Tag Archives: GSE

Returning Private Capital to Mortgage Markets: A Fundamental for Housing Finance Reform

May 15th, 2013 by under Faculty Commentary. No Comments.

Swagel-Phillip-HRThis is an excerpt from CFP Academic Fellow Phillip L. Swagel’s testimony before the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs on May 14, 2013.  Click here for the full transcript.

Bringing private capital back to fund mortgages and take on credit risk is an essential element of housing finance reform, particularly with respect to reform of the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac. Housing finance reform should ensure that mortgages are available across economic conditions, while shielding taxpayers from taking on uncompensated risk and protecting the broader economy from the systemic risks that arose in the previous system. Bringing about increased private capital as part of housing finance reform will help protect taxpayers and improve incentives for prudent mortgage origination by lenders and investors with their own resources at risk.

The situation in housing finance today is that taxpayers fund or guarantee more than 90 percent of new mortgages through the GSEs and through government agencies such as the Federal Housing administration (FHA). Fannie Mae and Freddie Mac stand behind virtually all new conforming mortgages through the two firms’ guarantees on the mortgage-backed securities (MBS) into which the two firms bundle the home loans they purchase from originators. There is loan-level capital to absorb losses in the form of homeowner down payments and private mortgage insurance (PMI), but no private capital at the level of the mortgage-backed security (MBS) ahead of the financial resources of Fannie and Freddie. With the U.S. Treasury committed to ensuring that Fannie and Freddie remain solvent, the U.S. government effectively backstops conforming loans, leaving taxpayers exposed to considerable losses in the event of another housing downturn—and this risk remains even while the two firms are now profitable. Taxpayers further take on credit risk in housing through the government backstop on the Federal Home Loan Bank (FHLB) system, and through guaranteed mortgages supported by the Federal Housing Administration (FHA) and other federal agencies. I have previously testified on reforms to the FHA that would better protect taxpayers while focusing the agency on its mission to expand access to mortgage financing for low- and moderate income families who have the financial wherewithal to become homeowners.¹ I thus focus here on GSE reform.

Bringing back private capital into housing finance would mean that private investors would absorb losses as some mortgage loans inevitably are not repaid. In some instances, this could involve mortgage loans with no government guarantee, while in others there could be a secondary government guarantee that kicks in only after private capital absorbs losses (or the guarantee could be alongside private capital, with losses shared). Private investors would be compensated for taking on housing credit risk, so that it should be expected that mortgage interest rates will increase as housing finance reform proceeds. This interest rate impact reflects the facts that the previous system was undercapitalized and provided inadequate protection for taxpayers.

It would be useful for reform to allow for a diversity of sources of funding for housing, and for private capital to come in a number of forms and through a variety of mechanisms. This will help make the future housing finance system more resilient to economic and market events that affect particular parts of financial markets and thus impinge on the availability of funds for housing.

At the level of the individual loan, capital for conforming mortgages will continue to be present from a combination of homeowner down payments, private mortgage insurance, and the capital of originators that carry out balance sheet lending. The recent housing bubble and foreclosure crisis highlighted the importance of homeowner equity as a factor in avoiding foreclosures, as foreclosure rates were especially elevated for underwater borrowers—those who owed more on their mortgages than the value of their home. As reform proceeds, it is vital to ensure that meaningful down payments remain a central aspect of underwriting and a requirement for mortgages to qualify for inclusion in MBS that benefit from a government guarantee. Similarly, regulators must ensure that private mortgage insurers have adequate levels of their own high-quality capital to participate in mortgages that receive a government guarantee.

The larger changes involved with the return of private capital to mortgage origination will come at the level of the mortgage-backed security. With nearly all securitization of conforming mortgages going through the GSEs, there is essentially no capital at the MBS level. The so-called profit sweep agreement between the Treasury Department and the two GSEs prevents Fannie and Freddie from building up the capital that would be the norm for an insurer.

Fannie and Freddie are setting up risk-sharing mechanisms to allow private investors to invest in securities that will take losses ahead of the firms’ guarantee (that is, ahead of the taxpayer guarantee). There is still little securitization of mortgages taking place without a guarantee (private label securitization of non-conforming loans), and firms other than Fannie and Freddie are not allowed to compete in the business of securitization of conforming mortgages with a government guarantee.Housing finance reform should involve changes on all of these dimensions so that private capital is present at the MBS-level.

¹February 28, 2013, Senate Banking Committee hearing on “Addressing FHA’s Financial Condition and Program Challenges, Part II.”

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Election Aftermath: Financial Policy, Legislation and Regulation

November 14th, 2012 by under Faculty Commentary. No Comments.

by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the November 2012 Longbrake Letter. To read the letter in its entirety, click here.

Congress will focus on tax and spending issues over much of the coming year. This will crowd out consideration of most other legislative issues. However, there is unfinished business in dealing with mortgage finance issues and the future of the housing government sponsored enterprises – Fannie Mae and Freddie Mac.

In spite of calls from several quarters to revamp provisions of the Dodd-Frank Act, the most Congress is likely to do in the coming year is hold hearings. It will leave it to regulators to continue the slow tedious process of writing and adopting implementing regulations, although hearings will be used to try to exert some influence on the direction and content of certain regulations.

Increased bank size and complexity and greater concentration of financial resources in fewer institutions have lead to concern about “too big to fail” and adverse competitive impacts on smaller banking organizations. This is a bipartisan issue. Both Democrats and Republicans are troubled. Hearings will be held and legislation will be introduced, although passage of anything in the coming year appears to be unlikely.

