[Senate Hearing 112-269]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-269

 
    EXAMINING THE HOUSING FINANCE SYSTEM: THE TO-BE-ANNOUNCED MARKET

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

THE EXAMINATION OF THE SECURITIZATION MARKETS WITH SPECIFIC FOCUS ON A 
PART OF THE SECURITIZATION SYSTEM IMPORTANT TO HOUSING FINANCE--THE TO-
                       BE-ANNOUNCED OR TBA MARKET

                               __________

                             AUGUST 3, 2011

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


                 Available at: http: //www.fdsys.gov /



                  U.S. GOVERNMENT PRINTING OFFICE
72-962                    WASHINGTON : 2012
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing Office, 
http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202ï¿½09512ï¿½091800, or 866ï¿½09512ï¿½091800 (toll-free). E-mail, [email protected].  


            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     William Fields, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

CHARLES E. SCHUMER, New York         PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey          MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
HERB KOHL, Wisconsin                 JIM DeMINT, South Carolina
MARK R. WARNER, Virginia             DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota

                Kara Stein, Subcommittee Staff Director

                          Robert Peak, Fellow

         Gregg Richards, Republican Subcommittee Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------                              

                       WEDNESDAY, AUGUST 3, 2011

                                                                   Page

Opening statement of Chairman Reed...............................     1

Opening statements, comments, or prepared statements of:
    Senator Crapo................................................     2

                               WITNESSES

Thomas Hamilton, Managing Director, Barclays Capital, on behalf 
  of the Securities Industry and Financial Markets Association...     3
    Prepared statement...........................................    20
Paul T. Van Valkenburg, Principal, Mortgage Industry Advisory 
  Corporation....................................................     5
    Prepared statement...........................................    34
Andrew Davidson, President, Andrew Davidson & Co., Inc...........     6
    Prepared statement...........................................    49

                                 (iii)


    EXAMINING THE HOUSING FINANCE SYSTEM: THE TO-BE-ANNOUNCED MARKET

                              ----------                              


                       WEDNESDAY, AUGUST 3, 2011

                                       U.S. Senate,
                     Subcommittee on Securities, Insurance,
                                            and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 9:33 a.m. in room SD-538, Dirksen 
Senate Office Building, Hon. Jack Reed, Chairman of the 
Subcommittee, presiding.

             OPENING STATEMENT OF SENATOR JACK REED

    Senator Reed. I would like to call the hearing to order.
    I first want to thank Senator Crapo for joining us today 
and also for his collaboration over the many, many months as 
the Ranking Member of this Subcommittee, and thank you very 
much, Senator, for your excellent work. Let me also welcome our 
witnesses.
    This morning we are examining the housing finance system, 
specifically the to-be-announced market. In May, the 
Subcommittee conducted a hearing on the state of the 
securitization market. This morning's hearing continues the 
Subcommittee's examination of the securitization markets with 
particularly focus on a part of the securitization system 
important to housing finance, and this is the to-be-announced 
or TBA market.
    In the early 1970s, the TBA market began as a trading venue 
for securities that were issued by Ginnie Mae, and its role 
expanded as Fannie Mae and Freddie Mac began issuing mortgage-
backed securities.
    This market has evolved, and today it is one of the deepest 
and most liquid markets in the United States, with average 
daily trading volume in excess of $320 billion--a market second 
only to the market for United States Treasury securities.
    The name of the market, to-be-announced, comes from the way 
the market functions. Unlike a traditional marketplace, 
investors do not know the specific collateral or pools of loans 
they are agreeing to purchase until months later. Accordingly, 
the collateral is designated to be announced at a date in the 
future.
    Many argue that the TBA market is vital for preserving key 
products that consumers have come to rely upon in buying a 
home, such as a 30-year fixed-rate loan, freely prepayable 
mortgages, and the ability to lock in an interest rate prior to 
closing a mortgage. Although the only securities traded in the 
TBA market are agency securities, defined as those securities 
issued or guaranteed by Fannie Mae, Freddie Mac, and Ginnie 
Mae, the TBA also serves as a benchmark for privately issued 
securities. Privately issued securities are priced relative to 
the TBA price. In addition, originators use the TBA market to 
purchase and sell positions to hedge the origination of loans 
that are not eligible for trading in TBA, for example, 
adjustable rate loans and jumbo loans.
    As we continue to explore different approaches to reforming 
our housing finance system, it is critically important that we 
understand how the TBA market works and what impact any reforms 
will have on this market. How will any changes affect the 
availability of the standard mortgage products sought by 
consumers? What characteristics of this market, if any, should 
be preserved? I look forward to hearing from all of our 
witnesses this morning on these issues. In fact, this is a very 
technical but vitally important part of our securitization and 
our mortgage industry. We have to understand the basics before 
we move forward. But as with all of our hearings, the point is 
to accumulate the information and the insight so that we can 
start dealing with some major issues with respect to housing or 
with respect to the GSEs.
    With that, I would like to introduce the Ranking Member. 
Senator?

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman, and I 
appreciate your kind words as well. I enjoy our working 
relationship, and I appreciate the opportunity for us to have 
this hearing on the TBA market.
    I share your view that the TBA market serves a valuable 
role in the mortgage finance system, and we need to better 
understand its mechanics as we move forward with housing 
finance reform. Today's witnesses all have a deep expertise 
with respect to the TBA market and will be able to explain how 
the TBA market allows mortgage originators to hedge the risk of 
a change in interest rates between the time that the mortgage 
is locked in and the time that the mortgage is actually closed 
and securitized.
    The main components of the TBA market are the 
standardization and homogeneity of the securities and their 
market practices and Government guarantee of timely payments. 
According to a Federal Reserve staff report on the TBA market, 
the deep liquidity of agency mortgage-backed securities cannot 
be attributed solely to the implicit Government guarantee of 
mortgage-backed securities.
    Going forward, the question is how the TBA market might 
change and develop without a Fannie Mae and Freddie Mac 
implicit or explicit guarantee. And what are the tradeoffs that 
we need to consider? To be able to answer that question, we 
need to understand the feasibility of creating a private TBA 
market over time and whether it would have the liquidity 
sufficient for mortgage companies to hedge their interest rate 
risk.
    Again, Mr. Chairman, I appreciate this hearing and look 
forward to what our witnesses will share with us today.
    Senator Reed. Thank you very much.
    We have been joined by Senator Corker. Senator, would you 
like to make some opening comments?
    Senator Corker. No. I am looking forward to the witnesses, 
as usual, and I appreciate you calling the hearing.
    Senator Reed. Thank you very much, Senator.
    Let me now introduce our panel. First is Mr. Thomas 
Hamilton. Mr. Hamilton is managing director at Barclays 
Capital. Mr. Hamilton heads securitized product trading at 
Barclays, including residential and commercial mortgage-based 
securities, as well as other asset-backed securities. He joined 
Barclays Capital in 2004 after 15 years with Citigroup, where 
he was a managing director. Mr. Hamilton is currently the 
chairman of the Securitized Products Division of SIFMA and has 
held that position for 7 years.
    Paul Van Valkenburg is a principal at Mortgage Industry 
Advisory Corporation, MIAC, a registered investment adviser 
which he helped to form. Prior to forming MIAC, he worked in 
mortgage research with major Wall Street firms, including 
Goldman Sachs & Company and Drexel Burnham Lambert. He has 
worked extensively valuing loan portfolios for lending 
institutions actively restructuring their asset/liability 
composition; developing pricing models for whole loans, CMOs, 
and stripped mortgage-backed securities; and analyzing the 
prepayment risk in mortgage-backed structured products. 
Selections of his research have been published in the ``The 
Handbook of Mortgage-Backed Securities'' and ``Interest Rate 
Risk Models: Theory and Practice.''
    Andrew Davidson is the president of Andrew Davidson & 
Company, a New York firm specializing in the development and 
application of analytical tools for the mortgage-backed 
securities market that serves over 150 financial institutions. 
He has written extensively on mortgage-backed securities 
product development, valuation, and hedging. Prior to the 
founding of Andrew Davidson & Company in 1992, he worked at 
Merrill Lynch where he was a managing director in charge of 60 
financial and systems analysts.
    We will begin with Mr. Hamilton. Gentlemen, your written 
testimony has been made a part of the record. Please feel free 
to summarize and make points.
    Mr. Hamilton, please.

   STATEMENT OF THOMAS HAMILTON, MANAGING DIRECTOR, BARCLAYS 
  CAPITAL, ON BEHALF OF THE SECURITIES INDUSTRY AND FINANCIAL 
                      MARKETS ASSOCIATION

    Mr. Hamilton. Good morning, Chairman Reed, Ranking Member 
Crapo, and Members of the Subcommittee. I am Thomas Hamilton, 
managing director at Barclays Capital, where I am responsible 
for the securitized products trading business. I am pleased to 
testify today on behalf of the Securities Industry and 
Financial Markets Association.
    Housing is a critical component of our economy and is at 
the center of a virtuous circle: housing begets jobs, which 
beget housing. Consequently, the U.S. mortgage market is 
enormous. For example, the home mortgage market is 
approximately equal in size to the total size of U.S. bank 
balance sheets. Given that banks engage in activities other 
than residential mortgage lending, their balance sheets alone 
cannot meet the country's need for mortgage credit. Ginnie Mae, 
Fannie Mae, Freddie Mac, and private institutions use the 
process of securitization to provide capital that allows for 
the growth of mortgage lending beyond the capacity of bank 
balance sheets. Today private securitization and the agencies 
finance nearly 70 percent of outstanding home mortgages, and it 
is, therefore, imperative that securitization continue to play 
a key role in any future mortgage finance system. The market 
for MBS issued by the agencies is approximately three times the 
size of the outstanding non-agency private label MBS market. In 
this agency MBS market, the TBA market is the single largest 
component. The TBA market is currently the key to funding 
mortgage lending, and because of this it plays a critical role 
in housing and the U.S. economy.
    The enduring liquidity of the TBA market, in contrast to 
the lack of issuance in the private label MBS markets, 
preserved the availability of mortgage credit in the recent 
crisis. This ability to maintain liquidity during stress 
periods is a key benefit of the TBA market. Furthermore, the 
liquidity and resilience of the TBA market attracts a wide 
range of investors who provide vast capital that is cycled into 
mortgage lending, including retirement savings vehicles, 
insurance companies, and foreign investors.
    The vast liquidity and forward-trading nature of the TBA 
market provides key benefits to consumers, such as the broad 
availability of 30-year fixed-rate mortgages that may be 
prepaid without penalty, and significant and consistent 
liquidity in the secondary mortgage market. This results in a 
stable and attractive funding source for lenders that allows 
them to provide lower mortgage rates and longer-term ``rate 
locks'' for borrowers and efficiently recycles funds back to 
local lenders to enable another round of mortgage lending.
    Of course, the TBA market is facilitated by the guarantees 
of the agencies and, therefore, the support of the Government 
that stands behind them. Currently over 90 percent of mortgages 
are financed through a program of one of these three agencies. 
This level of support is possible because agency MBS do not 
expose investors to credit risk, and, therefore, the market is 
attractive to risk-averse investors that have vast sums of 
capital available for investment. Without the TBA market, we 
believe that the majority of this investment capital would be 
directed elsewhere, reducing the amount of funding for and 
raising the cost of mortgage lending. Therefore, SIFMA believes 
strongly that maintaining a liquid and viable TBA market should 
be considered as Congress addresses housing finance reform.
    With that said, the reality is that that this current 
outsized role of the Government is not sustainable over the 
long term and should be reduced. The TBA market's role and the 
Government's role should shrink as the private markets 
regenerate over time. The means of achieving this rebalancing 
are very complicated and consequential on a national, 
financial, and personal level. While SIFMA believes the TBA 
market should play a role in the future, it should certainly 
not be 90 percent of the market. There are a number of 
challenges to the resurrection of the private label non-agency 
market, including the significant uncertainty faced by non-
agency MBS investors and issuers. The rules of the road for 
both sides are not clear. Until they are, it will be 
challenging for issuers and investors to see eye to eye on 
securitization transactions, at least in the volume and 
frequency that will be necessary to fund mortgage credit 
demand. Being able to withdraw the Government from mortgage 
markets will require a carefully planned and sequenced 
transition which should take many, many years. It is essential 
to remember that the necessary volume of non-agency investors 
will not simply appear because we would like them to. They must 
be drawn back in and made comfortable with private label 
securitization and its regulatory environment.
    We believe that it is critical that the planning and 
execution of significant changes to the funding of mortgage 
loans be done with attention to detail, be based on sound 
analysis of costs and benefits, be mindful of unintended 
consequences, and create a long-term beneficial and stable 
environment. While we cannot predict the future, we can use the 
past as a guide and apply lessons learned and mistakes made, 
the good and the bad, to design a system that will stand the 
test of time.
    We hope that the testimony we present today will he helpful 
in educating policymakers about how mortgage loans are funded 
in the capital markets, the critical role of the TBA market, 
and some of the critical issues that must be considered to move 
forward.
    Thank you for this opportunity, and I am happy to take any 
questions.
    Senator Reed. Thank you very much, Mr. Hamilton.
    Mr. Van Valkenburg.

   STATEMENT OF PAUL T. VAN VALKENBURG, PRINCIPAL, MORTGAGE 
                 INDUSTRY ADVISORY CORPORATION

    Mr. Van Valkenburg. Thank you. Good morning, Members of the 
Subcommittee. Thank you for the opportunity to testify before 
the Subcommittee today on the current and prospective role of 
the TBA market in our current housing finance system. In my 
written testimony, I offer a detailed description of how the 
current TBA market interacts with the mortgage industry and 
prospective borrowers. It is a complex process, but hopefully I 
have made it understandable and useful to the Committee.
    The TBA markets provide the exit price for long-term fixed-
rate mortgages and enable the borrower to accept capital that 
otherwise would not be available.
    Today the TBA market is the principal mechanism for the 
flow of capital into the current housing finance system. Any 
proposed new solution must preserve the TBA market liquidity in 
order to enable mortgage companies and their borrowers to 
access this capital efficiently.
    Given that the GSEs are currently in conservatorship, the 
current and prior system is clearly flawed. I would argue that 
the principal causes of the failure were the underreserved and 
undercapitalized GSEs against the unanticipated credit events, 
requiring the GSEs to underwrite U.S. mortgage credit risk and 
then restricting them to only investing in U.S. residential 
mortgage investments; a mispricing of their guarantee fees; a 
loosening of the loan underwriting standards; and the last of 
independence from political goals.
    Moreover, a fully functioning housing system should share 
the goals of the Administration's Option 1. To quote, 
``minimize distortions in capital allocation across sectors, 
reduce moral hazard in mortgage lending, and drastically reduce 
direct taxpayer exposure to private lenders' losses.''
    A stated concern over this option from the Treasury 
Secretary is that the mortgage credit risk will be transferred 
to the banking system and, as a result, expose the Deposit 
Insurance Fund to this risk. I disagree with this conclusion. I 
believe that the credit risk provides could be a mix of private 
mortgage insurance companies, credit default swap protection 
writers, and if necessary, Government guarantors. Some of the 
risk could be absorbed in the banking system, but not all of 
it.
    The GSEs currently provide 30-year guarantees to investors 
in MBS pools. This guarantee is a particular case of pool 
insurance. This guarantee is also a particular case of a credit 
default swap. When asked what a credit default swap is, I 
usually answer the GSE guarantee is a classic example because 
it is the largest credit default protection writer. A mortgage 
pool or company pays the GSE a guarantee fee in exchange for a 
guarantee of timely payment of principal and interest by the 
GSE on the mortgage pool.
    A significant difference between the GSE guarantee and an 
actual CDS is that an actual CDS trades in an active market 
with real price discovery and real risk transference. The 
amount of credit risk of mortgages that have a GSE guarantee is 
enormous, and I believe there is ample room for a private 
market to develop to price and exchange some or all of this 
mortgage credit risk. I believe that private financial 
institutions will be able to price and trade this risk and, as 
a result, spread this risk across the financial system and 
reduce the exposure to taxpayers. With such a mechanism to 
price and trade credit risk, the TBA investor will be 
protected, the mortgage borrower will be benefited, and our 
systematic risk will be reduced.
    I believe that the preference of the Committee should be to 
explore how to create a privately guaranteed residential credit 
market that will either solely private or, if the costs are too 
high as the market develops, a hybrid of private and Government 
guarantees. The development of a solely private market would 
take time and involve continual oversight. The GSEs exist 
today, and we have time to transition to a private credit 
market and allow it to fully develop.
    I believe the Committee should explore private market or 
hybrid private-Government solutions to avoid or reduce the 
problems of Government guarantees.
    I believe that should a private market solution be 
developed, the liquidity of the future TBA market would be 
sufficient for mortgage companies to hedge their interest rate 
risk, and the systemic benefits would be substantial.
    Thank you.
    Senator Reed. Thank you very much, Mr. Van Valkenburg.
    Mr. Davidson, please.

STATEMENT OF ANDREW DAVIDSON, PRESIDENT, ANDREW DAVIDSON & CO., 
                              INC.

