DeMarco Determined to find Just the Right Amount of "Skin in the Game"

By: Jann Swanson • Mon, Oct 28 2013, 3:19 PM

The acting director of the Federal Housing Finance Agency (FHFA) discussed the future of the government sponsored enterprises Freddie Mac and Fannie Mae (the GSEs) on Monday, focusing on the future of single family guarantee business and highlighting briefly the need for change in the putback risk loan originators face when selling mortgages.

Edward J. DeMarco told an audience attending the 100th Mortgage Bankers Association convention and expo that representations and warranties or reps and warrants have long served a key risk control mechanisms for the GSE's, helping to ensure that loans sold to them meet the requirements set forth in their seller guides. They attracted less attention when times were good but the tremendous breakdown in origination quality during the housing boom led to unprecedented delinquencies which led in turn to unprecedented loan reviews and putbacks.

DeMarco said that as conservator of the GSEs, FHFA believes that enforcement of long-standing contractual requirements was a necessary if painful process to protect taxpayers and assign losses appropriately. But the experience has also demonstrated the need for improved quality control including better use of technology to enhance that control.

Earlier this year he promised that the GSEs would first of all complete all rep and warrant claims on pre-conservatorship loans by the end of this year and the GSEs are on track in this regard. Second, the quality control review process for all new production has been moved near the time of purchase rather than a later time such as when the loan becomes delinquent. The period for which the rep and warrants remain active, except for limited issues such as fraud, is now limited to three years for performing loans.

While important changes have been made to the rep and warrant framework there is still a learning process going on and further improvements should emerge over time, especially improved data systems and technological developments to contribute to faster and more reliable loan reviews.

Another area of progress in wrapping up the past is resolving securities law claims on private-label MBS which are somewhat analogous to the rep and warrant issue and also need to be resolved. FHFA has now settled four of the eighteen outstanding lawsuits in this area and hopes to build upon those cases to resolve the pending ones.

DeMarco again stressed the "overarching goal" of reducing the market presence of the GSEs and that, as their conservator FHFA has three main tools to accomplish that objective. The first, risk sharing transactions, are important for reducing taxpayers' long-term risk exposure. FHFA has set a 2013 Scorecard target for each GSE to achieve $30 billion in risk sharing using multiple types of structures. Both Freddie and Fannie are on target with this goal and the transactions so far, including a new type of mortgage security and laying off risk on private mortgage insurers have been well received by the market.

Going forward he said he expects to see work done on other types of transactions such as senior/subordinated structures for certain portions of the GSEs' mortgage guarantees. Alternative approaches will contribute to efforts to develop a securitization infrastructure that is less reliant on the GSEs' traditional government-sponsored enterprise securitization model.

Second, DeMarco said, guarantee fees are about double what they were prior to conservatorship. A key reason for this is to price credit risk closer to what would be required by private sector providers. While that level is difficult to evaluate with precision, the fees are thought to be getting closer to a level that would encourage more private sector participation and future increases will be gradual in nature.

The third tool is a reduction in the maximum size of loans that the GSEs guarantee. This summer the President specifically endorsed a gradual reduction in maximum loan size and since then there has been much discussion about a near-term reduction in the loan limits.

During the past week DeMarco said he had made clear he understood the potential timing issues of such a change given the other regulatory changes in the mortgage market and that FHFA will follow its practice of announcing the 2014 conforming loan limits in late November, but will give market participants at least six months' notice of any change.

Any reduction would be across the board, not just in some parts of the country and would measured and gradual so as not to disrupt markets. In November FHFA will also provide further information on potential reductions in the size of loans the GSEs will guarantee going forward.

FHFA is also focusing efforts on building towards a future infrastructure to support the single-family mortgage market. Among these efforts is the Common Securitization Platform with the focus on functions that are routinely repeated across the secondary mortgage market, such as issuing securities, providing disclosures, paying investors, and disseminating data; all functions where standardization could have clear benefits to market participants.

FHFA recently announced the formation of Common Securitization Solutions as an equally-owned subsidiary of Fannie Mae and Freddie Mac. It will have its own independent location and leadership and will manage the development of the platform and the associated data and legal infrastructure for future securitizations.

DeMarco said he is committed to ensuring broad industry input into the effort and next year will formalize a means for MBA members and other market participants to participate in the development of the platform. He is also committed, he said to an outcome that strengthens, not weakens, the ability of small and mid-sized lenders to access the secondary mortgage market. "Competition, and thus consumer opportunities, is enhanced when large lenders and small effectively compete in offering mortgages to families and compete in servicing those mortgages. But to get there, we must be willing to envision the mortgage market working differently than it has in the past."

Long-term, continued operation in a government-run conservatorship is not sustainable the acting director said because each company lacks capital, cannot rebuild its capital base, and is operating on a remaining, finite line of capital from taxpayers. Furthermore, a taxpayer-backed conservatorship provides a significant subsidy to the mortgage market that crowds out private capital and underprices risk in the market. It also places long-term decision making in the hands of a government agency, decisions that should be made by private sector businesses based on reasonable returns on private capital.

At some point, lawmakers will need to decide on the appropriateness and level of a government credit subsidy for housing. Such a decision should include whether a government-owned corporation should undertake some or all of the business activities of Fannie Mae and Freddie Mac, or whether some or all of those functions should be repositioned in the private sector.