    [Senate Hearing 113-145]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 113-145

      HOUSING FINANCE REFORM: FUNDAMENTALS OF A FUNCTIONING PRIVATE LABEL
                       MORTGAGE-BACKED SECURITIES MARKET
    =======================================================================

                                    HEARING

                                   before the

                                  COMMITTEE ON

                       BANKING,HOUSING,AND URBAN AFFAIRS

                              UNITED STATES SENATE

                        ONE HUNDRED THIRTEENTH CONGRESS

                                 FIRST SESSION

                                       ON

     EXPLORING THE STATUS OF THE PRIVATE LABEL MORTGAGE BACKED SECURITIES
                   MARKET SINCE THE FINANCIAL CRISIS OF 2008

                                   __________

                                OCTOBER 1, 2013

                                   __________

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

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

                      U.S. GOVERNMENT PRINTING OFFICE
    86-292                    WASHINGTON : 2014
    -----------------------------------------------------------------------
    For sale by the Superintendent of Documents, U.S. Government Printing
    Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
    area (202) 512-1800 Fax: (202) 512-2104  Mail: Stop IDCC, Washington, DC
    20402-0001

                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      TIM JOHNSON, South Dakota, Chairman

    JACK REED, Rhode Island              MIKE CRAPO, Idaho
    CHARLES E. SCHUMER, New York         RICHARD C. SHELBY, Alabama
    ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
    SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
    JON TESTER, Montana                  MIKE JOHANNS, Nebraska
    MARK R. WARNER, Virginia             PATRICK J. TOOMEY, Pennsylvania
    JEFF MERKLEY, Oregon                 MARK KIRK, Illinois
    KAY HAGAN, North Carolina            JERRY MORAN, Kansas
    JOE MANCHIN III, West Virginia       TOM COBURN, Oklahoma
    ELIZABETH WARREN, Massachusetts      DEAN HELLER, Nevada
    HEIDI HEITKAMP, North Dakota

                           Charles Yi, Staff Director

                    Gregg Richard, Republican Staff Director

                      Laura Swanson, Deputy Staff Director

                  Erin Barry Fuher, Professional Staff Member

                          Elisha Tuku, Senior Counsel

                     Riker Vermilye, Legislative Assistant

                      Greg Dean, Republican Chief Counsel

                Chad Davis, Republican Professional Staff Member

                    Hope Jarkowski, Republican SEC Detailee

                           Dawn Ratliff, Chief Clerk

                          Kelly Wismer, Hearing Clerk

                          Shelvin Simmons, IT Director

                              Jim Crowell, Editor

                                      (ii)

                                C O N T E N T S

                                  ----------

                            TUESDAY, OCTOBER 1, 2013

                                                                       Page

    Opening statement of Chairman Johnson............................     1

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

                                   WITNESSES

    Martin S. Hughes, Chief Executive Officer, Redwood Trust, Inc....     4
        Prepared statement...........................................    29
        Responses to written questions of:
            Senator Kirk.............................................    62
            Senator Coburn...........................................    63
    John Gidman, President, Association of Institutional Investors...     5
        Prepared statement...........................................    34
        Responses to written questions of:
            Chairman Johnson.........................................    65
            Senator Kirk.............................................    65
            Senator Coburn...........................................    69
    Adam J. Levitin, Professor of Law, Georgetown University Law
      Center.........................................................     7
        Prepared statement...........................................    40
        Responses to written questions of:
            Chairman Johnson.........................................    71
            Senator Kirk.............................................    72

                                     (iii)

      HOUSING FINANCE REFORM: FUNDAMENTALS OF A FUNCTIONING PRIVATE LABEL
                       MORTGAGE-BACKED SECURITIES MARKET

                                  ----------

                            TUESDAY, OCTOBER 1, 2013

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Committee met at 10 a.m., in room SD-538, Dirksen
    Senate Office Building, Hon. Tim Johnson, Chairman of the
    Committee, presiding.