Implementation of Basel III capital and liquidity rules was supposed to occur in 2013. However, the final rules have not yet been adopted. There has been a firestorm of protest, especially from smaller financial institutions, that implementation could have extremely harmful effects. Banks have lobbied for implementation to be delayed until a thorough economic impact analysis is completed. Congress appears to be sympathetic to this complaint. Regulators recently announced a delay in implementation but did not indicate they would conduct the requested economic impact analysis.

1.    Congressional Leadership

Senate. Democrats increased their majority in the Senate by two seats and, assuming the two independent Senators caucus with the Democrats, will hold a 55-45 edge in the Senate. The overall composition of the Senate will be somewhat more liberal. Tim Johnson (D-SD) will continue to chair the Senate Banking Committee.

House of Representatives. Republicans lost a few seats in the House, but still have a comfortable majority which will enable them to control the legislative agenda in the House. Jeb Hensarling (R-TX) will chair the House Financial Services Committee as Spencer Bachus is term-limited by Republican Caucus rules. Jeb is known as a “free market conservative”. What this means for housing policy is that he favors privatization of mortgage finance. Maxine Waters (D-CA) succeeds Barney Frank, who retired, as ranking member.

2.    Regulatory Leadership

Because the presidency will not change hands, there will be few significant changes among regulators of financial institutions and financial services.

FDIC. Martin Gruenberg (D), who has been Acting Chairman of the FDIC, will likely quickly be confirmed as chairman. Thomas Hoenig (R), who was nominated to be Vice Chairman, but was confirmed as a director of the FDIC, will likely be confirmed as Vice Chairman at the same time Martin Gruenberg is confirmed as Chairman.

CFPB. Richard Cordray has a recess appointment as the Director of the Consumer Financial Protection Bureau (CFPB). That appointment expires in December 2013 unless he is nominated by the president and confirmed by the Senate to serve a full term. Nothing is likely to happen in the opening months of 2013, but the expiration of the recess appointment at the end of the year will force the situation. Republicans have blocked appointment of a permanent director because they believe the CFPB should be governed by a board rather than a director. The outcome of the election assures the status quo since the Senate will not agree to such a governance change. It remains to be seen whether Republicans will continue to block a permanent appointment.

FHFA. One regulatory change that seems highly probably before the end of the year is replacement of Ed DeMarco, Acting Director of the Federal Housing Finance Agency (FHFA). There have been repeated calls from Democrats in Congress to fire DeMarco. This cannot be done under the terms of the FHFA’s statutory governance structure. However, the president can appoint a director using his recess appointment authority. This is very likely to happen following the end of the 112th Congress and prior to the convening of the new 113th Congress on January 3, 2013.

Treasury Secretary. Tim Geithner has made it clear that he will not continue as Treasury Secretary. Needless to say, speculation on successors has begun. Names that have been mentioned include Erskine Bowles (former Senator and co-chair of the Simpson-Bowles Commission on tax  reform), Roger Altman (Clinton Administration Treasury official), Larry Fink (BlackRock), Gene Sperling (Director of the National Economic Council), Neal Wolin (current Deputy Secretary of the Treasury), Lael Brainard (Under Secretary of the Treasury for International Affairs), Jacob Lew (White House Chief of Staff), and Daniel Doctoroff (CEO of Bloomberg).

Federal Reserve Board. Elizabeth Duke’s term expired on January 31, 2012 but she is continuing to serve until the president appoints and the Senate confirms a successor. Chairman Bernanke’s term as chairman expires on January 31, 2014. It is widely believed that he plans to step down at that time. What this means is that by about the middle of 2013 speculation will crescendo about who the future chairman is likely to be. Republicans have been unhappy about the Fed’s quantitative easing monetary policy. However, because the composition of the Federal Open Market Committee is unlikely to change appreciably it is unlikely that there will be any material change in monetary policy in coming months.

3.    Dodd-Frank Act

No legislative tinkering with the Dodd-Frank Act seems likely in the coming year. Congress will hold oversight hearings. Democrats will focus on defending past achievements. Representative Brad Miller (D-NC) recently said, “I can’t imagine an ambitious agenda coming out of Democrats in Congress.” The House Financial Services Committee passed many bills in the current Congress, nearly all of which never were considered by the Senate. The same is likely to happen in the next Congress.

Regulators will continue the tortuous task of writing and implementing regulations covering:

  • Asset-backed securities offerings
  • Banking regulations
  • Consumer protection
  • Credit rating agencies
  • Derivatives
  • Executive compensation and corporate governance
  • Mortgage reforms
  • Orderly liquidation authority (living wills)
  • Investors: advisers/private funds
  • Investor protection/securitizations
  • Systemic risk (SIFIs – systemically important financial institutions)
  • Volcker Rule (proprietary trading)

Davis Polk puts out a monthly status report on Dodd-Frank rulemaking. The report makes it clear that regulators have a long road ahead. For example, banking regulators have finalized only 34 of 135 rules; the SEC has completed 32 of 95 and other regulators have finalized 27 of 108. The CFTC is the farthest along, having completed 43 of 60. This means that only about one-third of the 398 required regulations have been implemented.

Recently the Bipartisan Policy Center announced a “Financial Regulatory Reform Initiative” which will focus on the Dodd-Frank Act. A report is targeted for fall 2013.

