Ginnie Mae Contemplates MBS Evolution

By: Jann Swanson • Thu, Sep 25 2014, 2:54 PM

At its second annual summit for stakeholders on Monday the Government National Mortgage Association (Ginnie Mae) issued a policy paper detailing how it intends to meet the challenges it currently confronts in the aftermath of the housing crisis. The central challenge according to An Era of Transformation is "The retreat of commercial banks from mortgage lending and servicing and the replacement of this capacity by non-depository institutions with more complex financial and operational structures." This change, the paper says, represents a significantly different operating environment than that for which the program was originally designed, but "There has never been doubt that the [financial crisis] aftermath would transform the way mortgage lending operates in the United States."

The paper was authored by Michael Drayne, Senior Vice President of the Office of Issuer and Portfolio Management with consultation from Theodore Tozer and Mary Kinney, President and Executive Vice President and COO respectively of Ginnie Mae.

The retreat of commercial banks from home lending and servicing was not a pre-ordained event; during the crisis it would have been reasonable to envision a future in which mortgage lending was regulated so it would become even more exclusively the province of traditional banking institutions. But instead, banks have weighed the costs and benefits of these business lines and concluded that less exposure is more prudent.

The business model of the Ginnie Mae mortgage-backed security (MBS) program did not contemplate the complexities of the current evolving environment. The paper highlights five Strategic Views that explain Ginnie Mae's focus on the perspectives that will drive its actions and the specific initiatives that will shape its future.

Ginnie Mae emerged following the government's movement entry into the housing markets during and after the Great Depression. First Fannie Mae was chartered to create a secondary market for FHA and later VA loans and 30 years later Congress split off Freddie Mac to accommodate the purchase of conventional mortgages and created Ginnie Mae to pursue the creation of a mortgage-backed securities (MBS) market for government secured loans. Today Ginnie Mae along with Freddie Mac and Fannie Mae (the GSEs) are the dominant conduits of capital into the U.S. housing finance system and, the paper says, there is nothing on the horizon indicating this might change.

As issuer Ginnie Mae guarantees, for a statutorily capped fee, that the owner of an MBS will receive its principal and interest payments. The fee for the guaranty is readily accepted by the market and sufficient to compensate Ginnie Mae which has never posted an annual loss. Its securities are in high demand across the globe.

The success of the MBS programs with capital markets however has bred a critical dependency in that every pool of securitized and guaranteed mortgages must have an institution willing to take full responsibility for its servicing, remitting, and reporting. It is with these institutions, the Ginnie Mae issuers, where the marketplace is changing so rapidly today.

While there are many similarities between Ginnie Mae and the GSEs there are also important distinctions. The Urban Institute recently summarized them thus:

1. Ginnie Mae securities consist exclusively of loans that are backed by the federal government.

2. Ginnie Mae guarantees only the pass-through payments to security-holders, not the credit performance of the underlying loans.

3. Ginnie Mae securities enjoy the explicit full faith and credit guarantee of the United States Government.

These, in turn, give rise to other more-nuanced distinctions with a common element; the vastly narrower scope of Ginnie Mae's concern, capability and responsibility when compared to the GSEs. Ginnie Mae's potential for losses occurs almost entirely at the point where an issuer fails to fulfill its responsibilities under the program and almost certainly would involve the failure of the firm itself. Loan level losses below a level precipitating such failure are covered by the insuring agency with any shortfall absorbed by the issuer.

There are other differences as well: Ginnie Mae does not use its balance sheet to make a market, nor purchase loans or securities. The GSEs historically made a market in loans and securities, using their vastly larger, leveraged balance sheets.

Ginnie Mae also has limited ability to oversee servicing of assets while the GSEs are responsible for the full spectrum of risk. They are security guarantors as a byproduct of their broader role as asset gatherers and managers.

The individual issuers of Ginnie Mae securities are responsible for servicing the assets just as the insuring agencies are for the loan level credit risk and also for establishing and enforcing the servicing standards in order to protect their loan guaranty.

The difference in scope gives Ginnie Mae a heightened sensitivity to the health and liquidity of the overall market for agency MSRs where its risk is concentrated in its counterparties' success or failure. This places a premium on the existence of a broad universe of high-quality counterparties that are willing and able to administer the MSR assets underlying Ginnie Mae's securities. The company also has an extremely limited ability to operate in the MSR market and prefers that failed issuers portfolios be absorbed by other issuers rather than acquiring them itself.

