required, could be used for nonguaranteed securities.

There should be a competitive mortgage guarantor market independent from large institutions that originate mortgage loans.

Zandi supports a hybrid system as the most desirable option for reform and went into great detail in his testimony has to how it should be structured, funded, and protected.  His complete testimony and that of the other witnesses is available here.