4.    GSE (Fannie Mae and Freddie Mac) Reform Legislation

GSE legislation is needed to enable and encourage the private sector to provide mortgage finance solutions. It is also needed to define the future role of the government in providing mortgage finance and specifically what, if any, role Fannie Mae and Freddie Mac will have.

While legislation is a pressing need, Congress’ preoccupation with tax and spending issues is likely to leave little time for consideration of this issue. Moreover, a deep ideological divide exists, mostly among Republicans, over the role of the private sector versus the government in providing mortgage credit guarantees. According to Gary Miller (R-CA), “The untold story is how much division there is among Republicans on exactly what to do.”

There are three sets of issues that need to be addressed:

  • Consumer protection
  • Securitization and secondary market
  • Credit guarantees

Consumer Protection. Consumer protection issues are being addressed by the CFPB. The most difficult issue is defining what constitutes a “qualified mortgage” in terms of unfair, deceptive and abusive practices (UDAAP). The principal issue is whether and how to define a safe harbor or whether to rely on a “rebuttable presumption”. The stakes are high because aggrieved mortgagees have the right to bring private legal action for redress of any harm they believe they may have suffered. A safe harbor would preclude the right of private action. However, too narrow a definition of safe harbor could limit the availability of mortgage credit, particularly to low-income households. Adoption of a rebuttable presumption standard would permit more flexibility in mortgage instrument design but would entail potential legal ambiguity that could cause increased litigation risk. The CFPB has promised to issue a final regulation by January 21, 2013. Whatever the outcome, the availability and cost of mortgage credit is likely to be affected adversely.

Securitization and Secondary Market. Many of the reforms necessary to attract investors back to purchasing private mortgage securities can be implemented without legislation. The FHFA has already taken steps to initiate the process of standardizing many aspects of mortgage origination, securitization and servicing. A standard for providing representations and warranties has been adopted jointly by Fannie Mae and Freddie Mac. This covers securities issued by these two GSEs. This could also become the standard for privately issued mortgage securities.

Pooling and servicing agreements (PSAs), purchase and sale agreements and trust agreements also need to be standardized. Pooling and servicing agreements are especially important because they define the responsibilities of servicers and investors. In the aftermath of burst housing bubble lack of standardization and ambiguity in PSAs lead to disputes between investors and servicers over liability for loss mitigation costs. These disputes have contributed to the slow pace in resolving troubled mortgages.

Another reform that is needed, which requires legislation, is preventing holders of second mortgages from interfering with loss mitigation solutions for first mortgages.

In addition, transparent data on individual mortgages which provide detailed information about pricing, credit and payment history, while simultaneously protecting borrower privacy, must be readily available and updated regularly. The CFPB and FHFA recently announced a joint approach to creating such a database. The Office of Financial Research will also need to be involved as it has responsibility for establishing data protocols including requiring a loan specific permanent tracking identification number.

Mortgage Credit Guarantees. Who provides credit guarantees is at the heart of the debate about the role of government versus the private sector in mortgage finance. Historically, Fannie and Freddie provided mortgage credit guarantees for “conforming” loans which had a maximum size limit with some higher limits for “high cost” markets.

Guarantee fees averaged 22 basis points at Fannie and 18 basis points at Freddie in 2006. During the first half of 2012 guarantee fees were 27 basis points at Fannie and 24 basis points at Freddie, little changed from the housing bubble era. Recently, in an attempt to encourage the private sector to begin offering mortgage credit guarantees, Congress mandated a 10 basis point increase in April and the FHFA is requiring the GSEs to implement another 10 basis points increase this month.

Even though these increases would take credit guarantee fees to nearly 50 basis points, an analysis prepared for the Housing Policy Council indicates that if there is no government role in providing credit guarantees or backstopping private mortgage credit guarantees, the private sector would require a fee of 130 basis points. However, if there is a provision for the government to provide a catastrophic backstop, similar to how deposit insurance works through the FDIC for banks, the required private sector guarantee fee would drop to 71 basis points. The catastrophic backstop would only be activated if two lines of defense fail. The first line of defense would be the private insurer’s loss reserves and capital. If that were exhausted, the second line of defense would be assessments levied on other private insurers. Only in the event that both lines of defense were exhausted would the government’s loss reserves be tapped. The analysis indicates that 62 basis points of the credit guarantee fee would go to the private insurer and 9 basis points would go to the government’s catastrophic loss fund.

It should be noted that although many Republicans prefer eliminating the government completely from the mortgage guarantee business, financial institutions engaged in mortgage finance strongly prefer the catastrophic government backstop approach.

I should add that it has been the federal government’s policy for decades to provide housing subsidies of various sorts, all of which are intended to reduce the cost of owning a home. Subsidies are also intended to increase the number of lower income households who can afford to buy a home and qualify for a mortgage. There is a powerful lobby of realtors, builders, consumer advocacy groups and even financial institutions which want to continue some kind of government involvement in the mortgage market.

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The Housing Market and Government Intervention

October 2nd, 2011 by under Faculty Commentary. No Comments.


by Phillip Swagel
CFP Academic Fellow and Professor of International Economics at the
Maryland School of Public Policy

In a recent American.com essay, Peter Wallison asserts that it is “completely frivolous” to believe that the government is incapable of resisting the urge to bail out the housing market. But history is not so kind to this assertion.  Congress has taken many steps to foster homeownership and it seems far from frivolous to envision that Congress would act again in the future if mortgage credit dried up for American families. One can similarly imagine an intervention taking place if the secondary market in mortgage-backed securities locked up, since this in turn would likely lead to a lack of credit for new mortgages.  After all, the Federal Reserve and Treasury Departments intervened in the fall of 2008 to stabilize money market mutual funds, which then consisted of not quite $4 trillion of assets.  Housing-related securities are $10 trillion out of around $53 trillion in U.S. debt. While one can hope that a future administration and Congress in the midst of a financial crisis would avoid particular interventions, Wallison rests on just this—hope.