    Mr. Davidson. Chairman Reed, Ranking Member Crapo, Mr. 
Corker, as you have heard from the other witnesses and from our 
written statements, the TBA market plays a central role in the 
mortgage market. With monthly trading totaling more than $5 
trillion, it is truly an incredible achievement of our 
financial system.
    The TBA market helps lower mortgage rates, facilitates rate 
locks for borrowers seeking to buy homes, and made mortgages 
available through the financial crisis. I appreciate the 
opportunity to discuss this important market with you. For the 
next few minutes, I would like to highlight some of the key 
points of my written statement.
    While we can point to features of a market that make it 
useful, it is not easy to predict which market innovations will 
succeed. Much of the success depends on the confidence of the 
participants. A shift in confidence can lead to a rapid change 
in the viability of a market. Currently the TBA market enjoys a 
substantial degree of confidence. This confidence, I believe, 
is not just a result of good institutional design but also a 
long history of successful adaptation to change.
    Whether or not the TBA market will be able to adapt to the 
proposed changes in the structure of the housing finance market 
and the GSEs is difficult to predict with complete accuracy. 
While I cannot provide you with a definitive answer, I can give 
you my views on several proposed changes based on my 25 years 
of experience in the mortgage markets.
    The most important of the proposed changes would be the 
elimination of the Government guarantee on conventional loans. 
While the guarantee was only implicit until the conservatorship 
of Fannie Mae and Freddie Mac, the guarantee has played an 
important role in the structure of the TBA market. I do not 
believe that the TBA market could survive the loss of the 
Government guarantee.
    However, if the TBA does not survive, the market will 
develop other mechanisms to facilitate hedging and funding of 
mortgage loans. However, mortgages, especially fixed-rate 
mortgages, would be more expensive, less available, and more 
subject to market disruptions.
    Other proposals suggest increasing the number of issuers 
for guaranteed MBS. The idea is that multiple issuers would 
increase competition and decrease the concentration risk. While 
such a proposal has other benefits, I believe this would be 
negative for the TBA market and that multiple issuers will make 
establishing good delivery rules more complex and less 
workable. In the end, it is likely that one or two issuers 
would dominate the market.
    Some proposals recognize this problem with multiple issuers 
and recommend a single Government issuer with multiple 
insurers. Such a proposal is probably consistent with the 
survival of the TBA market, as Ginnie Mae already operates in a 
similar fashion. A single Government program for all mortgages, 
however, does run the risk that the issuer will be unable to 
adapt to changing conditions and will be less flexible and 
adaptable than the GSEs have been.
    Many proposals require that any Government guarantee be on 
MBS and not on other obligations of the guarantor, and this is 
likely a positive step for the TBA market. If the GSE or its 
successors are primarily focused on securitization, then they 
will likely act to continue to maintain and improve the value 
and liquidity of the MBS and the TBA market.
    Many proposals recommend that the Government guarantee be 
only a catastrophic guarantee that reduces risk to taxpayer 
while enhancing the liquidity of MBS. Such an approach is 
likely to be consistent with the TBA market, provided that 
investors in TBA-eligible mortgages do not face credit risk. 
This means that the credit risk must be absorbed by private 
capital outside the TBA mechanism and the Government guarantee 
must fully protect investors in the TBA-eligible mortgages.
    The approach that I favor is to provide additional private 
capital in the form of subordinate bonds. Private capital would 
provide funding for the subordinate bonds while the Government 
could provide a guarantee on senior bonds. The Government would 
be protected from loss by private capital but would facilitate 
liquidity on the senior guaranteed bonds. Such a program could 
be structured in a way to be consistent with the TBA market.
    As important as the direction of reform is the pace of 
change. Given the weak state of the housing market and the lack 
of currently viable alternatives to Government-guaranteed MBS, 
it would be disruptive to move too quickly to eliminate Fannie 
Mae and Freddie Mac and replace them with an alternative 
structure, even if that alternative were better designed and 
more economically sound.
    On the other hand, inaction also poses dangers as most of 
the mortgage loans are still reliant on Government guarantees 
and conservatorship is not a viable long-term option.
    Instead of either wholesale replacement of the GSEs or not 
taking any action at all, I believe it is possible to transform 
the existing GSEs step by step to a new system. In particular, 
I recommend that the GSEs be encouraged or even required to 
seek forms of private capital to stand in front of the 
taxpayers. Even while in conservatorship, GSEs can experiment 
with mortgage insurance, and subordinated bonds structures that 
could be used as templates for the longer-term restructuring of 
the housing finance system.
    Thank you for your interest in my comments. I look forward 
to your questions.
    Senator Reed. Well, thank you all, gentlemen, for very 
excellent testimony about a very important and very challenging 
topic.
    We are going to do 7-minute rounds, but I would be happy to 
entertain a second round if there are additional questions. And 
we have the luxury with the excellent panelists and three--not 
33--Senators to take some time. So let me begin with a question 
to all the panelists.
    You have all highlighted the fact that the TBA market does 
affect the availability of certain mortgage products--30-year 
fixed mortgage loans, the ability to lock in interest rates, et 
cetera. Changes to this that we are talking about, how would 
they affect these characteristics? I guess the other way to ask 
it, too, is: Is this ultimately going to be a tradeoff in terms 
of what we expect of a mortgage today, fixed rates, locked in, 
30 years? How is this all going to interact? I would just like 
your general comments, starting with Mr. Hamilton and down the 
row.
    Mr. Hamilton. I think there is definitely a tradeoff. I 
think one of the large benefits of the TBA sector and of the 
agency guarantee is that we were able to get 30-year fixed 
mortgages and keep monthly payments low. I think the 
elimination of that will absolutely force us into either a 
floating rate market or something that is certainly of shorter 
duration and more volatility for the homeowner in their monthly 
payments.
    Senator Reed. Mr. Van Valkenburg.
    Mr. Van Valkenburg. Yes, I think as it stands now, the 
Government guarantee is necessary to enable the risk to be 
absorbed by the investor and transferred from the homeowner. So 
I think the guarantee is functioning that today.
    The mechanism that the borrowers in the market, the TBA 
serving the mortgage companies, they are basically price 
takers. They take the information, and if they have an outlet 
to sell the loans, they will use the mechanics in place. So 
having a liquid market and having a liquid outlet for 30-year 
mortgages is the means by which they can execute that 
transaction.
    Senator Reed. Thank you.
    Mr. Davidson, your comments just in general.
    Mr. Davidson. So certainly without some guarantee, we are 
likely to have far fewer fixed-rate mortgages. Those rates 
would be higher. But I think probably more importantly than any 
of those is that the stability of the availability of mortgage 
credit would be much lower. We have seen the private markets, 
when you go through a shock to the financial system, just step 
back for a while, and then it takes a while for them to 
recover. So during that time period, mortgages would just be 
much less available.
    Senator Reed. Let me sort of ask the question again, 
starting with you, Mr. Davidson, saying that a lot depends in 
terms of where we come out is what goals we have when we go 
into it. And if the goal is to maintain that which people 
assume is the American mortgage--long term, maybe not 30 years 
but 20, et cetera; fixed rates and relatively low monthly 
payments--can we do that without a guarantee by the Federal 
Government in some way, shape, or form?
    Mr. Davidson. You know, it is hard to say it would not 
happen. It is certainly much less likely that we would have the 
same percentage in 30-year fixed-rate mortgages without the 
Government guarantee.
    It turns out there are some investors who want to buy 
interest rate risk and can take prepayment risk, but do not 
want to deal in credit risk. They want to be able to engage in 
transactions where they can buy hundreds of millions or 
multiple hundreds of millions of dollars worth of securities at 
one point in time. And without removing the credit risk, it is 
difficult to see how you could create that kind of market.
    Senator Reed. Mr. Van Valkenburg.
    Mr. Van Valkenburg. Yes, I think if we said tomorrow, hey, 
let us start a market, it would obviously fail to transfer the 
risk involved in a 30-year mortgage. But if we could develop a 
process where this credit piece could be transferred into 
private holders of the risk, everything comes down to a price 
at what it is worth, and we do not know what the price would be 
at this point because the Government is basically assuming that 
risk and subsidizing that risk. So a market would have to take 
years to develop in order for that risk to be priced and risk 
takers and markets to develop before we could understand really 
what the potential investors would require in a fee in order to 
absorb that risk.
    Senator Reed. And, Mr. Hamilton, your comments.
    Mr. Hamilton. I would just say the market will develop for 
whatever the rules are brought to them, but what I would say is 
certainly the 30-year mortgage would be less available. 
Mortgage credit would be less available, and the credit 
availability that you would be able to access would be at a 
significantly higher price and would have a significant impact 
on the housing market.
    Senator Reed. Let me ask another question which has been 
alluded to by all your testimony, and that is, right now there 
is a lot of capital going into this market because of the way 
it is structured, the guarantee, the credit risk aspects, and 
the presumption, I think, the conclusion from all your comments 
is that in some respects that capital will not go there any 
longer if the guarantee is changed significantly or it is a 
private system. And it raises a question. One, where does the 
capital go? You might not know. But is that a bad thing or a 
good thing and in terms of the overall economic performance of 
the country? This is very speculative, but feel free.
    Mr. Hamilton. There is a lot of foreign investment, foreign 
capital, insurance company money management, retirement funds 
that are putting large amounts of dollars into the U.S. 
mortgage market, and that is due to the fact that they do not 
want to take credit risk.
    Is there a market for that credit risk? I believe there is. 
But I think we are talking about a very large transition from a 
mortgage market that is determined by rates and investors who 
care about rates to an investor who cares about credit, and 
that transitioning can take--you know, to do it in an orderly 
fashion, we are talking about 10 or 15 years. This is not an 
easy scenario.
    Senator Reed. Mr. Van Valkenburg and then Mr. Davidson, and 
then my time is done.
    Mr. Van Valkenburg. Yes. Anytime you subsidize anything, 
you get more of it, so I think--and the Government is 
subsidizing the housing sector in many ways, you know, along 
the food chain, particularly the guarantee is just one area, 
but--so we probably get a little more access to consumer credit 
than we would otherwise. But it is hard to quantify these 
things without any kind of real price discovery about what 
things are traded at or what private institutions would pay for 
that risk.
    Senator Reed. And part of this transition phase would in a 
sense be that price discovery process.
    Mr. Van Valkenburg. Yes, if we could develop credit markets 
where we could transfer that to the private financial 
institutions, we could begin to understand what those costs 
are, what private parties are willing to pay for that risk, and 
move the credit risk across the world instead of just 
localizing it and concentrating it on the Government's balance 
sheet.
    Senator Reed. Mr. Davidson, your comments, please.
    Mr. Davidson. I think it is important to separate the 
liquidity function of the guarantee from the credit function of 
the guarantee. On the credit function, I think the credit risk 
should be moved into the private market. It was supposed to be 
there before, just that Fannie and Freddie did not really have 
enough capital.
    The liquidity function is a lot like deposit insurance, and 
deposit insurance keeps confidence in the banks even when there 
is uncertainty in the financial system. And so that function I 
think does serve a valuable purpose. The mortgage market is 
gigantic. And rather than moving more of the financial system 
into the banks where we have more deposit insurance, this is 
really another method of providing a liquidity guarantee to an 
important financial sector. I believe you can have an economic 
benefit without having significant cost to the Government.
    Senator Reed. Thank you very much, gentlemen.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    Mr. Davidson, to follow up on that, in your testimony, you 
indicate that the liquidity of the TBA market combined with the 
Government guarantee on the MBS serves to lower the rate on 
agency MBS by about 25 to 50 basis points in relationship to 
the non-agency alternatives during normal markets. Are you able 
to isolate and estimate the subsidy of the Government guarantee 
without the value of the liquidity in the market?
    Mr. Davidson. Yes. So right now, the two pieces are 
combined. But I would say that most of that benefit is 
liquidity guarantee rather than a credit guarantee. In normal 
markets, the actual credit risk on what should have been 
guaranteed by Fannie and Freddie, just the high-quality 
mortgages, is very small. It is on the order of, you know, five 
basis points a year, so that most of the advantage that we are 
seeing for the GSE loans is due to the liquidity guarantee, not 
due to the credit aspect.
    Senator Crapo. Thank you.
    And Mr. Van Valkenburg, could you explain in a little more 
detail how you feel that a mix of private mortgage insurance 
companies and credit default swaps and other activities could 
take on some of the credit risk that the Government guarantees 
currently provide.
    Mr. Van Valkenburg. Well, right now, the Government has 
absorbed a lot of risk, credit risk, as opposed to the mortgage 
market. The credit default swap market has parties who want to 
take that risk, and the mechanics of it would be involving 
possibly a future entity, this new issuer who now lays off 
their risk through credit default swaps through this 
intermediation process of that market. And so they can go out 
and get price discovery on what the wholesale price is, 
effectively, on where the market is pricing this credit risk 
and where--if there is no bid for the 30-year guarantee in the 
private sector, then the Government could decide, well, this 
is--we are going to subsidize that because we think it has 
important public policy goals, so we could elect to still have 
a 30-year guarantee. But at least we would know what it would 
cost in a private transaction.
    So what I am envisioning is that we could develop a system 
with, you know, obviously with SIFMA's leadership in developing 
the market practices, but right now, the GSEs cannot really lay 
off their credit risk. But we could develop structures and 
markets where that credit could be traded.
    Senator Crapo. For a private residential credit market to 
develop, it has got to be able to attract capital, and right 
now, it seems to me that is really difficult, given the 
overwhelming market share that Fannie, Freddie, and the FHA 
have. And for any of you, Mr. Van Valkenburg particularly, what 
are some of the interim steps that can be taken to transfer 
some of that credit risk, to move it away from Fannie and 
Freddie? Or, Mr. Davidson, did you want to----
    Mr. Davidson. Yes, I would be happy to.
    Mr. Van Valkenburg. Go ahead.
    Mr. Davidson. So I think right now, even within the 
existing GSE structure, there is no reason why the GSEs cannot 
work to start set up in these types of markets. There is no 
reason why they cannot be using more external private capital 
in the form of insurance, either pool insurance or mortgage 
insurance. There is no reason they cannot set up a credit 
default swap market, or the solution I said, which is they set 
up a subordinate bond market where they sell off some of this 
credit risk. So as a transition, we can start building private 
capital markets even within the current GSE structure.
    Senator Crapo. Thank you.
    Mr. Hamilton, you wanted to comment?
    Mr. Hamilton. Yes. I would just point out that some of this 
technology already exists at the U.S. agencies. You know, 
Freddie Mac for their multi-family lending program already 
sells off the subordinate and credit tranches of the 
securitizations that they create. So they are already doing it 
in other markets, the fact that there is definitely the ability 
to transfer some of that technology and structure into the 
residential market.
    One of the things the agencies provided to us is 
homogeneity, information, transparency, and we have spent 40 
years and the agency spent 40 years building that up. There is 
no reason we should not use that same information and that same 
homogeneity to create a market to disperse the credit risk on 
the other side and reduce the burden on the taxpayer.
    Mr. Van Valkenburg. And as the other witnesses point out, 
these would be ancillary new markets as opposed to disrupting 
the TBA markets. They could be new ways to trade credit that 
would not disrupt the current TBA process.
    Senator Crapo. All right. Thank you. I have no further 
questions, Mr. Chairman.
    Senator Reed. Senator Corker, please.
    Senator Corker. Again, thank you for having this hearing 
and I thank all of you for being here. I know everybody has 
kind of checked out after what has just happened and there are 
not a lot of folks here, but people certainly care about this 
issue.
    If you look at the TBA market, it is really nothing 
different than a futures market that exists, right. So why is 
it that we have to have this Government guarantee there to make 
that work when it works so well with corn and coffee and 
everything else? If you all could just briefly tell me why that 
would not work.
    Mr. Hamilton. I do not think any of us would say that it 
could not work. I think what I would say is you could create a 
TBA market out of private mortgages with an industry, maybe 
SIFMA or someone else, who is creating a homogeneous market, 
qualified residential mortgages that exist. But the important 
thing to note is it will be at a significantly higher rate to 
the homeowner. It will impact the U.S. housing market in a 
significant way. And it will take 10 to 15 years to produce a 
liquidity that we just spent 40 years producing.
    Senator Corker. But it would be fairly priced.
    Mr. Hamilton. It would be--one would hope----
    Senator Corker. It would be fairly priced.
    Mr. Hamilton. Well, I do not----
    Senator Corker. Why would it not be fairly priced?
    Mr. Hamilton. I think the market has proven, the agencies 
and the private market have proven that doing market risk 
pricing across the credit spectrum has not been perfect, and if 
the private market was to take over credit pricing, I would 
argue that people with good credit would get very good rates 
and people with mediocre and bad credit would not be able to 
get a mortgage. Maybe they should be renters. Maybe they should 
be, but that is certainly how----
    Senator Corker. I thought that was the way credit was 
supposed to work, but go ahead. If you had bad credit, you 
cannot get a loan. If you have good credit, you do.
    Mr. Hamilton. I guess----
    Senator Corker. We have gotten away from that.
    Mr. Hamilton. I agree with you, but I think----
    Senator Corker. Well, wait a minute----
    Mr. Hamilton.----if Washington is willing to depoliticize 
housing, then what you are saying is correct. If there is no 
interest in home ownership rates or----
    Senator Corker. Well, wait----
    Mr. Hamilton.----having credit available to homeowners, 
then I think what you are saying is absolutely true and only 
people who have very good credit and can bring 20 percent down 
to the table will ever get a mortgage. I think that is right. I 
am not making a judgment on who should have them, but I think 
that is the result.
    Senator Corker. I think what you just said is a very 
telling thing and I appreciate it.
    Paul.
    Mr. Van Valkenburg. I think that the guarantee subsidizes 
that spectrum of the borrower, and so it enables the 30-year 
fixed rate--we do not know if there is a market for a 30-year 
guarantee right now because it does not exist. So could we 
develop one? It is going to take, as Tom says, 5, 10 years to 
develop. But so we could probably go out and price it today, 
but there would be no liquidity in the credit. So we would be 
fairly priced? Probably not. But we are assuming that the 
Government guarantee is cheaper than what a fictional market 
that we do not have any real price discovery on.
    So the rationale, historically, to my understanding, is 
that you subsidize the borrower with this 30-year fixed rate. 
You are now instilling more benefits public policy-wise because 
now you have more homeowners--well, it achieves more home 
ownership or they can buy a larger house, whatever. But I do 
not know the studies and the reality of the analysis around 
that, but this is the message that has been sacrosanct for 
years, that we subsidize this 30-year mortgage. We create more 
home ownership and better communities because we have more 
bigger houses and more involvement in the community.
    Senator Corker. Mr. Davidson.
    Mr. Davidson. So while the mortgage TBA market is 
essentially like a futures market, it does have some important 
differences. One of them is that, at least under current SEC 
rules, you cannot sell a private security before it is created, 
where in the TBA market, you can sell loans that will go into a 
security that is not yet created. So at least technically, some 
rules would need to change in order to create a TBA market 
which would allow physical delivery of loans.
    In most futures markets, people actually do not deliver 
their product. They do not deliver the corn to the exchange or 
to the counterparty. They usually pair those trades off. In the 
TBA market, most of the originators actually sell the loans 
into the short positions that they have created.
    In addition, what we found in financial markets is that 
financial markets that have Government guarantees behind them, 
so sovereign markets, trade with much greater liquidity than 
the non-sovereign markets. So I agree that futures markets 
could work. Many of our clients who hedge mortgages also use 
futures markets, either Treasury futures or Euro-dollar 
futures, to hedge their positions. But the TBA market has 
proven to be the most liquid and most effective hedge for the 
mortgages.
    Senator Corker. I guess in September, the loan limit will 
go back to the pre-crisis levels, at least currently, that is 
what is going to happen. Will that give us an opportunity to 
see if this is something that will work?
    Mr. Hamilton. Yes. I think the first----
    Senator Corker. And what is the market expecting right now 
that, going back to your allusion to Washington and 
depoliticizing, what do they think Washington is going to do 
right now as it relates to that?
    Mr. Hamilton. Well, I think it is mandated that the loan 
limit goes down to $625,000 at this point. I think the market 
is expecting that to happen. I think the market would hope that 
it continues to drift down in a meaningful way. I do not think 
we are going to be able to create a private label mortgage 
market without product. We cannot compete against the----
    Senator Corker. So that is going to be--and will there be 
any TBA activity in those upper levels?
    Mr. Hamilton. My belief is, no, it will all go into private 
label mortgage securitizations, or banks will just keep those 
loans on their balance sheet.
    Senator Corker. Mm-hmm.
    Mr. Van Valkenburg. My point on this is that you are being 
asked, or somebody is being asked, hey, what about--what are 
the consequences? What are the tradeoffs to lower this lending 
limit down? What is the price and what are the benefits? And we 
do not have any real information to make the decision. We do 
not have any real price discovery as to what that cost as far 
as--what would willing parties in a private market trade that 
risk for, and then we could evaluate what that cost would be as 
far as the incremental guarantee fee, exposure to our balance 
sheet, if you will, for the U.S. taxpayer by reducing that loan 
limit down. And then we could evaluate it with real risk 
measurements so that we could assess what is the effect, what 
is the cost, and we do not have any other price discovery 
mechanisms to do that today because it is all--well, it is this 
amorphous blob of a Government guarantee.
    So I am suggesting that we can create private markets that 
trade and price credit. This price information will help the 
economy allocate capital more effectively and price this risk 
and help us make better public policy as part of the process.
    Mr. Davidson. Yes. I believe it is a good step to lower the 
loan limits. The private market used to support a trillion to 
two trillion dollars worth of our mortgage loans. There is no 
reason it cannot support a substantially larger portion than it 
is right now.
    Senator Corker. Mr. Chairman, again, thank you. I thank all 
of you. And, Mr. Hamilton, I was in no way critical. I 
appreciate the observation that we in Washington have created a 
mechanism where those people with good credit pay more for 
their mortgages and those people with bad credit pay less for 
their mortgages. The question is, will we ever depoliticize and 
cause the market to work in a normal way, where people who have 
bad credit pay more for their rates and people with good credit 
pay less. So I appreciate you bringing that out so clearly and 
thank all of you for your testimony and look forward to seeing 
you individually in our offices over the course of time. Thank 
you.
    Senator Reed. Well, thank you very much, Senator Corker.
    I have got a few additional questions, but I think the line 
of questioning both Senator Crapo and Senator Corker have 
developed has been excellent. It exposes the real policy 
choices we have. We have collectively for generations, both 
Republicans and Democrats and everyone else has said putting 
people in homes is key to America and it has resonated. It has 
resonated, and as a result, a lot of these programs were begun 
to do that.
    And now we are at the point where we are looking at, how do 
we make a transition and how do we do it in an effective way? 
How do we price it correctly? How do we maintain a market? And 
this hearing, despite the esoteric title, is absolutely 
essential to what we are going to do going forward for all the 
reasons that Senator Corker and Senator Crapo indicated. Can 
the private market step in? Will they step in?
    So let me just add a few other questions, but I will also 
join Senator Corker in inviting you to come by the office, 
because we are not going to settle this this morning. It is 
going to be a dialog going forward.
    But beginning with Mr. Davidson, and a question is that--
and again, if my understanding is not correct, please correct 
it--but the TBA market is not subject to the securities laws. 
It is exempt because of the participation of the GSEs, the 
agencies. If we move to a private market where these activities 
have to be performed by exclusively private firms, would that 
induce SEC registration requirements and other forums? And if 
so, would that complicate things further, or how should we 
think about that? Maybe that is a more general question.
    Mr. Davidson. Currently, loans that are delivered into the 
TBA market are exempt from SEC registration, so that allows you 
to essentially sell them before the securities are created.
    Senator Reed. Right.
    Mr. Davidson. In the private market, an issuer cannot do 
that. They cannot say, I am planning on securitizing next 
month. Please buy this security in advance. And that just 
eliminates the possibility for physical delivery into a forward 
sale. Other mechanisms could be developed, but they are just 
not going to be as efficient, or maybe there could be some 
exception created for some type of mortgage issues. But SEC is 
going in the other direction right now and sort of requiring 
more disclosure, more detailed disclosure about loans and 
longer time periods between when you announce a deal and when 
you sell it. The SEC's direction is contrary to what you need 
to create a TBA-type market for non-agencies.
    Senator Reed. So one of the aspects of creating this new--
and we all understand this is not going to happen next year, 
this is a phased adaptation going forward--would be to provide 
investor protections, but perhaps not in the same way that is 
done presently by the SEC and private labels, but to work both 
of those features in, the rapidity, the liquidity, the ease, 
the uniformity with the investor protections. So we would have 
to deal with that, I guess.
    Mr. Davidson. That is correct.
    Senator Reed. There is a--one of the proposals, and this 
was, again, Mr. Van Valkenburg proposed that we ensure 
liquidity in market--a single issuer with uniform capital 
markets, accepted practices necessary, essentially separating 
the guarantee function from the insurance function--the 
issuance function, rather. And, Mr. Hamilton, can you comment 
on that approach, of separating the guarantee function from the 
issuing function.
    Mr. Hamilton. Are you saying separate the Government 
guaranteeing it or someone private guaranteeing it?
    Senator Reed. I was----
    Mr. Van Valkenburg. Just the function itself. Do we need to 
have multiple issuers. I guess you are reading from my 
testimony.
    Senator Reed. Yes, I am. Go ahead.
    Mr. Van Valkenburg. I was just suggesting the issuance 
should be a single issuer so that investors are not confused if 
it is ABC issuer, XYZ issuer. It is always done by the same 
issuance. And then the guarantee function could be priced 
independently, or the role can be determined independently.
    Senator Reed. And I will not put words in your mouth, but 
if it is a single issuer, that likely could be a Government 
entity.
    Mr. Van Valkenburg. Yes, it could be.
    Mr. Hamilton. I think these are all--they are all saying 
the same thing, I think, that separating out the guarantee 
function is what we are talking about----
    Senator Reed. Right.
    Mr. Hamilton. When we discuss selling--when Mr. Davidson 
says selling subordinate tranches off of agencies or selling 
credit risk in a CDS or credit default swap off of a certain 
pool of residential mortgages, it is all accomplishing the same 
thing. We are trying to separate the guarantee function and 
mitigate and sell that credit risk so the taxpayer is not on 
the hook, yet at the same time maintaining one issuer or a 
couple of issuers and maintaining that liquidity. So I think it 
is all saying the same thing in a different way.
    Senator Reed. Mr. Davidson, it is your thoughts. Do you 
want to elaborate?
    Mr. Van Valkenburg. He is Mr. Davidson.
    Senator Reed. Oh, I am sorry----
    [Laughter.]
    Mr. Van Valkenburg. I am not as good looking as he is.
    [Laughter.]
    Senator Reed. Mr. Van Valkenburg.
    Mr. Van Valkenburg. Thank you. Yes. I was basically--in the 
current TBA market, there is a perception of if Fannie Mae has 
a better liquidity than Freddie Mac, it is minor, two or three 
ticks. I do not know, Tom knows better than I. So an issuer 
name is significant as far as liquidity, so that was basically 
it. I think if we get into too many issuers, it is going to 
confuse the investors, which is going to affect the level of 
liquidity. So a single name issuer is what I was advocating and 
the guarantee function separated. I think it costs us in 
liquidity if we have multiple issuers.
    Senator Reed. Right. But, I mean, in just thinking back, I 
think that is a way we sort of walked ourselves into the GSEs, 
which is basically if you are going to give a monopoly, then it 
has got to be quasi-governmental, at least. Otherwise, the 
monopoly profits go to someone. That is not our tradition. So 
this approach, I think, would imply the issuer would be some 
type of entity, either very closely regulated by the Government 
or some quasi-governmental entity, and then the guarantees 
would be subject to market pricing and market activity.
    Mr. Van Valkenburg. Exactly, and we are not going to get a 
credit market established quickly, but we could develop that 
over time. The current infrastructure with a 30-year guarantee 
is not going to go away tomorrow and it is going to take time 
for that to develop, but----
    Senator Reed. Mr. Davidson, your comments. You are Mr. 
Davidson----
    Mr. Davidson. Yes, I am Mr. Davidson.
    [Laughter.]
    Senator Reed. Forgive me. It is vision as well as----
    [Laughter.]
    Mr. Davidson. One idea is that if you are going to have 
this single issuer or a few issuers to avoid this monopoly 
situation is that you can allow that to exist only as a 
cooperative, so some sort of industry cooperative like the 
DTCC, and so that if there is monopoly profits, they have to go 
back into the chain where it is competitive, either above or 
below that cooperative.
    But I do think that having one or two issuers is good. 
Trying to get as many participants to take the credit risk is 
good. But you do have to find a way of standardizing the 
mortgage products. So let us say we had 20 different mortgage 
originators, all of who would go through this one guarantor, 
but they all had 20 different, like, loan documents, 20 
different types of disclosure. Then we would have 20 different 
markets and that is not going to promote the liquidity we need. 
So it is just a careful balancing act between spreading the 
risks and standardizing.
    Senator Reed. Let me ask this as a final question to all of 
the panelists, but I will begin with you, Mr. Davidson, which 
is you have proposed this subordinated debt approach. But I 
think it implicates a bigger issue, which is recognizing that 
we should probably begin to take steps now to begin a 
transition, that legislative steps, because it takes a long 
time to get legislation through and because of the potential it 
is not likely going to happen today or even next year, et 
cetera. But as you suggest, and I think everyone on the panel 
has suggested, there are things today that should be considered 
to begin this process, maybe even experiments which do not work 
out and save us the trouble of trying them in the future on a 
larger scale, or adopting them as an exclusive remedy.
    So if you can comment on your subordinated approach, how it 
might work and is it feasible to begin to adopt it today, and 
then I would like to ask the other panelists to think of either 
what other steps that you would suggest, again, outside of 
legislative but within the purview of the agencies today and, 
as you understand, the legal framework.
    So let us begin with Mr. Davidson.
    Mr. Davidson. So the subordinated approach is something 
that the GSEs have done in the past----
    Senator Reed. Mr. Hamilton pointed that out.
    Mr. Davidson. Right, sort of in the multi-family area----
    Senator Reed. Yes.
    Mr. Davidson.----and I believe it is something that the 
GSEs are exploring currently, different ways of adding private 
capital. And so it is certainly doable with the existing 
structure, but they probably do need the approval of FHFA. I do 
not know if they need the approval of Treasury. I think they 
can move in that direction. I think they should try several 
things. So I like subordinated bond approach. Other people 
might think we should use more private mortgage insurance.
    I think the key factor there is sending the message to FHFA 
that experimentation is good, you know, that is what you want 
to see, and you do not need to have sort of a sole focus on 
conservatorship of every dollar today, and I think finding the 
right solution actually adds value to the GSEs over time.
    And the other important component is to try to move the 
dialog away from let us destroy the--you know, eliminate the 
GSEs tomorrow because they were bad before. The managements who 
did that are all gone. So are there pieces of the GSEs that we 
would like to preserve over time. So, anyway, I think it is 
doable.
    Senator Reed. Thank you.
    Mr. Van Valkenburg, please.
    Mr. Van Valkenburg. Yes. I proposed one idea, but there is 
no single monolithic solution, and all these markets are 
complex and they price risk differently and there are a 
different audience of investors. So the subordinated bond 
solution may be the best solution. We do not know until we 
actually go out and try to execute and see what the price and 
cost of that credit is. So I proposed the CDS market just as 
one avenue as exploratory thought. So I do not have a 
particular single solution, but I think you have to price it, 
find out what the costs are, and find out what is the best 
execution for the Government's balance sheet.
    Senator Reed. Thank you.
    And Mr. Hamilton.
    Mr. Hamilton. I think we end up with a portfolio of things 
we need to work on in the interim, given the likelihood of 
legislation in the near term is low. The FHFA can obviously 
play a large part in this. Lowering of the loan limits is one 
step. We could lower them further on a gradual basis over the 
next 18 months would be the next step. It would enable the 
private market to open up. I think the FHFA could--you could 
limit the amount of borrowings that banks can do from the Home 
Loan Bank System. You could encourage the covered bond 
legislation and market to open up to be another funding 
vehicle.
    I think there is a portfolio of approaches that are going 
to attack the U.S. housing system and be the solution for 
mortgage finance, and I think there are quite a few of these we 
can do in the next 18 months without legislation, and I think 
those are just a few of the things we should work toward, and 
then I think we will find the answer. We will rise to the top 
quickly.
    Senator Reed. Well, thank you very much, gentlemen. This 
has been very, very helpful to the Subcommittee. As Senator 
Corker suggested, please do not be surprised if you are called 
again to get your views and your advice because it is 
extraordinarily helpful, and thank you very much for your 
testimony and your appearance today.
    Some of my colleagues might have additional questions. We 
will ask that these questions be submitted before the end of 
the week. It is Wednesday, and so by Friday, I think that is 
fair. We will get those to you and ask you to return them as 
promptly as possible if there are any written questions.
    Again, thank you very much. The hearing is adjourned.
    [Whereupon, at 10:32 a.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]