As noted earlier, the retreat of banking institutions from mortgage lending is one of the clear defining developments of the post-crisis era. The Ginnie Mae Strategic Views articulated in this paper all derive from this trend.

There are three primary drivers of this post-crisis retreat of the banks:

The impending imposition of capital standards (via the Basel III standard) that could have the effect of penalizing the ownership of MSRs.

A recognition that existing servicing organizations were inadequate to the current levels of defaulted loans and more onerous regulatory standards coupled with an unwillingness to invest in the infrastructure needed to change this.

Enormous retroactive costs of settlements and penalties that have made servicing appear to be increasingly challenging and economically uncertain.

The third driver is by far the most significant and likely to have the most durable impact. The possibility of unpredictable government-driven costs will continue to constrain enthusiasm on the part of banks which have experienced them and could facilitate rising prices for the consumer.

Ginnie Mae's program has never made a fundamental distinction between bank and non-bank issuers but in light of its dependence on capable private firms willing to support the MBS it guarantees, this pullback is not welcomed and leads to Ginnie Mae's Strategic View I:

"Policy-makers should be concerned with the retreat of banks holistically; not just the trend's most direct result (the rise of non-depositories), but also to its causes and long-term significance for the market.

"Ginnie Mae will advocate for an environment in which the importance of preserving residential mortgage servicing as an economically viable activity, and mortgage servicing rights as an attractive asset class, is recognized."

The banks retreat from mortgage lending has occurred as investment capital is plentiful. Non-bank institutions-many of them relatively new- have risen to take the place of banks, though the speed and scale of the transition is giving interested governmental entities pause. A comparison of Ginnie Mae's top ten issuers by unpaid principal balance (UPB) lists from June 2011 and June 2014 gives a flavor of the transformation:

There are two principal types of larger non-depositories emerging. The first are established firms that conduct mortgage banking traditionally and wish to expand their exposure to MSRs on attractive terms. The second and more significant firms are those which have developed primarily in the post crisis era. A subset of these have profiles characteristic of a network more than a full-scale mortgage banker. They to link capital with operating platforms for the purpose of overseeing MSR investments and do not aspire to become traditional mortgage bankers.

Smaller mortgage banks had become heavily dependent on banks as their conduits to capital markets, but post crisis have sought direct access to those markets in substantial numbers. This includes participation in the Ginnie Mae MBS program and has led to heightened demand for Ginnie Mae approval. This means the company will need to manage a significantly larger number of counterparties. The company is exploring ways to invite broad access through non-traditional 'gateway" issuers. An example is its new partnership with the Federal Home Loan Bank of Chicago in which the bank it would act as the issuer for its smaller member banks.

"STRATEGIC VIEW II. The rising prominence of non-depository firms, and the accompanying trend toward specialization and the establishment of networks of firms, represents a natural market response to prevailing factors, such as the pressures on legacy bank servicers. Though there are legitimate concerns about accompanying risks, there is also value in the diversity and innovation that such firms can bring.

"Ginnie Mae is supportive of a responsible evolution of the residential finance marketplace and is willing to explore making appropriate modifications to its MBS program and securitization platform to reflect such evolution."

A counterparty landscape dominated by enormous banking institutions with substantial resources, diverse lines of business and deep access to low-cost funding is an appealing proposition for a government guarantor. Each step away from it increases the possibility of loss. Issuers which are with regulated institutions also allow a guarantor to outsource a significant portion of its risk management to banking regulators but as the non-banks rise in importance no equivalent to the regulators is emerging. The increase of non-depository institutions as counterparties will require substantial changes to Ginnie Mae's monitoring and governing practices.

In addition to financial oversight the post-crisis transformation requires a need to oversee areas of operational risk. The new breed servicers tend to rely on networked arrangements with financial, origination, and servicing capacities each in separate locations and the core function of the primary entity is to manage and oversee the separate pieces and there is more room for breakdowns in such arrangements.

STRATEGIC VIEW III. Ginnie Mae will upgrade its ability to assess both the financial and operating capacity of its issuers, and the establishment of new measures and standards. Three areas will be the subject of particular focus:

Closer scrutiny of an issuer's liquidity and sources of funding, given the requirement that they remit required payments to security-holders under any eventuality.
More frequent and detailed MSR portfolio valuations
Greater attention to operational capability and dissemination of data-driven operational performance information, recognizing the importance of non-financial factors to the health of the MBS program.

Servicing guaranteed mortgage loans is a capital intensive proposition and market liquidity will be of primary importance as residential financing adjusts to post-crisis reallocations of institutions and assets.