Wallison criticizes my proposal for housing finance reform that includes an explicit secondary government backstop on conforming mortgage-backed securities. He points out that the government will charge too little for providing the insurance.  Oddly, Wallison writes as if my proposal does not recognize this.  But a key facet of my proposal is to allow entry by new firms that securitize conforming MBS precisely because the government will inevitably underprice the guarantee.  The competition from these entrants will help ensure that the implicit subsidy of underpriced insurance goes to homebuyers in the form of lower interest rates rather than being kept by GSE shareholders and management as in the previous system.   Wallison does not have to agree with this proposed response to the inevitable government underpricing of insurance, but his criticism has a disingenuous flavor in pretending that it was not made.

My view is that the government will intervene in housing in the future and will underprice insurance today.  As the saying goes, these are not problems to be solved, but instead facts of life that must be dealt with.  My proposal for housing finance reform does so by ensuring that there is considerable private capital ahead of a secondary guarantee, taxpayers are compensated for taking on risk, and private market competition directs the benefits of the inevitable government subsidy to homeowners.  Moreover, allowing for entry by new firms will eventually result in a housing finance system in which firms are no longer too big to fail.

The alternative espoused by Wallison would involve a system that is notionally private but in which the government guarantee is latent and uncompensated.  Moreover, given that there is little prospect for the fully private alternative to ever come into being, holding out for it in fact leaves Fannie and Freddie in government hands—and the longer this persists, the more likely they will stay there forever.  Waiting for a supposedly perfect but unattainable housing finance reform could instead leave us permanently with the worse alternative of a government-run housing finance system in which there is no private capital other than downpayments and none of the benefits of private sector competition and innovation.

This article was first published on American.com, the Journal of the American Enterprise Institute, on September 26, 2011.

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Will Free-Marketeers Save Fannie and Freddie?

July 21st, 2011 by under Faculty Commentary. 2 Comments.

by Phillip L. Swagel

Academic Fellow, Center for Financial Policy

This post was originally featured in Bloomberg on July 18, 2011.

Here is one clear lesson from the economic meltdown of 2008: Any future U.S. administration will intervene directly and heavily if faced with a potentially devastating economic crisis. Market purists might not like it, but it is a fact I witnessed firsthand at the Treasury Department during the George W. Bush administration.

As a corollary, it is also true that the government will be compelled to step in if it becomes concerned that American families cannot obtain mortgages at reasonable interest rates. Indeed, it is inevitable that the government will also intervene if secondary mortgage markets — that is, the trade in securities and bonds made up of bundled mortgages — lock up.

The math is simple: Home mortgages represent $10 trillion out of $53 trillion in total U.S. credit market debt; remember that the Treasury and Federal Reserve felt compelled to stabilize money-market mutual funds in the fall of 2008 when they held just under $4 trillion.

Acknowledging these facts is central to solving a problem Congress is finally taking seriously: deciding the future of the government-sponsored enterprises at the center of the housing collapse, Fannie Mae and Freddie Mac.

Members of Congress, who began debating several bills to reform Fannie and Freddie last week, must start from this implicit promise of government intervention. Thus it makes little sense for Republicans to push for an ideal, purely market-based system. That head-in-the-sand approach will only help those like Representative George Miller, Democrat of California, who call for increasing government involvement.

Instead of holding out for an unattainable goal, conservatives would be wise to move forward with housing reform that specifies an explicit, but limited, government role.

The centerpiece of any proposal should be protecting taxpayers. The best way to make that happen is to bring private capital back into the market and ensure that it would take losses ahead of any government guarantee on mortgages and securities composed of them.

Fortunately, Congress already has a good model to follow: a bipartisan proposal now before the House sponsored by John Campbell, a California Republican, and Gary Peters, Democrat of Michigan. Under the plan, at least five private firms would be set up to finance and securitize high-quality conventional mortgages. The government would guarantee the resulting financial instruments, but the companies would have to pay insurance premiums for that backstop. The firms themselves would not be guaranteed — only the mortgage-backed securities they created would be protected.

Such a program would create a competitive market in which Fannie and Freddie would become just two of many firms involved in securitization, and neither would be too important to fail. Over time they would probably be sold back into private hands or wound down.

Critics will no doubt make the case that Fannie and Freddie made housing possible for the less affluent, who would be left behind in a freer system. Under such a proposal, a portion of the insurance premiums could be earmarked for affordable-housing initiatives.

More important, an open market is also the best way to spur useful innovation in mortgages, as lenders would compete to find ways to help credit-worthy borrowers with modest incomes become owners. An irony is that the large banks so many Americans blame for the economic crisis are the companies most likely to compete effectively with Fannie and Freddie. (Disclosure: I have done consulting work for some large banks on reforming those enterprises.)

In order to give all competitors equal footing, regulators should require all firms involved to issue standardized mortgage-backed securities, as opposed to the current system in which Fannie’s and Freddie’s securities trade separately from other mortgage-backed instruments. This would have side- benefits: unifying the market would improve mortgage liquidity and thus probably lower interest rates for borrowers.