                 PREPARED STATEMENT OF THOMAS HAMILTON
   Managing Director, Barclays Capital, on behalf of the Securities 
               Industry and Financial Markets Association
                             August 3, 2011

    Good morning Chairman Reed, Ranking Member Crapo, and Members of 
the Subcommittee. I am Thomas Hamilton, Managing Director, at Barclays 
Capital, where I am responsible for securitized products. I am pleased 
to testify today on behalf of the Securities Industry and Financial 
Markets Association (``SIFMA'').\1\
---------------------------------------------------------------------------
    \1\ The Securities Industry and Financial Markets Association 
(SIFMA) brings together the shared interests of hundreds of securities 
firms, banks and asset managers. SIFMA's mission is to support a strong 
financial industry, investor opportunity, capital formation, job 
creation and economic growth, while building trust and confidence in 
the financial markets. SIFMA, with offices in New York and Washington, 
D.C., is the U.S. regional member of the Global Financial Markets 
Association (GFMA). For more information, visit www.sifma.org.
---------------------------------------------------------------------------
    We appreciate the opportunity to discuss the most liquid secondary 
markets for mortgage loans and mortgage-backed securities (MBS) in the 
world--the ``To-Be-Announced'' (TBA) markets. These are critically 
important markets which help consumers purchase homes, and we would 
like to discuss in detail how they work, the benefits they confer on 
consumers and the economy, and their important role in mortgage 
finance.

