Senate Witnesses Agree on Need for Government MBS Guarantee

The Senate Banking Committee held a hearing on Thursday on the preferred structure of any government guarantee of mortgage-backed securities (MBA).  Committee Chairman Tim Johnson (D-SD) opened the hearing saying the details of how a new guarantee should be structured is paramount to a well-functioning national market.  "The government guarantee in the current system ensures that qualifying mortgages are TBA eligible, which allows borrowers to lock in their interest rates and connects loans and MBS with investors from across the country and around the globe.

"If the structure of the new guarantee is not compatible with TBA execution, a wide range of stakeholders have expressed concerns that access to credit will tighten for borrowers, making mortgages more expensive - especially in rural and historically underserved areas. This outcome is unacceptable. "

Johnson also said that if the new system allows a variety of private capital participants Congress must make certain it is safeguarded against future boom and bust cycles.  'It will be essential to create a system that protects taxpayers, but also does not create so many inefficient layers that the mortgage market becomes too expensive for qualified borrowers."

Phillip L. Swagel professor at the University of Maryland's School of Public Policy told the Committee it is extraordinary for any private financial activity, asset, or firm to have a government guarantee.  Where there is one "it should be strictly limited and with the terms and conditions that reflect the fact that it should be rare to have arrangements in which American taxpayers come to the rescue of those who made bad investments."

Swagel says he sees housing finance as an instance in which having an explicit government guarantee is a better policy than not having one because policymakers would feel obligated to intervene anyway.  If mortgages loans were not available during a crisis the intervention would be for social reasons, the special place housing holds in America, and for economic reasons that reflect its importance for investment and consumption.  Government officials would also feel obligated to intervene if the market for mortgage securities locked up because it represents a vital part of U.S. financial markets and so not to impair the flow of new mortgage origination.

Thus government intervention is latent, Swagel says, and it would be better to formalize the guarantee and have it priced appropriately rather than allowing it to remain implicit and unpriced.

Doing away with the implicit housing finance guarantee is not easy.  "A housing finance reform in which the government ostensibly does not guarantee housing would inadvertently recreate the implicit guarantee that was one of the worst aspects of the previous failed system." That implicit guarantee made it possible for the private sector to receive the upside when Freddie Mac and Fannie Mae (the GSEs) did well, but left taxpayers with the bailout when the market collapsed.

It is vital to spell out what happens when the government must make good on its guarantee.  It should be designed so taxpayer liability is far behind private capital but eventually there will be another crisis severe enough to activate the guarantee.  With this in mind, Swagel said, there are several key decisions.

First, the guarantee should be switched to particular MBS rather than firms.  This would allow for entry and competition which would prevent the value of the guarantee going to management and stockholders rather than passing through to borrowers.  Entry and competition will also help address the issue of Too Big to Fail.  Allowing more firms to participate in the activity of securitization and guaranty for mortgages will ensure that these firms can fail without a bailout. If multiple firms fail the government could shore up only one firm to ensure liquidity and continuity in the crisis.

Michael Canter, Senior Vice President and Director of Securitized Assets, AllianceBernstein spoke on behalf of SIFMA, the Securities Industry and Financial markets Association.  He told the committee that the 30-year fixed rate mortgage provides a stable and affordable vehicle for many borrowers but provides risks to lenders and investors because the interest income is locked in over a long period.  To manage this risk, lenders need access to a liquid, forward market for mortgage loans.

The "to-be-announced" (TBA) market serves that function today, allowing mortgage originators to sell conforming loans before they are originated and thus provide interest rate locks to borrowers and hedge risk.  The TBA market also provides the necessary liquidity that enables a national market for geographically diverse MBS where buyers and sellers agree on a transaction even though buyers do not know the specifics of their purchase until two days before the trade settles. 

This is possible because of the standardization of terms and the absence of credit risk.  The GSEs provide the standardization and the implied but near explicit government guarantee on the principal and interest of the MBS eliminates the risk.  A structure where private capital would take first loss position ahead of a limited government guarantee would serve to diminish any credit risk concern, leaving only prepayment risk; a so-called "rates market", as opposed to a "credit market". 

The government guarantee also provides support to the market in times of crisis, allowing investors to fund mortgages even at times when other markets become less liquid. No one disagrees that the role of the government must shrink, but it must also be recognized the critical counter-cyclical role the guarantee plays.