There are a few caveats. There is a risk in having the government price insurance — something that it has done a terrible job at with flood insurance, for example. But any price it charges will be better than zero, which was the de facto rate in the Fannie-Freddie system that was ostensibly private but had its implicit federal guarantee.

The larger concern is what would happen to interest rates as the government backstop receded. If private investors overwhelmingly balked at taking on housing risk, it could lead to a surge in interest rates and further depress home sales and construction. Thus the prudent path would be to go quickly to a competitive system but phase out the current federal role at a slower pace, namely by gradually bringing in private capital ahead of a secondary government guarantee.

The longer Fannie and Freddie stay in government hands, the more likely they will become permanent wards of the state. This would be the worst of possibilities, yet it becomes more likely as conservatives push for a supposedly private housing financing system that has no hope of enactment. The government will always be part of the housing market; let’s make sure we keep its role as small and contained as possible.

(Phillip L. Swagel is a professor at the University of Maryland School of Public Policy. He was assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.)

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Reducing GSE Dividend Payments Would be a Gift from Taxpayers to Private Investors

May 27th, 2011 by under Faculty Commentary. 1 Comment.

by Phillip Swagel

Academic Fellow, Center for Financial Policy

This post was originally featured on the House Financial Services Committee’s Blog.

A reduction in the dividend payments that Fannie Mae and Freddie Mac make to the federal government would serve no policy purpose and amount to a gift from taxpayers to the investors who owned Fannie and Freddie when the firms required a $150 billion taxpayer bailout.  It is important to return Fannie and Freddie back to private hands in the future and have market participants rather than the government as the main provider of housing finance.  But there are ways to do this that do not involve a windfall for the old shareholders, who were appropriately wiped out when the two firms went bust.

The federal government now stands behind the financial obligations of Fannie Mae and Freddie Mac, the two government-sponsored enterprises involved with housing finance that were placed into conservatorship in September 2008. Taxpayers are on the hook for their losses, with some $150 billion committed so far to make good on the government backstop.

Taxpayers effectively own these two companies.  As part of the agreement with the firms when they were put into conservatorship, the U.S. government gained control of 79.9 percent of the common stock, and received preferred shares with a 10 percent dividend payment in exchange for capital injections to maintain a positive net worth for the two firms.  With $150 billion of taxpayer capital injected already, the 10 percent rate means that Fannie and Freddie make huge dividend payments each year.

The 79.9 percent figure for the common stock component was chosen because an 80 percent stake would have triggered government accounting rules that put the firms’ assets and liabilities onto the public balance sheet.  This is mainly a symbolic distinction, since the terms of the so-called “keepwell” agreements made between the firms and the Treasury mean that the government covers the firms’ net gains and losses even if their assets and liabilities are not formally on the public balance sheet.  Still, a concern in the fall of 2008 was that market participants and rating agencies might not understand the situation and respond poorly to $5 trillion of GSE obligations coming onto the federal balance sheet—even those these obligations were matched by nearly an equivalent value of assets and taxpayers had committed to cover the difference between assets and liabilities regardless of whether these were formally on the federal balance sheet.

In recent quarters, the large dividend payments on the government-owned preferred shares have given rise to the seemingly unusual situation in which Fannie and Freddie are now profitable in their operations but usually still make net losses because of the payments to the government.  As a result, the two firms take more government capital in order to turn around and pay some of the money back to the Treasury as dividends.  As discussed by Daniel Indiviglio of The Atlantic [LINK = http://www.theatlantic.com/business/archive/2011/05/fannie-needs-another-85-billion-from-taxpayers-but-freddies-okay/238618/], Freddie actually reported a profit in the first quarter even including its $1.6 billion quarterly payment to the Treasury, but the firm notes that this profit situation is not likely to continue into the future.  Fannie needed another $8.5 billion from the Treasury, including money to cover its $2.2 billion quarterly payment.  The dividend payments appear to be crushing the firms and preventing their return to profitability.

This is by design.  The steep payments on the dividends make it so that the remaining 20.1 percent of GSE common shares and the pre-conservatorship preferred shares have no value because the GSEs will never earn high enough profits to redeem the government’s preferred shares.  This is both intentional and appropriate.  Fannie and Freddie were deeply insolvent in September 2008 when they required a bailout.  With the housing market weak and credit markets strained in the fall of 2008, Treasury did not want to put the two firms into receivership and wind them at that moment, but it also wanted to make sure that the equity holders of the firms received nothing.  The preferred shares accomplish this while not crossing the accounting threshold.  Fannie and Freddie shareholders have not been abused—they got exactly what happens to shareholders of insolvent firms:  a loss of their investment.

Some people want to reduce these payments or take other steps to the advantage of the owners of the common shares.  In an April 11 letter to Committee Chairman Bachus and others [LINK = http://nader.org/uploads/gse.pdf], for example, Ralph Nader decries the treatment of common shareholders, including the delisting of the firms’ shares.   Others note that a lower dividend rate would allow Fannie and Freddie to build up retained earnings rather than relying on additional government capital to keep them solvent.

But reducing the dividend would simply transfer value from the government to pre-conservatorship shareholders.  This would be a pure gift from taxpayers to investors, without a public policy rationale.