Summary
    Housing is a critical component of our economy, and is the center 
of a virtuous circle: housing begets jobs, which beget housing. 
Consequently, the U.S. mortgage market is enormous; for example the 
home mortgage market is approximately equal in size to the total size 
of U.S. bank balance sheets. Given that banks engage in activities 
other than residential mortgage lending, their balance sheets alone 
cannot meet the country's need for mortgage credit. Ginnie Mae, Fannie 
Mae, Freddie Mac (together, ``the Agencies'') and private institutions 
use the process of securitization to provide capital that allows for 
the growth of mortgage lending beyond the capacity of bank balance 
sheets. Today, private securitization and the Agencies finance nearly 
70 percent of outstanding home mortgages and it is therefore imperative 
that securitization continue to play a key role in any future mortgage 
finance system. The market for MBS issued by the Agencies is 
approximately three times the size of the outstanding non-agency MBS 
market. In this Agency MBS market, the TBA market is the single largest 
component. The TBA market is currently the key to funding mortgage 
lending, and because of this it plays a critical role in housing and 
the U.S. economy.
    The enduring liquidity of the TBA market, in contrast to the lack 
of issuance in the private MBS markets, preserved the availability of 
mortgage credit in the recent crisis. This ability to maintain 
liquidity during stress periods is a key benefit of the TBA markets. 
Furthermore, the liquidity and resilience of the TBA market attracts a 
wide range of investors who provide vast capital that is cycled into 
mortgage lending, including retirement savings vehicles, insurance 
companies, and foreign investors.
    The vast liquidity and forward-trading nature of the TBA market 
provides key benefits to consumers, such as the broad availability of 
30-year fixed rate mortgages that may be prepaid without penalty, and 
significant and consistent liquidity in the secondary mortgage market. 
This results in a stable and attractive funding source for lenders that 
allows them to provide lower mortgage rates and longer-term ``rate 
locks'' for borrowers, and efficiently recycles funds back to local 
lenders to enable another round of mortgage lending.
    Of course, the TBA market is facilitated by the guarantees of the 
Agencies, and therefore the support of the Government that stands 
behind them. Currently over 90 percent of mortgages are financed 
through a program of one of these three Agencies. This level of support 
is possible because Agency MBS do not expose investors to credit risk, 
and therefore the market is attractive to risk-averse investors that 
have vast sums of capital available for investment. Without the TBA 
market, we believe that the majority of this investment capital would 
be directed elsewhere, reducing the amount of funding for and raising 
the cost of mortgage lending. Therefore, SIFMA believes strongly that 
maintaining a liquid and viable TBA market should be considered as 
Congress addresses housing finance reform.
     With that said, the reality is that that this current outsized 
role of the Government is not sustainable over the long term, and 
should be reduced. The TBA market's role, and the Government's role, 
should shrink as the private markets regenerate over time. The means of 
achieving this rebalancing are very complicated and consequential on a 
national, financial, and personal level. While SIFMA believes the TBA 
market should play a role in the future, it should certainly not be 90 
percent of the market. There are a number of challenges to the 
resurrection of non-agency securitization, including the significant 
uncertainty faced by non-agency MBS investors and issuers. The rules of 
the road, for both sides, are not clear. Until they are, it will be 
challenging for issuers and investors to see eye to eye on 
securitization transactions, at least in the volume and frequency that 
is necessary to fund mortgage credit demand. Being able to withdraw the 
Government from mortgage markets will require a carefully planned and 
sequenced transition which should take a number of years. It is 
essential to remember that the necessary volume of non-agency investors 
will not simply appear because we want them to. They must be drawn back 
into, and made comfortable with, private label securitization and its 
regulatory environment.
    We believe that it is critical that the planning and execution of 
significant changes to the funding of mortgage loans be done with 
attention to detail, be based on sound analysis of costs and benefits, 
be mindful of unintended consequences, and create a long-term 
beneficial and stable environment. While we cannot predict the future, 
we can use the past as a guide and apply lessons learned and mistakes 
made, the good and the bad, to a design that will stand the test of 
time.
    We hope that the testimony we present today will he helpful in 
educating policymakers about how mortgage loans are funded in the 
capital markets, the critical role of the TBA market, and some of the 
critical issues that must be considered to move forward.
    Thank you for this opportunity and I am happy to take any 
questions.

Discussion

A. Terminology
    We will first quickly review basic terminology to set the stage for 
the rest of our testimony.

    Mortgage-Backed Security (MBS)_An MBS is a type of bond 
        collateralized by mortgage loans that represents an undivided 
        fractional interest in that pool of loans. Beneficial ownership 
        of this interest may be transferred in trading markets. 
        Payments to bondholders result from the underlying payments and 
        cash-flows on the mortgage loans that serve as collateral. Cash 
        flows to MBS investors are variable, as most mortgage loans are 
        prepayable without penalty.

    Agency MBS_Agency MBS are collateralized by loans meeting 
        Fannie Mae (FNMA), Freddie Mac (FHLMC), or Federal Housing 
        Administration (FHA) underwriting guidelines, and are issued 
        and/or guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae 
        (GNMA). Agency MBS are perceived to have little to no credit 
        risk because they carry either an explicit Government guarantee 
        (GNMA) or an implicit guarantee (FNMA and FHLMC). Unlike Fannie 
        Mae and Freddie Mae, Ginnie Mae does not issue debt or 
        mortgage-backed securities. It is a guarantor of privately 
        issued securities collateralized by loans insured by the FHA, 
        Veterans Administration, and the Rural Housing Service.

   Non-Agency MBS_So-called non-agency MBS are collateralized 
        by a wider variety of loan types than Agency MBS, and are 
        issued by private lenders, and are not guaranteed by Fannie 
        Mae, Freddie Mac, or Ginnie Mae. Non-agency MBS are generally 
        structured into tranches with varying degrees of repayment 
        priority, and therefore introduce varying degrees of credit 
        risk to investors. Credit risk is the risk of losses if 
        borrowers do not repay their loans. Recently, there have been 
        two notable non-agency MBS transactions been backed by 
        extremely high quality, high-balance loans (a.k.a. ``Jumbo 
        Prime'' loans); prior to 2008, non-agency MBS also included 
        ``subprime'' and ``Alt-A'' loans.

   Common MBS Structures

  1.  Pass Through--A pass through security is the simplest form of 
        MBS. Payments on the loans are delivered to investors as they 
        are paid by borrowers (i.e., they are ``passed through''). Most 
        Agency MBS are issued in pass through form. MBS eligible for 
        TBA trading are in the form of pass-throughs.

  2.  Collateralized Mortgage Obligations (CMO) and Residential 
        Mortgage-Backed Securities (RMBS)--CMOs and RMBS structure cash 
        flows to investors by dividing borrower payments into various 
        ``tranches'', or slices that are entitled to particular streams 
        of payments. Agency securitizations are generally called CMOs, 
        and Non-Agency securitizations are usually called RMBS.

  3.  Real Estate Mortgage Investment Conduits (REMIC)--In 1986 
        amendments to the tax code created favorable treatment for 
        mortgage securitization structures that met certain 
        requirements. These rules are administered by the Internal 
        Revenue Service. Most MBS are issued in compliance with REMIC 
        regulations.

   To-Be-Announced (TBA) Trading of MBS--To-Be-Announced 
        trading is a trading convention whereby homogeneous MBS are 
        traded for forward settlement and the purchasing party does not 
        know the specific identity of the MBS pool to be delivered. 
        Trades are executed based on a limited number of criteria, 
        including issuer, coupon, term of mortgage collateral, and 
        settlement date.

B. Overview of the U.S. Mortgage Market, and the Importance of 
        Securitization
    Chart 1 below shows the enormous size of the U.S. mortgage market 
relative to bank balance sheets. The size of the mortgage market has 
previously exceeded, and is currently nearly equal to the total size of 
bank balance sheets. This chart demonstrates that there is not enough 
capacity in the U.S. bank balance sheets to fund our nation's housing 
stock alone. Through securitization we are able to recycle capital 
available for lending and attract vast sums of new capital to the 
markets.



    To put this in a global context, the U.S. mortgage market is larger 
than the combined mortgage markets of all of the countries in Europe. 
For this reason, the U.S. mortgage market is not directly comparable to 
any single other market in the world.



    Three quarters of U.S. mortgage debt is residential mortgage debt, 
as shown below.



    Securitization and the MBS markets play a critical role in funding 
this residential mortgage lending. We have shown above that the 
mortgage market is enormous, that it is primarily a residential market, 
and that securitization is necessary to fund this level of credit 
creation. We will now turn more specifically to the role of 
securitization and secondary markets in funding these markets, and 
discuss who ultimately provides this capital.
    Below is a chart that outlines how mortgages are funded in the 
United States. 67 percent, or $7.1 trillion, of home mortgages are held 
in a GSE portfolio or securitized (agency and non-agency). Secondary 
markets, therefore, are responsible for funding two thirds of 
residential mortgage lending. The securitized home mortgage market can 
be split between agency MBS and non-agency MBS, with 81 percent of all 
MBS in the form of an agency pass-through or agency CMO.



    To put the size of the MBS markets in perspective, the chart below 
places them in the context of the other fixed-income markets. They are 
larger than all markets but for Treasuries.



    Another important issue to understand is who holds these 
securities. Banks, pension funds, mutual funds, and insurance companies 
are key investors in MBS. Foreign sources of capital, including 
investment companies, sovereign wealth funds, and other Government 
entities are also critical sources of capital for U.S. mortgage 
markets. Below are two charts which outline the holders of both agency 
MBS and non-agency MBS.



    The most critical point of this testimony to this point is this: in 
any consideration of the future of housing markets, the future of the 
GSEs, or the future of mortgage lending, it is critical to remember 
that these markets will not work without the participation of 
investors. The U.S. mortgage market, as shown above, is huge. It is a 
key component of the economy and job creation, and is largely funded by 
many different kinds of investors. Therefore, any housing reform or 
changes to the current regime must be viewed through the lens of 
investor needs, and what investors are willing to pay for a given 
investment opportunity.

C. The Role of the Agencies
  A. What They Do
    The Agencies have long played a crucial role in the U.S. mortgage 
finance market. Fannie Mae and Freddie Mac purchase loans, securitize 
them, and guarantee the timely receipt of principal and interest on 
their MBS. Ginnie Mae securitizes Government-insured FHA, USDA, and 
other Government guaranteed loans, and places a similar guarantee of 
timely payment of principal and interest on the mortgage-backed 
securities. For the last 30 years, the Agencies have played a critical 
role in mortgage finance, utilizing securitization to expand the supply 
of capital available for mortgage lending.
    Standardization has been a key benefit of the Agency model. Due to 
their size and the scale of their operations, the Agencies have driven 
standardization of mortgage loan documentation, underwriting, 
servicing, and other items in ways that have created a more efficient 
origination process. This standardization extends beyond the Agency 
market, and has driven standardization of lending processes more 
generally, across product types, markets, and across institutions.
    Perhaps more importantly, the activities of the Agencies have 
driven the standardization of loan maturities out to 30 years, creating 
a mortgage product that is affordable to a greater proportion of 
consumers. Most people take for granted that typical mortgage loans 
have a 30-year term, but given the nature of bank funding, this is not 
a natural outcome. Before the implementation of Government programs 
such as the Homeowners Loan Corporation, FHA, and Fannie Mae in the 
1930s, mortgages tended to be short term and require a balloon payment 
at the end of the term. This was directly related to the short-term 
nature of bank funding. Many institutions derive a majority of funding 
for lending from customer deposits which are redeemable upon demand. 
The development of secondary markets for loans and MBS through 
Government initiatives allowed banks to extend loans with longer terms. 
Banks were able to access a longer-term funding source to match the 
terms of the mortgages, transfer risk, reduce balance sheet 
utilization, and reduce demands upon limited capital through loan sales 
into active secondary markets and ultimately securitization. Without 
the initiatives undertaken by the Government in the 1930s and the 
continuing support of the GSEs, it is not clear that today's ``normal'' 
mortgage loan would have a 30-year term. In a world without Government 
guarantees, the 30-year mortgage would likely still exist, but with 
lesser availability and presumably higher cost, due in part to issues 
related to risk hedging.

  B. Agency Market Share Trends and Performance During the Crisis
    The chart below shows the ratio of agency MBS issuance to non-
agency MBS issuance over the last 30 years. This chart clearly shows 
the reaction of the agency and non-agency markets to the financial 
crisis. Throughout the 80s and into the 1990s, the Agency share of the 
MBS markets was in the range of 80 percent. As the non-agency markets 
expanded in the mid-2000s, during the housing boom, the Agency share 
fell to approximately 50 percent. Therefore, even at the peak of the 
housing and securitization boom, the Agencies remained a critical 
participant in the MBS markets. As the non-Agency MBS markets collapsed 
in 2007 through the present, the Agencies took on a more critical role 
than ever, in terms of providing funding for mortgage lending to 
consumers. The Agency market was a stable source of funding throughout 
the crisis. 



    Another issue to review is the cost of a conforming loan (a loan 
eligible for securitization by a Agency) versus a non-conforming loan. 
The chart below compares the spread between conforming loan rates and 
non-conforming loans with balances that exceed the conforming loan 
limit. During the financial crisis of 2008, the spread between 
conforming and non-conforming mortgage rates increased to approximately 
five times its historic level, and pricing on non-Agency MBS relative 
to Agency dropped precipitously. The spread between these rates spread 
has yet to return to its historic trend.





    From these charts, you can clearly see that we need to reduce the 
share of lending funded through the Agencies. Over the long run, it is 
not healthy for the Government, in one way or another, to support 95 
percent of mortgage lending. SIFMA therefore agrees that housing 
finance reform is critical, and supports its careful implementation.
    At the same time, we believe that it is important to keep in mind 
that the Agencies have conferred significant benefits on U.S. mortgage 
markets. We believe that housing finance can and should be reformed and 
made more robust without destroying the benefits that the Agencies have 
conferred. We caution that the drive for reform should not cause 
collateral damage that would eliminate or make impossible the 
beneficial impacts and legacy of the old system that developed around 
the Agencies.
    One of the most important benefits of the system developed over the 
previous decades, if not the most important, was the development of a 
liquid forward market for mortgage-backed securities known as the TBA 
market. The TBA market allows lenders to hedge risk, attracts massive 
amounts of private capital, and reduces the cost of mortgage lending. 
SIFMA believes the TBA market should be a key component of a 
successful, liquid, affordable, and national mortgage market, as well 
as ensuring a sufficient level of capital is available to banks to 
lend. The historically huge and liquid global markets described above 
for Agency MBS are initiated by the TBA mechanism.

D. The TBA Markets
  A. History
    The genesis of the TBA market began in the 1970s, when members of 
the Government Securities Dealers Association began to discuss 
standards for the trading and settlement of bonds issued by Ginnie Mae. 
In 1981, the Public Securities Association \2\ published the ``Uniform 
Practices for the Clearance and Settlement of Mortgage-Backed 
Securities and Other Related Securities'', which is a manual that 
contains numerous of market practices, standards, and generally 
accepted calculation methodologies developed through consensus 
discussions of market participants, that are widely accepted and used 
in the MBS and asset-backed security markets. The GSDA and PSA were 
predecessors of SIFMA.
---------------------------------------------------------------------------
    \2\ The Government Securities Dealers Association and the Public 
Securities Association are predecessor organizations of SIFMA.
---------------------------------------------------------------------------
    Participants in the TBA market generally adhere to market-practice 
standards commonly referred to as the ``Good-Delivery Guidelines'', 
which comprise chapter eight of this manual.\3\ These guidelines cover 
a number of areas surrounding the TBA trading of agency MBS, and are 
promulgated by and maintained by SIFMA, through consultation with its 
members. The purpose of the guidelines is to standardize various 
settlement related issues to enhance and maintain the liquidity of the 
TBA market. Many of the guidelines are operational in nature, dealing 
with issues such as the number of bonds that may be delivered per one 
million dollars of a trade, the allowable variance of the delivery 
amount from the notional amount of the trade, and other similar 
details.
---------------------------------------------------------------------------
    \3\ The Good Delivery Guidelines are a part of SIFMA's Uniform 
Practices for the Clearance and Settlement of Mortgage-Backed 
Securities and Other Related Securities, which is available here: 
http://www.sifma.org/research/bookstore.aspx.
---------------------------------------------------------------------------
  B. Mechanics of a TBA Trade
    The majority of trading volume in the agency MBS markets today is 
in the form of TBA trading. For background, a TBA is a contract for the 
purchase or sale of agency mortgage-backed securities to be delivered 
at a future agreed-upon date; however, the actual pool identities or 
the number of pools that will be delivered to fulfill the trade 
obligation or terms of the contract are unknown at the time of the 
trade. Actual mortgage pools guaranteed by one of the Agencies are 
subsequently ``allocated'' to the TBA transactions to be delivered upon 
settlement. Settlement dates of transactions are standardized by 
product type (e.g., 30-year FNMA/Freddie Mac pools, 30-year Ginnie Mae 
pools, 15-year pools) to occur on four specific days each month. 
Monthly settlement date calendars for the TBA market are published 1 
year in advance by a SIFMA committee on a rolling 12-month basis. This 
is done to increase the efficiency of the settlement infrastructure, 
and facilitate forward trading. Most trades are executed for settlement 
within one to 3 months, although some trading may go further forward 
from time to time.



    For example, Investor A could call up Market Maker A on May 23, and 
order $10 million FNMA 5.5 percent coupon 30-year MBS, for settlement 
on July 14. The investor does not specify specific bonds or CUSIP 
numbers. On July 12, according to market practice, Market Maker A would 
notify Investor A of the specific identities of the pools that will be 
delivered on July 14. Most likely, these will be MBS that were just 
issued at the beginning of July.
    On the other side of an investor or market maker often stands a 
loan originator. Originators can enter into forward TBA sale contracts, 
allowing them to hedge the risk of their loan origination pipelines. 
This permits the lenders to lock in a price for the mortgages they are 
in the process of originating, benefiting the borrower with the ability 
to lock in mortgage rates earlier in the process. Pricing on loans 
varies from day to day with fluctuations in the TBA markets, and 
lenders will often re-price loans for their bankers and correspondent 
partners on a daily basis. Thus mortgage bankers follow the market in 
order to make decisions on when to lock in a rate for a borrower.

  C . Key Benefits of the TBA Markets
    1. Liquidity for U.S. Mortgage Lending
    The TBA market is by far the most liquid, and consequently the most 
important secondary market for mortgage loans. This liquidity is 
derived from its vast size ($trillions), homogeneity of collateral, and 
the forward nature of the trading. This liquidity is due to one factor: 
homogeneity. TBA trading is based on the assumption that the specific 
mortgage pools which will be delivered are fungible, and thus do not 
need to be explicitly known at the time a trade is initiated. At a high 
level, one pool is considered to be interchangeable with another pool. 
The sources of this homogeneity are primarily threefold:

    The Agencies each prescribe standard underwriting and 
        servicing guidelines (FHA plays this role in concert with 
        Ginnie Mae in those markets)

    Standardized market practices and guidelines (the ``Good 
        Delivery Guidelines'', discussed more below) ensure that 
        securities eligible for the TBA market are homogeneous, which 
        allows buyers and sellers to transact with confidence that 
        knowing the specific identity of a security they will trade, at 
        the time of trade, is not necessary;

    The explicit or implicit guarantee on the MBS eliminates 
        credit risk from the risk factors investors must deal with. 
        This guarantee also attracts classes of investors who would not 
        otherwise participate in these markets; investors who are 
        statutorily prohibited from, blocked by investment guidelines 
        from, or simply do not desire to take on mortgage credit risk.