To Ginnie Mae "Market liquidity" first refers to an adequate supply of funding for mortgage servicing activity and the provision of accessible sources of funding at the point of need. The most critical point an issuer's ability to fund servicing advances on loans that are in default.

Ginnie Mae's second definition of "market liquidity" isa market that will permit the ownership of Ginnie Mae MSRs to change hands. Ginnie Mae's mission to attract global capital into the U.S. housing markets could be thwarted by an insufficient supply of institutions to service the securities and underlying loans it guarantees and lack of ability to transfer MSR could make institutions less willing to invest in these assets. Ginnie Mae has far fewer resources for and less control over, the servicing of pools and loans as compared to the GSEs, rendering it more reliant on the existence of a deep pool of qualified servicers.

Ginnie Mae's approval rights over the transfer of the MSRs of the securities it guarantees and its guarantor function make the acquiring servicer's ability to fulfill its obligations under the MBS program critically important. Decisions to decline a transfer are likely the result of concern that the proposed transaction presented the possibility of undue risk of losses, which could inure to Ginnie Mae in the event of a future default by an issuer.

This counterparty risk decision, though, is made amidst the backdrop of a larger concern for the maintenance of a liquid market for MSRs. Ginnie Mae's actions with respect to servicing transfers are therefore mindful of both counterparty risk at the micro level and market liquidity at the macro level.

The existing structure of the Ginnie Mae program already impedes liquidity because it is dominated by pools of loans out of which transferring of individual loans is not possible. Upgrading systems to provide for loan level servicing and bond administration is an important strategic initiative for Ginnie Mae.

MSR strips, the segmentation of cash flows into narrower streams that can be owned by investors completely removed from the operational aspects of producing them may be established through private market arrangements or in the form of tradable securities. A plausible future may involve increasing levels of economic ownership of MSRs by passive investors.

Accordingly, Ginnie Mae will consider MSR strip arrangements, though it has not yet committed to develop a securitized product. The development of loan level servicing capability is a higher priority initiative.

STRATEGIC VIEW IV. Much of Ginnie Mae's strategic efforts over the near future will be directed at providing for market liquidity:

Enhanced standards for issuer liquidity and increased attention to MSR valuations and markets and recognition of MSRs are collateral.
Recognition of the importance of entities that finance servicing activities and incorporation of that role into the standards and procedures that govern the execution of the MBS program.
Continued exploration of how advance financing can be provided for in the realm of government-insured loan servicing.
Development of the ability to support loan level servicing, so that Ginnie Mae issuers are no longer constrained by the need to service or transfer an entire pool.
Attention to the development of MSRs as an alternative asset class, divorced from servicing operations, and consideration of program modifications that might appropriately support this trend

As the universe of non-bank issuers grows Ginnie Mae must consider possible increases in issuer failures and thus has given consideration to the posture it will take toward issuer infractions and has begun to adapt its approach to issuer non-compliance.

The most serious threat to the narrowly-defined nature of Ginnie Mae's would be a spate of issuer failures sufficient to introduce doubt about the rationale and soundness of the MBS program. This has happened with the GSEs and even FHA. At the same time the narrow responsibility enables Ginnie Mae to succinctly describe the essential duties of issuers: to report pool date in a timely and accurate manner and manage and pass-through funds on behalf of security holders.

Failure on the second score is the ultimate failure and these have historically resulted in Ginnie Mae's declaration of default and extinguishment of approval status and the issuer's rights to the MSRs which revert to government property. The failure of Taylor, Bean & Whitaker underlined the difficulty of making a small government agency designed to administer a guaranty program also an asset manager so Ginnie Mae's strategic direction will be fostering the maximum potential for permitting MSRs from failed institutions to be absorbed by other private firms.

STRATEGIC VIEW V. "Because a spiraling series of compliance failures could pose a threat to the continued viability of the MBS program, institutions that clearly demonstrate difficulty complying with essential program terms will be deemed unacceptable risks and will be removed from the MBS program.

When issuer failure necessitates the transfer of MSRs Ginnie Mae's will seek place such MSR assets in the hands of a more suitable Ginnie Mae-approved private sector owner, rather than to seize and manage them itself."

Adapting to changing circumstances, while preserving the integrity and strength of its MBS program must be performed by Ginnie Mae as a delicate balancing act. Ginnie Mae's overriding goal will be to protect and preserve the utility, relevance and remarkably successful track record of the Ginnie Mae MBS program.