There are better ways to restore Fannie and Freddie to private hands in the future that recoup as much of the bailout as possible without providing a windfall to investors.  One approach would be to split the firm into two companies each.  So-called “good companies” would have clean balance sheets with the valuable assets of Fannie and Freddie’s computer systems and networks through which to acquire mortgages from originators throughout the United States.  These would be profitable firms and perform the socially valuable tasks of securitizing and guaranteeing conforming mortgages.  The legacy mortgage-backed securities (MBS), guarantees, and debt would remain with the two “bad companies,” which would continue to have their net worth kept positive by the Treasury while their assets and liabilities run off.  The 79.9 percent share of common stock and the $150 billion of senior preferred shares held by the Treasury would likewise remain with the bad firms, which in turn would own the two new good firms.

The separation of Fannie and Freddie into “good” and “bad” firms would in effect leave the government providing a ring-fence around the legacy assets and liabilities.  The two good firms could then be sold back to private investors as profitable companies with clean balance sheets and functioning business systems.  Taxpayers would realize all of the proceeds of these two IPO’s, because these funds would go to the bad firms and thus to the government as dividends on the Treasury preferred shares as the old Fannie and Freddie are wound down.  Even so, it is unlikely that the proceeds of the public offerings of the two good firms would recoup all of the $150 billion in taxpayer money paid out to stabilize Fannie and Freddie.  The remaining net loss after the initial public offering and including any additional future capital needed to stabilize the firms would constitute the overall cost of the GSE bailout.

Since the government is not likely to recoup its investment in the firms, this means that pre-conservatorship common and preferred stockholders will realize no value from their holdings.  This is appropriate, since the two firms were deeply insolvent when they were put into conservatorship.   This differs from the situation with AIG, where AIG was illiquid but not insolvent and thus pre-crisis shareholders will come out with some value, even though for holders of common stock this value will be greatly diluted by the government stake acquired in the rescue of that company.  Again, this is an appropriate distinction to make between AIG on the one hand and Fannie and Freddie shareholders on the other.  The GSEs were insolvent while AIG was not.

It is vitally important to move forward with GSE reform to ensure that the U.S. housing market is supported by private capital rather and so that the securitization and guarantee functions performed by Fannie and Freddie benefit from private sector incentives and innovation.  While an eventual path for GSE reform is discussed, it is equally important to avoid taking steps that transfer value from taxpayers to private investors without appropriate compensation.  This would be the effect of proposals to reduce the dividend payments made by Fannie Mae and Freddie Mac on the capital invested in the two firms by the United States Treasury.

Phillip Swagel is a professor of international economic policy at the University of Maryland School of Public Policy.  He was formerly Assistant Secretary for Economic Policy at the Treasury Department from December 2006 to January 2009.  He testified before the committee on GSE reform on September 29, 2010.

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Reforming the GSEs: Where’s the Beef?

February 24th, 2011 by under Faculty Commentary. 1 Comment.

by Cliff Rossi, Executive-in-Residence
Center for Financial Policy

The much anticipated joint report from Treasury and HUD on reforming mortgage markets in the end was short on specific recommendations but had a central theme of laying out options that would sharply limit government involvement in housing going forward in the short- and long-term.   The report also offered some introspection into the causes of the GSEs’ demise including a lack of credit discipline, particularly late in the housing bubble.  Unfortunately, the administration lost a prime opportunity for laying out a comprehensive strategy for getting the housing market back on track.

If we step back before 2007 and reflect on what part of the housing system was most responsible for the crisis, it can offer clues to which course to follow for reforming mortgage markets.   In the end, even an imperfect model such as existed for the GSEs leading up to their conservatorship held up remarkably well from a credit perspective.  As will be described below, the key to any reform is ensuring asset quality.  Without effective oversight of credit underwriting standards, any model for mortgage markets will eventually fall victim to another credit crisis.

In looking back at the credit performance of the GSEs before the crisis, the two agencies performed very well over an extended period of time as shown in the figure below.  It is clear that the agency model at least up until about 2001, held up well in terms of asset quality.  Thereafter, as competition from private-label securities heated up due to material increases in risk-layered products coming into their own as Alt-A and subprime mortgages, the GSEs relaxed their credit standards which allowed them to compete more effectively with this business.

Figure 1 – Serious Delinquency Rates on Single-Family Mortgages: Freddie Mac and Fannie Mae

The two agencies had for many years adhered to strict underwriting criteria that limited the combinations of risk attributes for a mortgage.[1] As the agencies began to see erosion in their market shares by the 2003-2006 period, the die was cast for excessive risk-taking.  The combination of weak corporate governance and regulatory oversight lies squarely at the center of the credit meltdown for both agencies.  This parallels a similar set of governance and regulatory deficiencies apparent at many large mortgage-originating depositories during the period as well.   With no effective regulatory counterbalance to poor governance practices by the GSEs, the relaxation of underwriting standards and proliferation of risk-layered products such as Fannie Mae’s Expanded Approve program was relatively easy to execute.  The advent of automated underwriting systems also facilitated greater product underwriting expansion as the statistical merit of these systems such as Loan Prospector and Desktop Underwriter to evaluate multiple risk attributes at once became apparent.

In effect, the agencies were allowed to “dump” product in the mortgage secondary market with government support and a blind eye from safety and soundness regulators.  Had this lapse in oversight and governance occurred in the electric power industry, it would have created a monumental environmental catastrophe.  But the difference between the two industries is that strict regulations apply to the power generation industry.  Given the importance of the housing market to the US economy, any option for reforming mortgage markets must include a strong form of regulation similar to that found in public utilities.  Any of the three options proposed by the administration would eventually suffer at some later point another credit crisis for the reasons provided above.