    Thus, investors can buy securities without knowing their exact 
identity because they know that (1) the underwriting will be consistent 
across pools, (2) the servicing will be consistent across pools, (3) 
the MBS and operational mechanisms around their trading will be 
consistent across pools, and (4) they do not need to perform a loan-
level dive to explore credit risk before they purchase the bonds.
    There are currently over $4 trillion in bonds eligible for TBA 
trading--it is a vast market. It is also extremely liquid. Federal 
Reserve data shows average daily trading volumes of Agency MBS reported 
by the Fed's primary dealers as exceeding $300 billion per day over 
each of the last 3 years. Private estimates of daily TBA trading 
volumes exceed $600 billion (these estimates take in to account trading 
beyond that of the primary dealers). Liquidity in this market is second 
only to the market for Treasuries. This liquidity allows investors to 
buy and sell significant quantities of securities quickly and without 
disrupting the market. This makes the market very attractive to these 
investors who have substantial funds to be invested.



    This liquidity draws trillions of dollars of investment capital to 
U.S. mortgage markets, as discussed in detail in the previous section 
of this testimony. Given the size and liquidity of the market, buyers 
and sellers are able to trade large blocks of securities in a short 
period of time without creating distortions.
    2. Originator Hedging and Rate Locks
    As mentioned, this market allows lenders to sell their loan 
production on a forward basis, in some cases before MBS pools are 
formed, and hedge risk inherent in mortgage lending. A benefit of this 
ability to hedge risk is that the TBA market allows lenders to lock-in 
rates for borrowers. Lenders can sell forward in the TBA market at the 
then-current interest rate. Without TBA markets lenders would either 
have to charge substantially more for (probably shorter-term) rate 
locks, because hedging in derivatives or options markets is more 
expensive and less efficient. It is possible that some lenders simply 
would not offer rate locks at all. The liquidity of the TBA market 
creates efficiencies and cost savings for lenders that are passed on to 
borrowers in the form of lower rates and broad availability of mortgage 
products, and helps to maintain a national mortgage market.

    3. Benchmark Status of the TBA Market
    For all of the reasons outlined above, the TBA market is a 
benchmark for all mortgage markets--it is the reference by which other 
mortgage markets and products are priced. In this manner it is similar 
to the Treasury market. This is an issue that is often overlooked, but 
one that we want to highlight. Non-agency mortgage product is priced 
relative to TBA; TBA provides a sort of risk-free reference point for 
those markets. Without the TBA market, we believe that non-TBA markets 
would be somewhat more volatile as pricing would become more 
challenging. We also note that predictions of the movement of mortgage 
rates in a world without TBA generally do not take into account this 
role. While the actual change in rates would be quite dependant on the 
exact contours of a mortgage finance system without TBAs, we suspect 
that the change may be greater than many currently believe.
    It is difficult to exaggerate the consequences from a loss of 
confidence or liquidity in this market if a suitable replacement were 
not found. The effects would be directly and immediately felt by the 
average mortgage borrower. The impact would include, at a minimum, 
higher mortgage rates, as yields required by investors would rise as 
liquidity falls. It is also likely that credit availability would be 
constricted. This would occur because secondary market executions for 
originators would be more expensive and take longer, requiring longer 
warehousing periods for loans they originate. Balance sheet capacity is 
a currently a scare commodity for most lenders, and is finite in any 
case. Furthermore, the ability of borrowers to lock-in rates on 
mortgage applications would likely be reduced, creating uncertainty for 
them and likely depressing real estate activity which is an important 
component of broader economic activity.

  E. Looking Forward--Considerations for TBA Markets and the Future of 
        Mortgage Finance
    There is no single ``right answer'' or any easy solution to the 
question of how to resolve the conservatorships of Fannie Mae and 
Freddie Mac and/or define the future infrastructure for mortgage 
finance in the U.S. Policymakers are faced with a series of difficult 
choices, each with its own costs and benefits, which will shape the 
future of housing finance. Ultimately, this essential infrastructure is 
both a creation of and a reaction to past public policy choices, and as 
such the future of it will grow out of further determinations of what 
is the appropriate public policy regarding mortgage finance. While 
there are many important questions, we believe a special and near-term 
focus needs to be placed on resolution of the current status of the 
GSEs and the restoration of the private-label securitization markets 
for mortgages.
    Secondary mortgage markets will continue to function regardless of 
what policymakers decide. As the saying goes, there is a price for 
everything. This price, however, is not always desirable to everyone. 
Accordingly, policymakers need to determine what they want from the 
mortgage markets before they can address what to do with the GSEs or 
the broader infrastructure of mortgage finance. Among the issues for 
policymakers to consider are:

    how liquid secondary markets for loans and MBS would be;

    the breadth of products that would be offered to consumers;

    the capacity of lenders to extend credit;

    whether national lending markets could be sustained or if 
        regional pricing differentials would reappear;

    the cost and affordability of mortgage credit to consumers.

    SIFMA believes that the TBA markets are one of the keys to a 
successful, liquid, affordable, and national mortgage market. TBA 
markets also ensure that a sufficient level of capital is available to 
banks to lend. We repeat our previous statement: the historically huge 
and liquid global markets for Agency MBS are initiated by the TBA 
mechanism.
    1. Can the TBA Market Function without a Government Guarantee?
    Ultimately, the answer to this question is unknown. We are not 
aware of any meaningful, consistent TBA-style trading of any other non-
guaranteed mortgage product at this time. To the extent that guarantees 
were completely removed, we believe that the best case outcome with 
respect to TBAs is a much smaller, much less liquid market. The worst 
case outcome would be the dissolution of the markets. But in the end, 
we do not know at this time.
    As we mentioned earlier, the key driver of the TBA market is 
homogeneity. In the future, one can envision a recreation of ``Good 
Delivery Guidelines'' for a non-guaranteed product. However, this is 
only one piece of the puzzle. The Agencies play a critical role in the 
TBA markets through their standardization of underwriting and 
servicing, and their enforcement of that standardization through 
automated underwriting systems and otherwise. It is unclear to SIFMA 
how this could be recreated to the degree of detail at which it 
currently exists, and be done so in a format that was efficient and 
manageable enough to support liquid TBA markets.
    The guarantee on MBS traded in TBA markets eliminates a key risk--
credit risk. Investors in TBA markets focus on prepayment risk, that 
is, the risk that borrowers will repay their loans early, and on 
interest rate and market risk, or the risk that interest rates or 
market pricing will move against them. This allows what are called 
``rates investors'' to invest in the Agency MBS markets. Rates 
investors, put simply, are investors who do not wish to take on credit 
risk. They include various investment funds, and importantly, many 
foreign investors.
    In the non-Agency markets, investors must also deal with credit 
risk. This entails an examination of the credit risk factors of the 
loans that collateralize the MBS. Going forward, we expect that 
investors will perform this review at a loan level, as disclosure 
practices and regulations for non-Agency MBS drive to this end. In and 
of themselves, loan level reviews are not practical for TBA trading 
(because one cannot review loan level detail on an unknown pool of 
loans). Therefore, to create a level of comfort that would allow 
investors and market makers to trade non-agency collateral on a TBA 
basis, underwriting standards would need to be very strict because they 
would need to eliminate as much credit risk as possible. As a result, 
lenders would likely draw such a small circle around eligible mortgage 
loans that the supply of loans would likely not be sufficient to 
support large and liquid TBA trading. Additionally, to define the 
underwriting standards for every bank that would deliver into this 
market, and on top of that to outline servicing procedures, would 
entail a massive expansion of market practice guidelines in terms of 
breadth and length. This would complicate the ability of investors to 
get comfortable that the loans that underlie the securities they will 
be delivered next month, or the following month, will comply. 
Importantly, there would be no clear enforcement mechanism for 
compliance.
    The expansion of the usage of mortgage insurance to provide comfort 
to MBS has been put forth as one alternative. SIFMA's discussions with 
its members have evidenced significant doubts that the investing 
markets would take anything near the current level of comfort from 
private mortgage insurance solutions. In any case, members generally 
believe this solution would be inadequate to support liquid TBA 
trading.
    Given all of this, it is not clear what proportion of the current 
rates investor base would shift into the proposed new non-guaranteed 
TBA markets. If a significant proportion of the rates investor base did 
not shift into the new market, the potential liquidity and potential 
size of the new market would be severely compromised (if it functioned 
at all). It is also not clear on the supply side whether or not a 
sufficient quantity of loans would be produced that would comply with 
the extremely strict underwriting guidelines that would be needed. It 
is notable that no other mortgage market or funding system via 
depositories has ever provided sustained liquidity to the extent that 
the Agency MBS markets have. It is also notable that each secondary 
mortgage market that was not the beneficiary of a guarantee collapsed 
in 2008.
    SIFMA's Housing Finance Reform Task Force has concluded that some 
form of explicit Government support is needed to attract sufficient 
investment capital to maintain liquidity and stability in the TBA 
market at a level comparable to that created over the last 30 years. 
Members believe that total privatization of mortgage finance will 
likely result in greater volatility, decrease efficiency, and 
ultimately make mortgage loans more expensive and less available. There 
are a number of ways that an explicit guarantee on MBS could be 
structured. The bottom line for a guarantee is that investors in TBA 
markets must know that they will receive back at least their invested 
principal. Without it, certain rates investors would completely drop 
out of the market and others would have significantly smaller 
allocations of investment capital available for the asset class, and we 
expect that at best, the peak volume and liquidity of such a market 
would be orders of magnitude smaller than the current TBA market.
    Furthermore, as discussed above, Agency MBS currently provide a 
safe, liquid investment product for many risk-averse 401k plans, 
pension plans, and insurance companies. Without this asset class, these 
investors would struggle to replicate the combination of liquidity and 
return, and would either move toward lower yielding products such as 
Treasuries, or into riskier products such as corporate or other 
sovereign debt. Such shifts in asset allocation would not only reduce 
the flow of capital to mortgage markets, but it could also have a 
negative impact on the performance of those investment vehicles in 
times of stress.
    A related issue in many discussions of housing finance reform 
regards the appropriate number of number of chartered GSE-like 
entities, with or without a guarantee. These would be organized by the 
Government or by the private sector as co-ops or otherwise. Regardless 
of specific structural form, we note that an increase in the number of 
entities will not necessarily reduce risk, as the performance of each 
entity will be strongly correlated. They all will make the same bet on 
U.S. housing, and to the extent we have another national downturn, they 
all will suffer. Also, because of a lack of diversification, a given 
entity would be more exposed to regional economic downturns. 
Organizationally, we also see challenges in recruiting 10, 15, or 20 
skilled management, and especially risk management, teams. Furthermore, 
to the extent a TBA market would be viable (see our discussion above); 
a larger number of issuers would serve to fracture liquidity into 
multiple smaller markets. Put simply, a trader can only monitor so many 
screens at one time, and a large part of the liquidity in a given 
market is derived from its size. To the extent that a larger number of 
entities is a desired policy choice, we think it will be critical to 
(a) have only one security issuer that (b) issues diverse pools 
collateralized by loans from all of the issuing entities (i.e., similar 
to Ginnie Mae's multi-issuer pools). This would create a larger, 
unified securities market to stand behind the more fractured front end 
of the system. This would minimize any regional differentiation in 
pricing, maximize liquidity, and maximize the benefit to consumers.
    SIFMA believes that the current situation is undesirable and 
unsustainable and must be changed. We also believe strongly that 
private capital should stand in front of any backstop or guarantee on 
MBS. We note that it is a policy choice to decide the appropriate size 
of the TBA market. Our concern lies with the end result, and that the 
end result is liquid and beneficial to lenders, investors, and 
consumers.

    2. The Importance of a Smooth Transition to the Future Housing 
        Finance System, and the Recovery of Non-Agency MBS Markets
    The future of mortgage finance in the U.S. is a critical policy 
decision facing Members of Congress. The impact of this decision will 
reverberate across the nation's housing markets, across financial 
markets, and across the economy. It is no exaggeration to say that the 
future state of the housing finance system is central to the future of 
our nation as a whole. Regardless of what Congress chooses, the 
transition from our delicate current situation to the future must be 
carefully considered.
    We have discussed above SIFMA's view that the TBA market is central 
to the functioning of our mortgage markets. To the extent that Congress 
desires to create a new mortgage finance regime that makes this 
possible, SIFMA would strongly support doing so. It will be important 
to put in place the basic structures that are required, as we have 
discussed, to allow for a transition from one TBA environment to the 
next with minimal disruption to current securities or mortgage markets. 
Such a regime would allow for the preservation of a homogeneous 
mortgage market eligible for TBA trading.
    To the extent that Congress decides to significantly pull back or 
completely eliminate the Government support for mortgage lending and 
thereby significantly shrink or make impossible TBA trading, it will be 
important to create a smooth path from the current state, which is over 
90 percent Government supported, to the future state. Ultimately, as 
the Government role is pulled back, something or a combination of 
things must fill in the hole in mortgage funding that will be left 
behind.
    In either case the role of the Agency MBS market should and will 
shrink from where it is today. Likely the most critical of the 
components that will allow this to happen will be the reinvigoration of 
the non-Agency MBS markets. These markets, aside from a few small 
transactions, have been dormant in terms of their funding of new 
origination. The bottom line to get these markets going is that we must 
get to a point where issuers of MBS and investors in MBS see eye to eye 
on the value proposition. Investors must receive a return that meets 
their needs, and issuers must pay a cost that works economically. There 
are a number of obstacles in the path. For example, many investors 
suffered significant losses on holdings of non-agency MBS in the latter 
part of the last decade, and it will take time for confidence to be 
fully restored in those products. Mortgage demand from consumers, 
because of the depressed economy, has significantly dropped. 
Importantly, both investors and issuers face significant regulatory 
uncertainty in addition to and apart from of the issues presented by 
resolution of the conservatorships of Fannie Mae and Freddie Mac.
    For example, servicing is a key component of the value proposition 
for non-agency MBS. At this time, the future regulatory regime for 
servicing is up in the air. Investors have identified a number of 
concerns with current and past practices, and the market expects that 
the current paradigm may see dramatic changes. However, no one is 
certain of the timing or scale of these changes, which creates 
significant uncertainly. A precedent-setting settlement of major 
servicers with the State Attorneys General is expected, but the scope 
and timing are unknown. FHFA is leading an important industry 
discussion of the potential for revisions to the compensation of 
servicers in Agency and non-Agency markets, but again, the end of the 
story is still being written. The SEC in 2010 proposed a major set of 
revisions \4\ to rules that govern asset-backed securities, some of 
which were re-proposed,\5\ and some of which have been finalized,\6\ 
but the most critical elements are not yet final.
---------------------------------------------------------------------------
    \4\  SEC's April 2010 Asset-Backed Securities rule proposal here: 
http://www.sec.gov/rules/proposed/2010/33-9117.pdf, SIFMA comment 
letter in response here: http://www.sec.gov/comments/s7-08-10/s70810-
79.pdf.
    \5\ E.g., rules related to asset-level disclosure, shelf 
eligibility, and disclosure in non-registered transactions reissued for 
comment on July 26: http://www.sec.gov/news/openmeetings/2011/
agenda072611.htm.
    \6\ E.g., disclosure related to repurchase demands: http://
www.sec.gov/rules/final/2011/33-9175.pdf.
---------------------------------------------------------------------------
    Another issue relates to recently proposed credit risk retention\7\ 
and mortgage underwriting rules.\8\ The three main issues here are risk 
retention, the definition of a Qualified Residential Mortgage (QRM), 
and the definition of a Qualified Mortgage (QM). Each of these items is 
open, and is expected to be finalized by regulators in the future. Risk 
retention rules by their nature will change the economics of many 
securitization transactions. In part, this is expected to help restore 
the confidence of investors in securitized products and therefore 
stands to provide a benefit to the securitization markets. On the other 
hand, this benefit must be balanced by the preservation of 
securitization as an economical funding alternative for lenders. 
However, certain proposed provisions found in the credit risk retention 
proposal, such as so-called ``premium capture'', have raised concerns 
among many market participants as to their potentially devastating 
impact on the economics of, and therefore future of, many type of 
securitization transactions.\9\
---------------------------------------------------------------------------
    \7\  Credit Risk Retention NPR: http://www.sec.gov/rules/proposed/
2011/34-64148.pdf, SIFMA's sponsor/issuer response: http://www.sec.gov/
comments/s7-14-11/s71411-79.pdf, SIFMA's AMG response: http://
www.sec.gov/comments/s7-14-11/s71411-80.pdf.
    \8\ See proposal from Federal Reserve Board under Regulation Z that 
would require creditors to determine a consumer's ability to repay a 
mortgage before making the loan and would establish minimum mortgage 
underwriting standards: http://www.federalreserve.gov/newsevents/press/
bcreg/20110419a.htm.
    \9\ For further discussion of premium capture and its potential 
impact, see SIFMA letters referenced above.
---------------------------------------------------------------------------
    We expect the final form of the QRM and QM definitions to 
essentially define the shape of the mortgage market after they become 
effective. We expect that there will be little or no lending that falls 
outside of the QM standards, given that significant liability may 
attach to such loans. SIFMA has advocated that the final rules 
delineating QM include a true, bright line, legal safe harbor so that 
lenders will be comfortable to originate, and secondary markets will be 
comfortable to purchase QMs in steady volumes. Many expect that 
mortgage rates on QRMs will be lower level than those of non-QRMs (to 
an extent that is unknown). Regardless of any individual decision with 
respect to QM and QRM, it is important that these regulations be 
closely coordinated and finalized in a manner where it is explicit to 
lenders and secondary markets what is, or is not, a QM or QRM.
    There are also significant regulatory revisions being made to the 
permitted activities of banks, to global and national capital 
standards, to the activities of credit rating agencies, the process of 
obtaining ratings, and the usage of their ratings. These changes 
include the capital treatment of mortgage servicing rights, eligible 
assets for various liquidity and capital buffers, and more generally 
changes to the capital treatment of securitized products.
    All of this contributes to a great uncertainty as to the size, 
scope, and liquidity of securitization as a funding tool for consumer 
credit. It is difficult for lenders and creditors to make long-term 
plans for how they want to run their lending programs and how they will 
fund them, and it is difficult for investors to know the terms on which 
they will be expected to invest. Key principles must be followed to 
resolve this uncertainty: (1) Regulatory changes must be coordinated 
and sequenced properly; (2) changes must be based on robust data 
collection and analysis; (3) changes must keep in mind the dual needs 
of any financial markets: investors must receive adequate returns, and 
issuers must be able to fund at affordable cost levels.
    All of these changes that directly impact the non-Agency markets, 
and the goal of promoting the responsible resurgence of those markets 
must then be viewed in connection with the resolution of Fannie Mae and 
Freddie Mac, as they cannot be separated. One cannot come before the 
other--they must work together. The ultimate question, yet to be 
addressed, is that of the capacity of other forms of funding of 
mortgage finance, be they non-agency securitization, covered bonds, or 
new measures, to replace the support for mortgage lending that the 
Government currently provides.