When thinking about the private capital that should stand in front of the guarantee, Canter said that the possibility of taxpayer loses should be very remote and behind multiple levels of private capital which include borrower equity, loan- or pool-level mortgage/bond insurance providers, and a well-capitalized insurance reserve funded by fees paid for government backstop.

Global capital markets are better at pricing mortgage credit risk than the government and capital market participants also price risk relative to other investment options.  This should help temper risks of a race-to-the bottom.

Canter said there is a risk that a mandatory, fixed level of risk sharing would contribute to volatility in mortgage markets and credit availability and exacerbate booms and busts.  SIFMA could support an approach where levels of risk sharing fluctuate in relation to the demand for mortgage credit risk.

The liquidity of the current $4 trillion GSE MBS markets must flow seamlessly into the new market and not be orphaned in the transition.  Abandoning outstanding securities would immediately diminish liquidity and value in the market for existing MBS, and would likely damage the confidence in the new securities. It would also mean that the market for the MBS would start with zero liquidity and be very volatile. Therefore, the form of the conforming MBS in the future needs to be generally compatible with conforming MBS today, or at least not so different that the current MBS could not be made fungible.

Joseph Tracy, Executive Vice President and Special Advisor, Federal Reserve Bank of New York presented the results of a paper he had developed with Patricia C. Mosser and Joshua Wright also of the New York Federal Reserve on government support for housing finance.  He said he and his co-authors started with the observation that in the face of truly systemic housing shocks, government always intervenes. 

Given the importance of housing to Americans and the economy the possibility that government might have to intervene cannot be eliminated.  We need to acknowledge that risk and take measures to reduce and manage it or there will be again an implicit guarantee that puts taxpayers at risk.

Tracy said in his view the private sector must absorb all losses up to an agreed point and time  The level at which the government steps and when it does so in must be well known in advance and credible to the market so there can be no destabilizing speculation.

The answer to how much parties should pay for the government guarantee should be based on government's exposure net of the loss absorption capacity of the private sector including an assessment of counterparty risks from risk sharing.  Risk sharing must require a payment of cash and oversight of the capital and risk profile of participants and the private capital should be of high quality and determined relative to the total risk associated with a given set of mortgage underwriting standards.

In other words the government should bear only the cost of extraordinary systemic risks; the private sector must bear losses associated with the normal business cycle.  If this can be arranged then most of the overall guarantee fee will be priced by the market and not by the government.

David H. Stevens, president and CEO of the Mortgage Bankers Association (MBA) said his organization believes a successful secondary market must retain and redeploy key aspects of the GSEs' existing infrastructures, including certain operational functions, systems, people, and business processes and must include three key elements:

• An explicit government guarantee for mortgage securities backed by a well-defined class of high quality mortgages;
• Protection for taxpayers through deep credit enhancement that puts private capital in a first loss position, with no institution too big to fail; and
• Fair and transparent guarantee fees to create an FDIC-like federal insurance fund in the event of catastrophic losses.

"The government should provide quality regulation of guarantors and systems along with a clearly defined, but limited, catastrophic credit backstop to the system. Without this government backstop, the mortgage market would be smaller and mortgage credit would be more expensive.

Stevens said we must define where private risk-taking ends and where government support begins.  Most proposals assume the private entities or capital structures will take losses up until the point the entities fail or the structures are tapped out so the question then becomes how much capital these entities must set aside in anticipation of losses.  This, he said, is not simple.

First, there will always be uncertainty about the amount of risk within a pool, vintage, or population of mortgages.  While lenders, investors, rating agencies, and regulators have developed tools and skills to accurately gauge the relative risk of default and loss from mortgages with different characteristics it is more difficult to get a handle on the level of absolute risk, which must be estimated across a range of home price, interest rate, and economic scenarios.

Private credit enhancers should have sufficient capital to make it a rarity that the insurance fund is called upon and the insurance fund and its premiums should be large enough that government outlays would almost never be required.   Still there is a cost to being too conservative.  Requiring capital beyond reasonable risk drives up rates, limits access to credit and distorts market behavior.

Congress should set broad parameters that the regulator can use to establish capital requirements and credit enhancement levels that are in line with those for mortgages held by other institutions.  This would be a system with no opportunity for capital arbitrage; requirements would be the same for all participants.  The regulator should also have rigorous criteria for approving lenders, servicers, and credit enhancers and should be an active supervisor with access to timely information to enable judgments about when potential actions might be required to limit risk.