In an earlier briefing, I laid out the basic principles of a market that featured a significantly reduced level of involvement by the federal government and a strong regulator.[2] The mortgage market would be segmented into three parts; a much smaller FHA market; fully supported by the federal government for affordable borrowers needing a helping hand; a plain vanilla mortgage secondary market privately capitalized with a federal backstop only required during periods of financial distress; and a heavily regulated private-label market for nonstandard products with no federal backstop.

The product characteristics of the plain vanilla market would essentially define a Qualified Residential Mortgage (QRM) for risk retention assessment.  Such a product set would allow for mortgages up to 90% loan-to-value (LTV) ratio with appropriate mortgage insurance.  All loans in this market would include standard 1st lien fixed-rate loans and amortizing adjustable-rate mortgages (ARMs).  Allowable ARMs would qualify the borrower at the fully-indexed mortgage rate rather than at some teaser level.  Minimum credit standards would be imposed across various LTV and product combinations with full verification of income, employment and assets required.  The characteristics reflected then in the QRM provisions for this market would limit any further take-out for FHA mortgages while providing broad standardization for an effective and liquid secondary market.

Among the major features of the proposed structure was the creation of a number of privately capitalized mortgage security issuers that would provide credit guarantees on the mortgage security instrument.  This model featured a public utility-style of regulator charged with approving new products, fees and credit guarantee pricing.  Multiple issuers would exist to mitigate systemic risk exposure and a consolidated mortgage servicing unit would be maintained to support the issuing entities.  This new structure, combined with the elimination of the Federal Home Loan Bank System and cultivation of a robust covered bond market would allow for a housing finance market capable of sustained performance for the next generation of homeowners.

The administration’s recommendations for extricating the federal government from its dominant position in housing markets today has merit only if it establishes a comprehensive framework for addressing disequilibrium in housing demand and supply.  Recommendations lowering loan limits and increasing guarantee fees are procyclical in nature, leading to higher borrowing costs and restricting availability to credit for potential borrowers.  With home prices still falling and foreclosures up 12% last month, the administration must get more creative in resolving the housing crisis.  In another briefing on this subject, I laid out a set of potential mortgage product innovations targeted to specific segments of housing demand and supply.[3] Adapted from successful products in such countries as Australia, a shared equity mortgage allowing downside protection for a borrower with shared upside for the lender combined with a job loss protection component could spark additional housing demand by overcoming deeply rooted pessimism regarding short-term improvement in housing and employment.  Further, other products including a Negative Equity Certificate (NEC) providing lenders incentives to promote principal modifications could be fashioned to reduce foreclosures and improve the fate of delinquent borrowers.  A number of companies today have worked out many of the details of such products, however, a policy vacuum has stifled experimentation and testing of these products on any scale thus far.

In the time it has taken the administration to craft its housing finance reform report, home prices have fallen further, foreclosures have accelerated and government support of mortgage markets has continued unabated.  What is newsworthy about the report is not so much the recommendations, but the great lack of clarity in attacking the housing problem through a comprehensive set of regulatory, innovative products, and capital markets solutions.

Clifford V. Rossi, PhD, Executive-in-Residence and Tyser Teaching Fellow
Center for Financial Policy
Robert H. Smith School of Business
University of Maryland

Contact Information: crossi@rhsmith.umd.edu

The views of this article are those of the author solely and do not represent those of the Center for Financial Policy or the University of Maryland.


[1] For several years the author managed the Single Family Mortgage Credit Policy Department at Freddie Mac and was responsible for establishing all residential credit underwriting and collateral standards for the agency.

[2] Toward Comprehensive GSE and Housing Finance Reform, Center for Financial Policy Briefing, November 18, 2010.

[3] A Way Forward on the Housing Crisis, Center for Financial Policy Briefing, November 4, 2010.

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CFP Partners with NYU Stern to Host Conference on The GSEs, Housing & the Economy

January 26th, 2011 by under News & Events. No Comments.

On Monday, January 24th, the Center for Financial Policy at the University of Maryland’s Robert H. Smith School of Business and the Salomon Center for the Study of Financial Institutions at the NYU Stern School of Business co-hosted a daylong conference on “The GSEs, Housing & the Economy”.

The conference brought together leading academic experts and policymakers to address issues facing government sponsored enterprises (GSEs) and effects on the housing industry and the macro economy. Keynote speakers were Rep. Randy Neugebauer (R-Texas), member of the House Financial Services Committee, and James Lockhart, former Director of Federal Housing Finance Agency (FHFA).

To watch Rep. Neugebauer’s keynote address, access all the presentations and read more about these subjects in the Related Articles section, visit http://www.rhsmith.umd.edu/cfp/events/2011/GSE2011/.

Thanks to all who made this event a success.

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Pulling Back the Veil on Foreclosures by Cliff Rossi

October 15th, 2010 by under Faculty Commentary. No Comments.

Today’s headlines showing that foreclosures have reached record levels punctuate the widening debate over the causes and cures of the ongoing foreclosure crisis.   It is tempting to assign full blame for the crisis to widespread industry fraudulent behavior.  The real answer, far more complicated and deeply rooted in history, requires us to step back away from the politically charged atmosphere of the approaching midterm elections and seek a clearer understanding of what lies behind the foreclosure numbers.  From that perspective, the foreclosure problem can be attributed to four elements;

  • The economics of the transaction vis a vis workout alternatives; e.g., loan modifications;
  • The incentive structure of servicers, lenders and investors;
  • Operational and infrastructure deficiencies; and
  • The fragmentation of foreclosure laws and regulatory oversight in this country.