F. Conclusion
    SIFMA greatly appreciates the opportunity to present this testimony 
today and we hope that it is useful and informative to members of the 
Subcommittee. SIFMA believes that the TBA markets play a critical role 
in the current housing markets, and have provided tremendous benefits 
to mortgage markets and consumers of mortgage loans. SIFMA therefore 
believes that TBA markets can and should play a role in the future 
housing finance system in this country. Regardless of the path chosen 
for mortgage finance, SIFMA believes it is critical to properly 
transition from the current market structure to the future. We stand 
ready to assist Congress in any way necessary.
                                 ______
                                 
              PREPARED STATEMENT OF PAUL T. VAN VALKENBURG
           Principal, Mortgage Industry Advisory Corporation
                             August 3, 2011
    Members of the Subcommittee:

    Thank you for the opportunity to testify before the Subcommittee 
today. Our firm, the Mortgage Industry Advisory Corporation (``MIAC'') 
was started in 1989 and we serve mortgage market participants from 
smaller mortgage companies to the largest banks and MBS investors. In 
one of our product offerings, we offer loan origination hedge advisory 
services to mortgage companies who want to mitigate their market and 
fallout risk of loans and commitments of loans to borrowers. In order 
to offer this service, we need to capture the most current pricing 
information from the TBA (To-Be-Announced) securities and from the pool 
insurance providers (currently only Fannie and Freddie) so that 
mortgage companies can reflect these terms to prospective borrowers. 
The TBA market has served to attract trillions of dollars in additional 
capital to our housing finance system and to enable borrowers to have 
access to fixed-rate 30-year mortgages. Fixed rate 30-year mortgages 
enables borrowers to finance more home with a certain cash-flow 
liability. I hope to offer some additional clarity and detail around 
how these processes function in today's mortgage market and how they 
might work in prospective TBA and mortgage markets.
    The Committee has prepared a set of questions. Rather than answer 
each one individually, I chose to provide a high level description on 
the process whereby the TBA markets interact with the loan origination 
process. In doing so, I believe that I will address each of these 
questions with more clarity. In financial markets so much of what makes 
a market or a product successful is a marginally better solution, e.g., 
slightly lower financing costs, slightly better liquidity, 
incrementally better servicing advance terms, etc. It is therefore 
necessary to have some specific descriptions of the market mechanics in 
order to fully access their current role of the TBA market and how a 
prospective housing finance system could be structured successfully.

  1.  What is the purpose and function of the TBA market?

    a.  What is the role of the TBA market in providing liquidity and 
        facilitating mortgage-backed securities (MBS) trades?

    b.  How does the TBA market affect certain mortgage constructs, 
        including the provision of 30-year fixed rate loans and 
        interest rate locks?

    c.  Does the TBA market allow for greater investor participation 
        and diversity than would exist without the TBA market?

    d.  How does the TBA market impact mortgage rates?

How the TBA market impacts loan terms for borrowers
    Mortgage companies want to be in the business of creating mortgages 
for prospective borrowers and not in the business of speculating on 
interest rates and credit risk. The mortgage industry has developed so 
that the price information of mortgage assets in the capital markets 
and the credit risk insurers can be utilized by mortgage companies to 
offer loan terms to borrowers reflecting the most current risk pricing. 
This process is enormously complex on several fronts--the scope of the 
data collection, the timing of the data collection, the legal 
underpinning, the market conventions, and how all these players 
interact and compete.



    The Tradeweb electronic trading screen with the current and 
executable TBA market prices. See www.tradeweb.com/businesses/rates/
tba_mbs for more information.
    The image above is a screen shot of the TBA market on July 26th, 
2011 at 3:11 PM EDT. The bids and offers of individual broker dealers 
are consolidated and displayed on the Tradeweb screens. Market 
participants still execute with their chosen broker/dealer and they can 
use Tradeweb screens to execute. Smaller mortgage companies can't get 
approved as counterparties to large broker dealers, so the pricing that 
they execute at is usually \1/64\ or \1/32\ behind these screen prices. 
The market is a forward market where securities are created and settled 
in the future. The mortgage companies are modeling and estimating when 
their loan commitments will close and how long it will take and the 
cost to get a MBS pool certificate from Fannie or Freddie.
    The TBA pricing on the screen are the most liquid segment of the 
MBS market. The screen shows the FannieMae 30-year with pass-through 
rates from 3.5 percent to 6.0 percent for settlement in August, 
September, or October. The prices are quoted in percentage of notional 
amount with a somewhat usual convention. For example, the bid side of 
the October delivery FN4's is 99 (``the handle'') and 31 32nds plus 
one-64th or a plus ``+''. The number just to the right of ``99-31+'' is 
the offer side of the market. The ``00+'' means that the offer side 
price is 100-00+ or 100 percent plus \1/64\. The difference between the 
bid side of a market and the offer side of a market is a common method 
for measuring the liquidity of a market. Market participants would say 
that bid/offer spread is \1/32\. However, the depth of the market is 
measured by the difference between the highest bid and the next highest 
bid. Because large pools of mortgage are created with very similar loan 
terms, the cover bids/offers are usually only \1/64\ off highest bid or 
lowest offer. The TBA market is both liquid and deep. However, only the 
largest mortgage companies can execute directly with the largest 
broker/dealers who offer the best pricing. Slightly smaller companies 
will execute with regional broker/dealers with a \1/64\ or \1/32\ price 
difference because of their incremental counterparty risk.
    If a mortgage company anticipates creating a mortgage on July 26th, 
they are estimating that they will have the loan closed and eligible 
for delivery into a FN30-4 security for the October month settlement. 
They could sell the majority of their risk as a FN30-4 TBA for 100 
percent and \1/64\ of a percent (100-00+) in the TBA market with a 
large broker dealer or (100-01) with a regional broker. They would also 
have to pay for the guarantee fee and some loan level price adjustments 
to FannieMae. And they would have to decide whether they would prefer 
to retain the mortgage servicing rights or sell/release the mortgage 
servicing rights to another mortgage company. Below is a diagram 
illustrating the basic flow of the pricing information from the TBA 
market to the borrower.
    As part of the price discovery process for mortgage companies, the 
GSEs will charge a guarantee fee to provide pool insurance for the 
investors in the MBS pool. The guarantee fee for a typical qualifying 
conventional mortgage is 0.0025 or 0.25 percent. However, for loans 
that are still eligible for the GSE pool insurance but with a more 
credit risk, the GSE will charge substantially higher guarantee fees. 
These guarantee fees are called Loan Level Price Adjustors (``LLPA'') 
and the industry refers to them as risk-based pricing. For example, 
loans with higher LTVs, low FICOs, Investment Property, Condo/Coop's, 
and Cash-Out Refi's have LLPA's. I've included FannieMae's Selling 
Guide with the most current LLPA's with this testimony.



The Loan Creation Process from Application to TBA

Initial Application--Loan Broker or Retail Loan Officer
(subset of necessary data for full underwriting; data needs to be 
verified)

Application Approved/Loan Commitment created
(complete set of collateral and credit data for full underwriting; 
verification of employment; verification of income; appraisal (IRLC 
could still be subject to subsequent appraisal))

IRLC (Interest Rate Lock Commitment)--Exposes the mortgage company to 
fall out risk and market risk.

Loan Closes and is subsequently QC'ed and delivered to Fannie for the 
creation of a TBA security. The mortgage company obtains a pool 
certificate number from Fannie.

Mortgage Company can sell the IRLC (Best Efforts) to a larger mortgage 
company and the larger mortgage company can measure and manage the fall 
out and market risk. Or the mortgage company can retain the IRLC and 
measure and manage the fall out and market risk with their balance 
sheet. If they retain the IRLC, they will be selling the future loan 
with the Mandatory delivery option, meaning they will be required to 
deliver the loan or pool of loans. The party that sells securities 
(after the loans have been approved as collateral in TBA pools by FN/
FH) into TBA pools is required (mandatory) to deliver the TBA 
securities on the appropriate settlement dates. If they closed more or 
less loans than they expected, they have to absorb the market 
consequences.

The owner of the mortgage servicing rights must be a Fannie approved 
servicer for Fannie securities. Approval is subject to minimum capital 
requirements and regular business process performance audits.

  e.  Are there any alternatives that would accomplish the same 
        objective and what are the obstacles to the development of such 
        a market?

    In the current mortgage origination process with a liquid TBA 
market, mortgage companies can know with a sufficient clarity and near 
certainty what the exit value of GSE eligible, fixed-rate loans will 
be. They can even sell their IRLC's to a larger mortgage company that 
will measure and manage the fall out risk, pay a competitive price for 
the MSR component, and handle the data delivery requirements.
    Over the past several years, bank balance sheets are constrained as 
they grow their capital and operate under stricter underwriting 
guidelines. Mortgages created for bank balance sheets (typically 
adjusted rate mortgages or jumbos) have represented only a very small 
percentage of loan origination. Mortgage products that are not eligible 
for GSE guidelines do not have a liquid TBA market and as a result, 
mortgage companies have not been originating non-agency eligible 
mortgages. The vast preponderance has been 30-year fixed rate mortgages 
that form the collateral of outstanding MBS and currently qualified for 
new MBS pools. This new housing finance capital was distributed from 
global investor to U.S. home borrower by means of the TBA market. Even 
the Fed chose to provide their $1.2 trillion of capital through the TBA 
market.

Homogeneity and Standardization
    The ``Uniform Practices for the Clearance and Settlement of 
Mortgage-Backed Securities'' created and maintained by SIFMA has 
provided sufficient homogeneity and standardization of the individual 
MBS pool attributes and the clearing and settlement practices to enable 
a liquid market to be created. Investors in mortgage-backed securities 
recognize that each pool is a population of individual mortgages and 
therefore, their pricing and valuation metrics employ actuarial or 
statistical assumptions about the payment and prepayment behavior of 
the population. This valuation paradigm and the homogeneous pool 
attributes enable market participants to trade in large pools of TBAs 
as fungible securities. If a privately guaranteed TBA market were to be 
developed, the market would surely coalesce to an AAA credit rating. 
And SIFMA settlement practices ensuring market liquidity would only be 
tweaked slightly. A slightly lower credit rating would make the terms 
of the mortgage more expensive to borrowers, but the market liquidity 
could be utilized in same manner as today by mortgage companies to 
hedge their interest rate risk for creating long term fixed-rate 
mortgages.
    If a solely private TBA market was created today, I believe that 
the size of this market would be substantially smaller than the current 
Government supported market. However, the development of a solely 
privately supported TBA would necessarily involve a longer term 
transition. We have time to explore developing a solely private market 
in parallel with the current Government guaranteed market. The largest 
buyers of TBAs today are the Wall St dealers gathering collateral for 
CMO issuance. They could take AAA rated TBA and credit enhance their 
CMO bonds to distribute the bonds to a wider audience of investors 
including typical CMO buyers such as mutual funds, insurance companies, 
and other non-banking investors. The investor acceptance of these new 
products would be a gradual process.
    The principal challenge of a privately capitalized TBA market is 
who would hold the first loss or mezzanine risk pieces in the privately 
guaranteed TBAs. In the market right now, there is an enormous amount 
of this risk that is available for risk takers to purchase. And the 
dynamics are such that there is a very weak bid for holding this risk. 
One of the structural problems is that nearly all regulated financial 
institutions would not be permitted to underwrite this risk without 
enormous capital charges and regulatory oversight. The current market 
for holding this residential credit risk is saturated. At this point, a 
Government guarantee is necessary. However, I believe that going 
forward consumers, investors, and tax payers are best served with a 
single TBA issuer, standardized market practices necessary to preserve 
and enhance market liquidity and investor acceptance, and segregated 
credit providers either solely private or a hybrid private/Government 
solution.

Single Issuer--Separate ``Government-Backed'' Creditor
    The GSEs currently offer their guarantee to a number of mortgage 
products that have failed to become actively traded securities in 
liquid TBA markets. Although many other GSE loan guarantee program 
exist, they represent only a tiny minority of loans that are 
originated. This implies that an explicit Government guarantee alone is 
not sufficient to create a mechanism to attract capital market 
participants to invest in federally guaranteed mortgage securities. The 
standardization and homogeneity of the securities and their market 
practices and Government guarantee of timely payments have led to 
market liquidity. This liquidity has created marginally better pricing 
to enable mortgage companies to offer marginally favorable terms to 
borrowers for those loan products that become the collateral for liquid 
securities. A single federally approved and regulated securities issuer 
would serve as a gatekeeper of the investor acceptance of newer 
guarantee products. Moreover, a single MBS securities issuer would act 
as an implicit agent of the investors to ensure market acceptance of 
the newer TBA products.

Pricing the Credit Risk Accurately
    Currently the GSEs have migrated toward Loan Level Price Adjustors 
as mechanism for accurately pricing the incremental credit risk 
associated with incrementally higher credit risk in the underlying 
mortgages. Are these LLPA's accurate in measuring the expected and 
potential credit losses of these underlying loans? Frankly, no one can 
accurate price this risk because no one can foresee all the future 
economic scenarios that would result in loan losses. We've recently had 
one economic scenarios where U.S. residential real estate declined 
approximately 30 percent and certainly this one scenario would be 
useful but by no means is it comprehensive in describing all the future 
economic scenarios and what the direct impact will be on particular 
mortgage borrowers and their future default behavior. Accurate pricing 
involves estimating the probably that the future credit event happens. 
Accurately estimating the probability of a 30-year credit event and its 
impact on particular mortgages is nearly impossible.
    And what's the value of this credit insurance to the investor or to 
the housing finance system that benefits from this incremental flow of 
capital? What's the price and value of this credit insurance next 
month? Or years later? Quantifying the current market price and value 
of a Government guarantee is daunting challenge without any ongoing 
market that prices and transfers this risk between two parties. Can we 
create a market place where this risk can have some price discovery?
    The GSE Government guarantee is basically pool insurance. Pool 
insurance replicates the economics of a credit default swap. The GSEs 
are currently the largest writers of protection in illiquid CDS. If we 
take these pool insurance contracts (CDS) and allow these contracts to 
be bought and sold to other financial institutions, we can distribute 
the credit risk more broadly throughout the financial system. And we 
gain valuable price discovery on the cost of this insurance in an 
actively traded market. This price discovery can be very useful for 
creating innovation but also have the regulatory role in quantifying 
the risk and for establishing appropriate capital charges.

Other issues with providing Government guarantees
    Using the U.S. Government balance sheet to insure against 
particular credit events has a long history of over extension and 
mispricing of these guarantees. Ideally, if we could create a mortgage 
origination system that allowed for the credit risk to be underwritten 
and priced in the private capital markets, this would ensure a more 
effective allocation of capital and a more effective economic system. I 
believe we should start from a point of view of attempting to build a 
solely privately capitalized system and then, if circumstances dictate, 
migrate toward a solution that utilizes hybrid Government guarantees. I 
believe a liquid TBA market could be created with solely private 
capital. The question of whether this purely private market reduces the 
size of the market materially and thus provides less capital to the 
housing markets can be managed as the market evolves. And as the fall 
of 2008 capital market events illustrated, a Government guarantee in 
times of unparalleled market skepticism was necessary for the capital 
markets to become restored and operational. The solution should include 
a mechanism or structure for the Federal Government to intercede to 
guarantee market liquidity in extreme conditions.