Servicers work on behalf of investors in ensuring that payments from borrowers are distributed in a timely fashion, and when borrowers get into trouble, servicers attempt to triage loans in accordance with a set of least cost criteria.  In addition, many investors such as Freddie Mac provide financial payments to servicers to align interests toward promoting pre-foreclosure workout solutions.  The simple fact then is that absent other causal factors at work, the economics of loss mitigation activities should incent servicers to intervene early in the delinquency process and develop economically viable workout solutions for the borrower and investor.  Unfortunately, other factors oftentimes prevent this from happening.

It should not be a surprise that foreclosures are mounting at what appears to be an alarming rate.  In part, the ineffectiveness of federal loan modification programs such as the Home Affordable Modification Program (HAMP) in its various incarnations has so far been of limited help at identifying permanent modification solutions for distressed borrowers.  Recidivism rates remain high and qualified borrowers fitting the eligibility criteria of the program along with NPV models used to determine economically viable candidates pose the greatest challenge toward a solution that truly stems the foreclosure tide.  Underlying the loan modification issue is the simple reality borrowing from financial theory that lenders wrote a put option to borrowers at the time the loan was taken out and these options are now deep-in-the-money for borrowers due to the crash in home values.  Loan modifications, either by reducing interest rates, extending loan terms and/or forgiving principal either readjust the strike price to prolong inevitable redefault or cannot be structured sufficiently to avert future delinquency due to borrower credit and capacity profiles.

Unfortunately, data suggest that about 50% of the time, servicers have been unable to contact and reach out to distressed borrowers for various reasons.  Although counseling efforts and refinements to borrower contact strategies by servicing units has improved since the crisis began, delays in establishing a dialogue early with borrowers on the path to foreclosure forestall necessary actions to prevent foreclosure from becoming a reality.  These delays, coupled with programmatic design limitations of modification programs, contribute to an ominous buildup in the foreclosure pipeline.

Building foreclosure inventories are compounded by vast operational deficiencies in staffing and infrastructure across mortgage servicers.  Rewinding to the boom years in housing, many servicers emasculated their default and collections shops in light of short-term operational cost efficiencies.  The cyclical nature of mortgage servicers to optimize cost efficiencies was empirically identified in a study I wrote some time ago and is reinforced today by apparent widespread instances of mishandling of foreclosure cases in the industry.[1] By the time the crisis ensued, many servicers were caught flat-footed in what lay ahead in default management.  Staffing levels were down and the expertise limited – I know of one servicer for example, that redeployed underwriting staff in 2008 to plug gaps in the workout units that were awash in delinquent mortgages.  Ill-trained to address the specialized needs of default management processes, these types of responses illustrate the staffing limitations at work.  Another cost containment strategy used by servicers was outsourcing certain aspects of default management functions.  Viewing the collections process as an assembly-line to achieve scale economies vastly underestimates the extensive institutional knowledge required to develop effective workout solutions fitting each borrower’s circumstances.  The housing boom and bust also witnessed significant consolidation within the servicing industry.  An unintended consequence of this consolidation was the difficulty in integrating servicing system platforms across acquired firms.  This led to significant systems limitations at a time when technology was critically needed to handle the scale of defaulted mortgages now upon servicers.  The phenomenon of robo-signing and documentation lapses that appear daily in the media should therefore be of little surprise.

Another significant contributing factor to the problem is a complete fragmentation of foreclosure law and oversight of the process.  At the national level there is no single authority responsible for the ongoing assessment and oversight of mortgage servicing entities.  For that matter, there is no comprehensive federal overseer of national housing policy and unfortunately we can see all too painfully the results from that gap.  Bank regulatory agencies are charged with overseeing the safety and soundness of depository institutions; however, the capacity and level of expertise of examination teams is woefully inadequate to address the complexity and size of servicing operations at other than a cursory level.  Is it any wonder then that the vacuum left by the federal government has been replaced by states attorneys general from across the country conducting their own review of the foreclosure crisis?

Finally, state foreclosure laws in this country have created a byzantine maze of rules and regulations that facilitate inefficiency, operational breakdowns and unevenness in the application of fair treatment of borrowers across the country in foreclosure.  It is well know that depending on the state in which the foreclosure proceeding takes place and whether it is a judicial or nonjudicial process, foreclosure timelines vary considerably.

Putting these elements of the foreclosure process together has given rise to a perfect storm of foreclosures that is sure to be with us for some time.  While the economics of servicing would suggest that these entities opt for the least cost solution to default, implying a pre-foreclosure workout would be in the best interest of all affected parties, short-sighted decisions made by servicers to cut costs coupled with ineffective loan modification programs and a fractured foreclosure legal and regulatory process has acutely accentuated an already dire problem.

Clifford V. Rossi, PhD, Executive-in-Residence and Tyser Teaching Fellow
Center for Financial Policy
Robert H. Smith School of Business
University of Maryland

Contact Information: crossi@rhsmith.umd.edu

The views of this article are those of the author solely and do not represent those of the Center for Financial Policy or the University of Maryland.


[1] Clifford Rossi, Mortgage Banking Cost Structure: Resolving an Enigma, Journal of Economics and Business, Vol 50, Issue 2, March-April 1998, pp. 219-234.

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