Government Guarantor Competition
    Over the past 30 years, we've had two GSEs and GNMA competing for 
originator acceptance and investor appetite. This competition has led 
to innovation of the financial products and increased the capital flow 
into the mortgage market. One of the MBS securities' terms that has 
evolved most significantly over the years is the servicing remittance 
terms and the interaction with the guarantee of timely payment of 
principal and interest. In the current housing finance system servicing 
remittance terms are again highly controversial and therefore an area 
where market innovation could be adopted. (MIAC is not an advocate of 
the alternative minimum servicing fee proposal. MIAC believes having 
the servicer continue to have a financial incentive in the performance 
of the loans is crucial.)
    Also in the current market place, larger servicers are usually 
charged a lower guarantee fee by the current GSEs for the same 
underlying loans than smaller mortgage companies. If the market 
acceptance of solely privately guaranteed TBAs does not prove 
sufficient to providing adequate capital to our housing finance needs, 
a system of multiple Government credit provider would be a preferred 
approach. Having a larger number of GSE-like competitors to offer 
Federal Government credit guarantees could allow for more product 
innovation and help widen the product mix of mortgage products that 
could have liquid markets. The appropriate location on the spectrum of 
the credit quality of the underlying mortgages and the appropriate mix 
and cost of the originator retaining risk versus the GSE-like credit 
guarantor of timely payment of principal and interest could be 
competitively determined. Federal housing policy could prescribe that 
particular borrowers could be priced with more affordable credit 
guarantee terms.
    The FHLBs have successfully weathered the recent mortgage credit 
crisis and have served as an enormous source of liquidity for mortgage 
holders, particularly non-agency eligible and illiquid mortgages. 
Although they have historically operated with a very different model of 
offering liquidity, they would be natural potential credit providers 
for newly created mortgages that would qualify for the single new 
securities issuer's parameters. Having multiple Government credit 
providers each constructing innovative solutions of creating hybrid 
private/Government credit enhancements would enable innovation and 
competition to create better solutions for investors and borrowers. All 
Government credit providers would have the same regulator and capital 
requirements.
    Mortgage companies could seek outside credit providers such as the 
current private mortgage insurers or work with broker/dealers to create 
and price new products for participants interested in taking the credit 
risk of residential real estate. Over the past 10 years, the corporate 
bond market has evolved so that credit default swaps provide market 
participants a liquid market for trading and pricing heterogeneous and 
complex credit risk. Pool insurance is a particular example of a credit 
default swap. However, liquidity in pool insurance is non-existence, 
but credit default swaps can provide active price discovery and 
liquidity. An active market for residential credit risk would create 
some level of price discovery for the credit risk in residential real 
estate and also allow the risk to be more widely shared throughout the 
financial system. This price discovery would also assist each of the 
Government guarantors and their regulators in measuring the current 
price for particular residential credit risk. The GSE-like creditor 
providers could trade their credit risk between GSE-like institutions 
to manage their risk exposure. They could trade and manage their credit 
risk with private market risk takers. Having reference pricing for a 
long dated residential credit risk would help the regulatory role in 
helping to determine the appropriate amount of capital required by the 
small set of approved Government guarantors.
    How would Congress distribute the Federal guarantee among the 
various Federal credit providers each of which would have a different 
mix of credit risk and amount guaranteed? Each GSE-like should be 
separately capitalized with each institution's own capital acting as 
the first line of defense against future claims. One guiding principle 
should be that each GSE-like be capitalized to at least the level of 
capital required for a private market insurance company. In addition, 
Congress could establish global, system wide limits to the credit risk 
exposure.
    This proposal does not eliminate the moral hazard and distortion in 
capital allocation that is created by a Government guarantee that has 
been historically mispriced and credit providers undercapitalized. I 
merely attempt to outline a structure that in many ways mitigates these 
risks and addresses the fundamental challenges with pricing this risk.
    I believe that going forward the flow of capital to housing finance 
will be best served if we can create a system that continues to have 
competition in the particular guarantee programs. However, in order to 
ensure liquidity and market acceptance, a single issuer with uniform 
and capital market accepted practices is necessary. I believe we should 
segregate the guarantee function from the issuance function.

  2.  How will proposed housing finance reforms impact the TBA market? 
        Please consider:

    a.  Proposals that change (or impact) the Government-sponsored 
        enterprises (GSEs) role or any Government guarantee;

    b.  Proposals that increase the number of GSEs or other MBS 
        issuers; and

    c.  Other proposals that affect the structure of the housing 
        finance system.

    Regarding recent proposals, I only have passing knowledge of other 
proposals at this time. Constructing a successful solution involves a 
detailed and careful analysis of the risks and these complex tradeoffs.

  3.  What, if any, changes or improvement can or should be made to 
        improve the functioning of this MBS marketplace?

    One principal lesson from the recent failures of the GSEs is that 
it isn't prudent to mitigate the risk of writing insurance on the U.S. 
residential real estate industry by restricting their investment 
portfolios to the purchase to only securities with risk exposure to 
U.S. residential real estate. In my view, the Federal guarantee 
providers of the future should be restricted from purchasing MBS. The 
goal of the guarantee is to subsidize housing by creating more capital 
to the residential housing market and the risk is absorbed as general 
obligation of the United States. Having the mortgage insurance capital 
pool invest in mortgage investments is a structural failure for the 
current GSEs.
    In the past the GSEs have also played a role in using a small 
portion of their investment portfolios to support the prices and 
liquidity of their MBS securities. Many market observers believe these 
temporary price supports, in modest magnitude, have led to greater 
private capital involvement in the TBA market. This may be the case but 
I believe that this role can be served by the Fed in the future. The 
Fed currently plays a similar role in the U.S. Treasury markets and 
could play this role of supporting the price of mortgage assets in the 
capital markets in the future.

A future TBA market
    The current mortgage origination market has been providing new 
capital to borrowers as the result of an active and robust TBA market. 
This liquid TBA market allows mortgage companies an effective means to 
price and sell/hedge their mortgage loans. The TBA market with a 
Government guarantee enables 30-year fixed rate consumers to transfer 
their interest rate risk to the investors and provide them with a fixed 
liability stream for 30 years. This liquid market has been the source 
of approximately 90 percent of mortgage capital in the past few years. 
At a time of tremendous contraction in private capital into the housing 
markets, the TBA market has been the sole beacon of success. However 
going forward, I believe that we can create a TBA product that reduces 
the risk exposure of the Government guarantee and provides a role for 
private capital risk takers. This won't be a simple task, but 
introducing mechanisms to enable risk to be priced and traded will 
enrich our housing finance system. The future U.S. Housing finance 
system must protect the strength's of the TBA market and the pocket 
books of the taxpayer, because an effective and stable housing finance 
system is essential to our collective prosperity.

















                 PREPARED STATEMENT OF ANDREW DAVIDSON
                 President, Andrew Davidson & Co., Inc.
                             August 3, 2011
    Mr. Chairman and Members of the Subcommittee:

    I appreciate the opportunity to testify before you today about the 
TBA or ``To-Be-Announced Market.'' Despite its prosaic name, the TBA 
market is a crucial component of the housing finance system. I believe 
it is one of the greatest financial innovations of the last 50 years; 
another colleague has called it a ``national treasure.'' The TBA market 
helps lower mortgage rates, facilitates rate locks for borrowers 
seeking to buy homes and has helped the make mortgages available 
through the financial crisis. Policy alternatives to the GSEs may 
enhance or disrupt this market. It is my hope that my testimony today 
might give you a better understanding of the functioning of this 
market.
    I have been involved with Mortgage-Backed Securities (MBS) since 
1985. I was a managing director at Merrill Lynch responsible for MBS 
research and risk management for their mortgage trading desk. In 1992, 
I founded Andrew Davidson & Co., a New York based firm, specializing in 
the development and application of analytical tools for the MBS market 
that serves over 150 financial institutions. I have a broad view of 
housing finance as our clients include originators, servicers, mortgage 
insurers, GSEs, investors, dealers and regulators.
    Today's TBA market represents a more than 40-year evolution of a 
voluntary system of trading mortgage-backed securities that provides 
for efficient, transparent risk-transfer and funding for most of the 
fixed-rate mortgages originated in the United States. The market serves 
two primary purposes: First it allows originators of fixed-rate 
mortgages to hedge the price risk associated with changing interest 
rates from the time that the originator makes a commitment to a 
borrower to lend at certain rate, until the loan is sold to an investor 
in the form of a mortgage-backed security (MBS). Second, it allows 
investors to engage in extremely large transactions to buy or sell MBS 
at very low costs of execution. In addition to its primary purposes, 
the TBA market also provides a mechanism for investors to efficiently 
finance their holdings of MBS and provide liquidity to the market, 
through a mechanism called ``dollar rolls'' or ``rolls.''
    I have divided my testimony into three parts. Part I is a general 
discussion of the TBA Market. Part II is a discussion of how proposed 
housing reforms might affect the TBA market. Part III contains some 
recommendations.

Part I. The TBA Market
    To better understand the value of the TBA market, it might be 
instructive to see how the TBA market is used to reduce risk in the 
mortgage origination process. This is in Section 1. In Section 2 we 
discuss features of the TBA market that make it effective. Section 3, 
is a discussion of why the TBA market is able to achieve these 
benefits. Section 4 provides estimates of the cost benefit to borrowers 
associated with the TBA market.

Section 1. The Role of the TBA Market in Origination: Hedging Interest 
        Rate Risk
    In this section we examine the role of the TBA market in the 
origination process via an example that shows how the interest rate 
risk of originators looks with and without TBA hedging. Before 
launching into the assumptions and looking at originator profit and 
loss, we review the links between the origination of loans to borrowers 
to the TBA market of MBS.

Process Summary
    The largest broker-dealers maintain an actively traded TBA market 
and the prices from this market can be seen by originators and 
investors in real time on electronic screens. The prices of TBA 
securities, together with the loan-level pricing adjustments (LLPAs), 
base guarantee-fees of Fannie Mae (FNMA) and Freddie Mac (FHLMC), and 
the required servicing fee help originators determine the mortgage rate 
for any loan which is eligible for securitization through the GSEs. For 
example if the par security (the one priced closest to 100) in the TBA 
market has a 4.5 percent net coupon. The originator would add on a 
servicing fee of 25 basis points and a guarantee fee of 20 basis points 
to produce a mortgage coupon of 4.95 percent.
    Suppose a borrower applies for a loan and locks in their rate in 
August, and the originator hopes to complete underwriting and close the 
loan in late September. Then the loan would be delivered into an 
October TBA security (suppose FNMA for our example). Between August and 
October, the LLPAs and servicing fee going into the borrower's rate 
would not change; however, interest rates can change, and any change in 
the level of prevailing mortgage rates affects the value of TBAs. 
Because borrower rates are locked, the risk of a mismatch between the 
rate given to the borrower and prevailing rates at closing is borne by 
originators.
    If the mortgage loan is a product that is eligible for delivery 
into TBAs however, the originator can estimate how many loans they will 
be delivering into the October security based on their application 
pipeline, approval rate, and historical ``fall-out'' rates (the rate at 
which approved borrowers fall out of the application process for 
various reasons). The originator can then short (or sell) the 
appropriate quantities of Fannie TBA securities to hedge their 
interest-rate risk. When the settlement of that TBA security occurs, 
they will deliver loans to FNMA and receive a FNMA pool which they can 
deliver to cover their short position with the broker-dealer. The 
originator is fully protected from changes in interest rates because 
they have already locked in the price for sale of the pool.

A Hedging Example
    For this example, we make the following assumptions: as above, the 
net coupon in the TBA market is 4.5 percent and the coupon to the 
borrower is 4.95 percent and originator profits are $0.50 for every 
$100 of loan balance originated in the absence of any interest rate 
changes (relative to forward rates). We examine three scenarios: (1) 
where interest rates do not change from the time that the borrower 
locks in their rate until the time that the loans are delivered into a 
security, (2) interest rates fall 100 basis points, and (3) interest 
rates rise 100 basis points. Since the time that elapses between a 
borrower's lock to loan closing can range from 30 to 90 days, this 
range of interest rate changes often occurs.
    If interest rates fall the par net coupon in the TBA market will be 
3.5 percent. The 4.95 percent loan to the borrower will be more 
valuable since it carries an above market coupon. However if interest 
rates rise, the new par net coupon in the TBA market will be 5.5 
percent. The 4.95 percent loan to the borrower will be at a below 
market rate and will have fallen in value.
    Figure 1 shows originator net profit taking into account the $0.50 
in fee income as well as the impact of interest rate changes. The three 
lines demonstrate originator profit assuming three different actions by 
originators: no interest rate hedging, hedging using TBA markets in the 
same loan type as the originated loan, and hedging using a different 
instrument (labeled ``Cross Hedging'').



    In the middle scenario, where rates are flat, we can see that all 
three types of behavior result in the same $0.50 net profit; that is, 
interest rate risk has no role, and originators earn their desired 
$0.50 of each $100 originated. However, we can see that without any 
hedging, if interest rates fall, profit swings up to $4. If interest 
rates rise, the originator takes a loss of $5. (The asymmetry results 
from a characteristic of mortgages called negative convexity, caused by 
the right of borrowers to prepay when rates fall.)
    The red line, with TBA hedging, shows that these swings in 
originator profit are completely flattened with the use of a TBA hedge 
in the same category as the originated loan. The TBA market allowed the 
originator to lock in a sales price.
    The green line shows that using a different instrument to hedge 
could result in losses of $0.40 and $0.60 in the changed rate 
scenarios. An example of a cross-hedge would be originating 7/1 hybrid 
ARMs and hedging them using 15-year fixed-rate TBA markets (because 
ARMs do not have TBA markets). When it is time to sell the pool of 
ARMs, the originator will not be able to deliver the pool to satisfy 
the short position. Instead the originator will need to buy back the 
short position in the TBA market and enter into a separate transaction 
to sell the ARM pool. There is no assurance that the price change on 
the TBA and the price change on the ARM pool will match. The difference 
between these price changes is called ``basis risk.'' The losses in 
this third case stem from having an imperfect hedge, and the numbers we 
show reflect potential errors occurring in both directions. The amount 
of gain or loss is uncertain because the hedge does not lock in the 
sale price.
    Cross hedging cannot reduce risk as effectively as a direct hedge 
in the market of the product. The effectiveness of cross hedging 
depends on the similarity between the product and the hedge and the 
cost of execution in the hedge market. Because of its liquidity and 
close relationship to other mortgage markets, the TBA market is widely 
used to hedge many non-TBA eligible mortgage products including hybrid 
ARMs and non-agency mortgages.

Alternatives
    Originators prefer to focus on the underwriting and credit 
decisionmaking process and would like predictable profits. If the TBA 
market did not exist, some alternatives might be:

  (a)  Originators take the interest rate risk or use other, more 
        imperfect hedges. This would most likely result in an increase 
        in mortgage rates to compensate the originator for taking this 
        risk.

  (b)  Offer mortgages that do not have a rate-lock feature, leaving 
        the interest rate risk with borrowers. This makes the mortgage 
        qualification process somewhat difficult, especially for 
        borrowers that are near qualification limits. For example if 
        their debt-to-income ratio is near a lending limit and rates 
        rise, the borrower would no longer afford the subject property, 
        and the purchase could not go through. This option would raise 
        the overall volatility of the real estate transaction process.

    It is possible that both would occur, with rate-lock loans offered 
at higher rates, giving borrowers the option to take the risk in 
exchange for a lower rate (which could end up higher or lower at 
closing). Borrowers with economic flexibility might prefer to take 
their chances, whereas first-time buyers who are near their purchase 
price limits would likely be forced to pay the higher rates.

Section 2. Benefits of the TBA Market
    The TBA market delivers benefits to its participants due to several 
important features.
    Physical Delivery. The TBA market allows mortgage originators to 
complete the sale of newly originated mortgages directly into the TBA 
market. As described above, the TBA market establishes the pricing for 
mortgages, and originators are assured of achieving their expected 
profitability if they successfully close and deliver the loan. Other 
forms of hedging are generally cash settled or do not allow the 
delivery of the mortgage loan. In these cases, the originating firm 
must separate the hedging process from the ultimate sale of the 
mortgage loan. This creates basis risk, as described above.
    Limited Delivery Option. The TBA market operates with sufficient 
clarity as to the nature of the loans that will be delivered to the TBA 
market. This means that investors are confident of the value of the 
securities they will receive, and therefore do not substantially 
discount their purchase price to accommodate adverse delivery by the 
sellers. (These markets operate under a principle called ``cheapest to 
deliver,'' which means that the seller will find the lowest value 
instruments to sell to the buyers.) Some loans do have greater value 
than average, primarily due to desirable prepayment characteristics. 
The TBA market has found a way to accommodate loans which might have 
greater value through the use of pool specific and stipulated trades, 
without overly degrading the value of the vanilla TBA trades.
    Low bid-ask spread. The size and scope of the TBA market means that 
it can deliver extremely low transaction costs to buyers and sellers 
with typical bid-ask spreads in the range of \1/64\ of a percent to \1/
32\ of a percent. This is comparable to the bid-ask spread on the most 
liquid Treasury securities. The TBA market allows investors to make 
very large commitments of capital in very short periods of time, with 
little or no impact on pricing in the market, making it one of the key 
markets used by investors to express interest rate exposure objectives.
    Even during the financial crisis bid ask spreads in the TBA market 
remained in check. As shown in Figure 2, bid-ask spreads at the worst 
of the crisis may have approached \1/2\ point, but during this period 
many other markets were not trading at all. Even today, non-TBA trades 
in the mortgage market might have a 1 point or greater bid-ask spread 
while the TBA market has returned to a \1/32\ of a point or less bid-
ask spread.



    Built in financing market/liquidity provision. Another important 
component of the TBA market is that it provides a mechanism for 
financing ownership of mortgage-backed securities, much like a repo 
(repurchase) market. Owners of MBS can sell their positions into the 
TBA market in a near delivery month (say August) and re-purchase that 
position in the next month (say September). Since they receive cash for 
their sale in August and then pay cash to reacquire the position in 
September, the investors have effectively borrowed money from the TBA 
market. The sale of mortgages for one period and purchase in a later 
period is called a ``roll,'' as investors have ``rolled'' their 
position to a later month.
    This mechanism also provides a way for investors to get 
compensation for providing liquidity to the market. If there is a great 
demand for MBS in the current month relative to a future month the 
price paid for current delivery rises relative to the forward price. 
This serves to effectively lower the financing cost for holders of 
mortgages. MBS holders can take advantage of this financing benefit and 
provide additional liquidity to the market while maintaining their 
investment in MBS.
    Transparency. Participants in the TBA market have access to current 
pricing information from a variety of sources. For example, Bloomberg 
and Tradeweb post current prices.
    Analytical Tools. Investors and Originators using the TBA market 
have access to a wide range of historical data and analytical tools 
that help them assess value and risk in this market. While there is 
substantial volatility in MBS prices, there is no shortage of 
information and tools to help market participants assess the risks of 
TBA eligible MBS.
    Cross hedging. The TBA market also serves as a primary hedging tool 
for non-TBA eligible agency loans and for non-agency mortgages. That 
is, even loan products that are not eligible for physical delivery into 
the TBA market make use of the TBA market for price risk reduction, but 
with greater risk to the originator. Without the TBA market it would be 
more difficult to hedge and manage the risk of non-agency fixed-rate 
mortgages as much of the hedging for non-agency fixed-rate mortgages, 
as well as many hybrid ARM products, utilizes the TBA market. Much of 
the efficiency of these products is derived from the TBA market for 
fixed-rate mortgages.

Section 3. Sources of Value of the TBA Market
    As policy options for the GSEs are considered, policymakers may 
want to consider what structural features allow the TBA market to be so 
successful and consider whether proposed changes might impact the 
functioning of the TBA market. The functioning of the TBA market is the 
result of a combination of features. The success of a market is largely 
determined by the confidence of the market participants. That 
confidence creates liquidity, which is further self reinforcing. A loss 
of confidence can lead to a rapid decline in liquidity and the collapse 
of a market. I believe that participant confidence in the TBA market 
arises from four key features. Changes to these four features might not 
destroy the TBA market, but would likely reduce investor confidence.
    The Government guarantee is a central feature of the TBA market. 
GNMA securities have traded with the explicit guarantee of the U.S. 
Government, and GSE securities traded with an implicit guarantee until 
the conservatorship of the GSEs and now are backed by funding from 
Treasury. The Government guarantee serves to eliminate the need for 
credit analysis when evaluating TBA transactions. Investors do not need 
to consider the credit worthiness of the borrowers, the adequacy of 
credit enhancement, or the financial strength of the issuer when 
investing in TBA eligible mortgages. Furthermore, due to the Federal 
guarantee, GSE mortgages are exempt from SEC registration. This 
exemption facilitates the TBA market because firms can sell securities 
prior to issuance. For registered securities there is a prohibition on 
sale prior to registration so originators are not able to sell pools of 
loans that have not yet closed.
    The underwriting requirements of the GSEs and the limitations on 
the type, nature, and documentation of mortgages allowed in various 
types of mortgage pools provides investors with confidence that the 
mortgages in the pools that they buy will be sufficiently similar so as 
to make forecasts of cash-flows reasonably certain. The GSEs have 
served to standardize the entire mortgage origination and servicing 
process. Without such standardization, investors would be less willing 
to engage in TBA trades or would demand a greater premium for the risk 
that they would receive non-standard loans and pools in TBA delivery.
    The Securities Industry and Financial Markets Association (SIFMA) 
also serves an important function by setting the rules on good delivery 
for TBA trades. SIFMA standardizes delivery dates and notification 
rules and limits which agency pools qualify for delivery into TBA 
pools. This role protects investors from sellers including pools which 
might have adverse performance characteristics in TBA pools.
    While these structural features and the roles played by the GSEs 
and SIFMA have been crucial to the success of the TBA, another 
significant, but more elusive feature of the market is also important. 
As this market has developed over the past 40 years, it has adapted to 
changing market conditions. The ability of this market to adapt 
enhances participant confidence. Examples of adaptations are: the 
growth of the dollar roll market (described above), the on-going 
evolution of settlement and clearing operations through DTCC and its 
predecessor organizations, updated and evolving good delivery 
guidelines from SIFMA and its predecessor organizations, the evolution 
of the stipulated trade market as the GSEs produced enhanced data 
disclosures, and the development of electronic trading platforms such 
as Tradeweb.
    These features enabled the MBS TBA market to withstand the recent 
financial crisis with virtually no disruption. For example, the DTCC 
risk management and clearing operations were able to shield key market 
participants (its clearing members) from the failure of Lehman 
Brothers.
    The success of this market is a reflection of the confidence of the 
participants to engage in tens of trillions of dollars of transactions 
each year. Market participants estimate monthly trading volumes of 
about $5 trillion split between dealer-to-dealer and dealer-to-customer 
business. Average daily volumes are estimated at $300 billion and are 
substantially higher around settlement days.

Section 4. Impact on Mortgage Rates
    The TBA market has a significant effect on the availability and 
cost of fixed-rate mortgages. It contributes in three important ways.
    First, the extremely low bid-ask spread and high liquidity lower 
the transaction costs for originators to sell mortgages. During normal 
markets, the TBA market has a bid-ask spread that is \1/4\ to \1/2\ 
points lower in price (5-10 basis points in mortgage rate) than 
alternatives. During the crisis period there were times when it was 
nearly impossible to execute in non-TBA markets. Even several years 
after the crisis, the bid-ask spread for many senior non-agency 
mortgages is more than one point.
    Second, the ability to hedge origination risk with an instrument 
that allows physical delivery of the loans lowers the cost of hedging. 
During normal time periods this probably lowers the cost of mortgages 
by about \1/2\ point in price (about 10 basis points in mortgage rate). 
It is important to note that the TBA market also lowers the cost of 
non-TBA mortgages as it provides a good vehicle for cross hedging. Due 
to the unique characteristics of mortgages, particularly prepayment 
risk, other instruments are generally not close substitutes.
    Third, the liquidity of the TBA market, combined with the 
Government guarantee on the MBS serves to lower the rate on agency MBS 
by about 25-50 basis points in rate relative to non-agency alternatives 
during normal markets. As shown in Figures 3 and 4, during the 
financial crisis that spread rose to more than 400 basis points and 
still remain at much higher levels.





    Overall the TBA market lowers mortgage rates for both TBA eligible 
and non-eligible mortgages by about 30-70 basis points in normal 
markets and facilitates lending that might otherwise be prohibitively 
expensive during crisis periods.

Part II. Housing Finance Reform and the TBA Market
    The process of reforming the housing finance system following the 
financial crisis is not yet complete. The GSEs, Fannie Mae and Freddie 
Mac still operate under Federal conservatorship and the private label 
securitization market has not yet recovered. Over the past 3 years, 
there have been many proposals to reform the housing finance system. 
Due to the importance of the TBA market to the functioning of the 
housing finance system, it is important to assess the impact of these 
proposals on this market. Rather than assess each individual proposal 
for the GSEs and their possible successors, for the purpose of this 
analysis common features of those proposals will be addressed.

  1.  Retain or eliminate a Federal guarantee on the MBS.

  2.  Reduce or increase the number of entities that can issue 
        guaranteed MBS.

  3.  Guarantee MBS, not GSE obligations.

  4.  Provide only a catastrophic guarantee.

  5.  Utilize covered bonds.

    Analysis of these points is difficult in that there are no 
objective criteria to say what is required to maintain a successful 
market. The success or failure of a market is largely a result of 
investor need and investor confidence. The TBA market has proven itself 
to be resilient to many changes in the mortgage market over the past 40 
years. This resilience derives at least in part from the efforts of the 
participants in the market to address problems as they arise. The 
fundamental (unanswerable) question about a proposed change in the 
structure of the GSEs is whether the market can adapt to the change.

Eliminate the Federal Guarantee
    Eliminating the Federal guarantee on conventional MBS would be a 
major blow to the TBA market. The Federal guarantee serves to insulate 
investors from credit risk. As a result, investors do not need to 
consider the credit worthiness of the borrowers or the issuers. If the 
underlying MBS had a wide range of credit risk exposure, only the 
riskiest, least valuable mortgages would be delivered into the TBA 
forwards. This would rapidly degrade the value and liquidity of the 
market. Issuers producing high quality loans would be unable to use the 
market as a hedging and delivery vehicle. Tradeweb, the electronic 
trading platform which handles about 65 percent of all dealer-to-
customer trading in TBAs and is involved in many other markets, does 
not currently handle any markets that do not have Government 
guarantees. This provides a strong indication of the importance of a 
sovereign guarantee in promoting liquidity.
    Eliminating the Federal guarantee would also, presumably, eliminate 
the SEC exemption for conventional MBS. Without this exemption, firms 
would be unable to sell MBS prior to issuance, thus would lose the 
ability to hedge as they do currently. All hedges would need to be 
``paired off'' and would result in additional basis risk and cost.
    Finally, eliminating the Federal guarantee would also remove a 
substantial portion of the investor base from the TBA market. Many 
large investors utilize the mortgage-backed securities market to 
execute trades driven by macroeconomic views and would not utilize a 
market which combines credit risk with interest rate risk. With a 
smaller investor base, liquidity would be dramatically reduced. It is 
likely that the proportion of fixed-rate loans would be substantially 
and permanently reduced and mortgage rates would be higher without the 
twin benefits of the Government guarantee and the TBA market.
    While it is unlikely that the TBA market, in its current form, 
could survive the loss of the guarantee, it is likely that other 
mechanisms to hedge and trade mortgage-backed securities would be 
created by market participants. Such mechanisms, including futures 
contracts on treasuries, interest-rate swaps, and credit-default swaps, 
already exist. These vehicles as well as new vehicles would likely pick 
up market share if the TBA market was not viable. The GNMA TBA market 
could also continue to function separately if the FHA continues to 
guarantee loans. There would likely be a long adjustment period before 
any of these could match the liquidity, cost effectiveness, operational 
efficiency, and stability of the TBA market. The loss of the TBA market 
would likely lead to further disruptions in the housing finance as the 
market shifts away from fixed-rate mortgages and markets slowly 
develop.

Increasing the number of GSEs
    Many proposals require the creation of numerous GSEs to decrease 
concentration risk and increase competition. My view is that this is a 
slippery slope for the TBA market. The TBA market has benefited from 
the close cooperation between SIFMA and the GSEs. While they do not 
always agree, they recognize the importance of maintaining the TBA 
market. With more issuers such cooperation would be more difficult. In 
addition, it is unlikely that securities issued by different issuers 
would all be accepted as good delivery for a single TBA by market 
participants. Even now Ginnie Mae, Fannie Mae, and Freddie Mac 
securities all trade in separate markets. Even with additional issuers, 
market participants would likely concentrate their trading in one or 
two issuers. These issuers would then have a competitive advantage over 
the other issuers leading once again to a concentrated market.
    A large number of competitive issuers is not necessarily a good 
thing for the market. The non-agency mortgage market had a large number 
of issuers. (See Figure 5.) This led to a race to the bottom and ever 
more complex securitization structures as issuers initiated changes to 
their securitization programs to boost profits through product 
differentiation or to subtly shift value from investors to issuers. 
Note that most of the top 10 issuers of non-agency mortgage-backed 
securities are gone and the non-agency mortgage market has not 
recovered from the crisis. In addition, a substantial difficulty in 
resolving the housing crisis is a result of the wide range of 
contractual features created by numerous issuers.



    Some proposals attempt to address the problem of multiple issuers 
by having all MBS issued by a single Government entity, essentially 
like GNMA. This proposal would help the TBA market provided that the 
loans from the different originators had substantially similar risk 
characteristics. If each originator had different underwriting, 
documentation, or servicing standards, the market would fragment even 
if they shared a common issuer and guarantor. Maintaining sufficiently 
similar programs across multiple issuers may not be possible.
    A single Government issuer, enforcing strict guidelines, might also 
be detrimental to the TBA market as one of the hallmarks of the TBA 
market is that it has been able to balance the needs of many 
conflicting parties. A Government-run guarantor might not have the 
flexibility to adjust to changing conditions. The long, difficult road 
to eliminate seller-financed down-payments for FHA loans is an example. 
SIFMA has been successful because it has been able to recognize and 
address investor concerns as they arose. If a problem that arose in the 
Government securitization program was not addressed expeditiously, it 
could lead to a loss of confidence in the market.

Only Guarantee MBS
    Many proposals would only allow a Government guarantee on mortgage-
backed securities, and not on debt issued by the GSEs. Such proposals 
would likely have a positive effect on the TBA market. Investors would 
retain confidence in the guaranteed MBS, and without a guarantee on 
their debt, the GSEs would be less willing to grow large portfolios of 
mortgages and mortgage-backed securities. In fact, many proposals 
explicitly prohibit the GSEs from retaining a mortgage portfolio. These 
proposals would likely have a positive impact on the TBA market, 
because they would remove a conflict within the GSEs. The large 
portfolios at times might have motivated the GSEs to encourage higher 
spreads and less liquidity in the market. In addition they were 
competing with investors to purchase the best loans. That competition 
at times led to lower values and less confidence in the TBA market. If 
the competing portfolio incentive is reduced or eliminated, the GSEs 
would focus more directly on enhancing the value of TBA eligible pools.
    Reducing the GSE portfolios could have the effect of increasing 
mortgage rates as a large investor is taken out of the market. It would 
be important for this process to be gradual and transparent, so the 
market had time to adjust to the change in investor base.

Catastrophic Guarantee
    Some proposals have suggested that the Government only provide a 
catastrophic guarantee to mortgage-backed securities. If structured 
appropriately, such an approach could allow the TBA market to continue 
substantially unchanged, while protecting tax payers from significant 
risk. The important component of such a guarantee is that the investors 
in the TBA-eligible MBS do not need to assess whether or not the 
Government guarantee will protect them. That is, the investors want to 
know that they have the full assurance of the Government that they will 
be paid regardless of the credit performance of the borrowers, issuers, 
or guarantors. Approaches where the investors retain risk for the 
failure of the issuer or guarantor are less likely to be consistent 
with the continuation of the TBA market.
    A catastrophic guarantee can be created at the issuer level or at 
the MBS level. At the issuer level the guarantee would require that the 
issuer maintain sufficient capital to cover potential losses. The 
Government guarantee would cover losses once the issuer failed. 
Provided that the Government guarantee covered the full obligation of 
the issuer whether or not the issuer was properly capitalized, much 
like deposit insurance, investors would not need to focus on the credit 
worthiness of the issuer. The Government would need to actively 
regulate the issuers and guarantors to assure that they had sufficient 
capital.
    A catastrophic guarantee could also be provided at the MBS level. 
In this case a portion of the MBS would be guaranteed by the 
Government; the remainder would be subject to credit risk. In this 
solution, the senior guaranteed bonds could trade in the TBA market, 
while the non-guaranteed portion would trade in a separate market. I 
favor such an approach as it can minimize taxpayer exposure while 
maintaining the liquidity of the market. Freddie Mac has issued 
securities with a guarantee only on senior bonds in the multi-family 
market, demonstrating the viability of this approach.

Covered Bonds
    Covered bonds generally are not a solution for fixed-rate mortgages 
as they do not transfer interest rate risk and prepayment risk to 
investors and would not be consistent with the TBA market. The Danish 
covered bond market is an exception in that Danish Covered Bonds are 
essentially mortgage pass-throughs with a guarantee from the 
originator/issuer. A similar system in the United States could provide 
alternative methods for hedging and funding of fixed-rate mortgage 
loans but would probably take some time to develop sufficient liquidity 
and institutional support to be a viable substitute to the TBA market.

Part III. Recommendation
    Given the importance of the TBA market, the best strategy for 
reforming the housing finance system may be to make a series of 
transformational changes to the current structure of the GSEs rather 
than scrapping the existing system and starting anew. By building off 
the current structure of the GSEs, it may be possible to preserve or 
even enhance the TBA market while addressing flaws in the existing 
structure that contributed to the financial crisis. Given the weak 
state of the housing market and the economy, completely eliminating the 
GSEs or completely replacing them with an alternative structure would 
likely be severely disruptive. Gradual transformation of the GSEs would 
also allow the private MBS market and other alternatives to develop.
    One such step that is possible without a complete dissolution of 
the GSEs is to increase the amount of private capital ahead of the GSE 
guarantee, thereby decreasing risk to the taxpayers. It is unlikely 
that the GSEs could raise additional equity capital until their future 
role and structure is determined. Moreover it will probably be better 
not to reconstitute the GSEs as shareholder-owned companies which can 
deliver a Federal guarantee. Thus capital would need to be provided in 
a different form.
    I believe that private capital can be put in front of the GSE 
guarantee through the use of commonly used credit enhancement 
structures. Mortgage insurance, either at the loan level or the pool 
level, could be used to reduce risk to the GSEs. As some proposals 
favor the use of this type of structure for the future of the housing 
finance system, this would be a good opportunity to test these ideas. 
Greater use of mortgage insurance would require that the insurers had 
adequate capital to back up their obligations.
    An even better approach, in my opinion, would be to encourage, or 
require the GSEs to utilize a senior subordinated structure to attract 
capital that would stand in the first lost position, either side by 
side with the GSEs or ahead of the GSEs for some of their MBS issuance. 
Such an approach would reduce risk to the taxpayers and help the GSEs 
and regulators determine the cost and availability of private capital. 
If properly executed, senior securities created under this structure 
and guaranteed by the GSEs would remain eligible for TBA delivery, 
while the junior classes, which would not have a GSE guarantee, would 
trade separately. If such a program were successful, it could be 
expanded, and if not, policymakers would better understand the 
obstacles to replacing the GSEs.
    Utilizing the current capabilities and infrastructure of the GSE to 
implement housing finance reform offers the best chance to improve our 
economy without the risk of severe disruptions.

Summary
    The TBA market is an important component of the housing finance 
system. It is currently central to the pricing and hedging of fixed-
rate mortgages. The TBA market helps lower mortgage rates, facilitates 
rate locks for borrowers seeking to buy homes and has helped the make 
mortgages available through the financial crisis. The TBA market has 
evolved over a 40-year period and has proven to be resilient. It 
functioned extremely well during the financial crisis.
    The continued success of the TBA market depends upon the confidence 
in traders, and confidence is difficult to measure or forecast. 
Therefore, it is difficult to determine in advance what changes to the 
market would be detrimental. It is likely that elimination of the 
Government guarantee would severely disrupt the TBA market and 
permanently reduce the availability of fixed-rate mortgages. Other 
changes to the structure of the housing finance system may have 
positive or detrimental impact on the TBA market, but those effects are 
harder to predict. While it is likely that other mechanisms could 
replace the TBA market over time, it is unlikely that new market 
mechanisms would have the same efficiency as the TBA market.
    While it is tempting to start from scratch, it is probably better 
to preserve those aspects of the existing housing finance system that 
have worked well and correct the flaws that contributed to the crisis. 
Step-by-step transformation of the GSEs may be a less disruptive path 
to reform. Adding private capital in front of the Government guarantee 
through the use of subordinate bonds would be a good first step.