               OPENING STATEMENT OF CHAIRMAN TIM JOHNSON

        Chairman Johnson. Good morning. I call this hearing to
    order.
        Today we meet to examine the private label mortgage-backed
    securities market, the barriers that exist in the current
    market that prevent private capital from reentering, and how
    this market fits into any housing finance reform effort.
        At the height of the housing boom, private capital
    represented more than 50 percent of the mortgage market. Today
    it is closer to 5 percent. While Government-backed loans
    represent 95 percent of the current market, the volume of
    Government-backed loans has not changed that much. What has
    changed is a major reduction in volume by the private market.
        I think we can all agree that the private market should
    play a more substantial role in our housing finance system than
    it is currently. That said, we must be certain that any new
    system we design will actually attract private capital.
        For securitization to work well, especially in the PLS
    market, the underlying loans must be well underwritten and
    there should be greater transparency. The Wall Street Reform
    Act includes key reforms, such as QM, QRM, and disclosure
    requirements, that will help prevent another crisis caused by
    high-risk loans that were bundled and sold to investors. Final
    rules, along with higher guarantee fees, will provide strong
    incentives for the private market to return.
        Additionally, the recent crisis showed us weaknesses in the
    current loss mitigation and foreclosure process. We should look
    at ways to eliminate barriers to reasonable loss mitigation
    efforts that are ultimately in the borrowers' and investors'
    interest.
        With any reform, we must create the necessary conditions to
    bring private investors into this market while at the same time
    sustaining structures like the To-Be-Announced market. The TBA
    market is a key component to ensure access, affordability, and
    liquidity for borrowers and investors, and it allows for the
    existence of the 30-year mortgage, important to millions of
    Americans. We will have future hearings on these issues, but if
    private capital were to take any first-loss position ahead of a
    future Government-guaranteed security, we must make sure it is
    compatible with the TBA market.
        These are extremely complex issues, and there are no easy
    answers. That is why we are exploring the role of private
    capital early in our series of in-depth housing finance reform
    hearings this fall. We must get this part right. As we have
    learned, private capital may not always participate in all
    segments of the housing finance market under all economic
    conditions. Any steps this Committee takes to refocus and
    redefine the Government's role and improve the securitization
    process in the housing finance system must foster stable
    private capital flows, provide access to smaller lenders, and
    not price the middle class out of affordable mortgage products.
        Clearly, we have our work cut out for us, and I look
    forward to this morning's discussion.
        Senator Crapo, do you have any opening statement?

                    STATEMENT OF SENATOR MIKE CRAPO

        Senator Crapo. Yes, and thank you, Mr. Chairman.
        We have just passed the 5-year anniversary of the
    conservatorship of Fannie Mae and Freddie Mac, and now the
    Federal Housing Administration has announced that it will
    require a nearly $2 billion draw from the Treasury, almost
    double the amount that was projected in the President's 2014
    budget. This announcement highlights the reality that we must
    act now to reform the Government-sponsored enterprises and the
    larger housing market.
        As we noted during our last hearing, the Committee will
    examine individual components of our housing finance system
    through a series of hearings intended to produce bipartisan
    agreement by the end of the year.
        Today we take a more in-depth look at our first issue as we
    hear from witnesses on the private label securitization market.
    This being one of the first topics we discuss should indicate
    just how important a vibrant, well-functioning private
    mortgage-backed securities market is to our housing finance
    system.
        Unfortunately, today's private label market is a tiny
    fraction of what it was prior to the financial crisis. The
    Federal Housing and Finance Authority's latest conservators'
    report showed that the Federal Government, through Fannie,
    Freddie, and Ginnie Mae, backed nearly 100 percent of the
    mortgage-backed securities that were issued in 2012 and the
    first quarter of 2013.
        It is clear that private capital is on the sidelines and
    that the Government needs to reduce its footprint. Our goal
    should be to identify what particular challenges face the
    private mortgage-backed securities market, be they regulatory,
    legal, or structural hurdles. To that end, this hearing gives
    us an opportunity to learn why private capital is sidelined in
    our mortgage market and what needs to be done to bring the mix
    of the private sector and the Government into an appropriate
    balance.
        We have seen some experimentation in the private label
    market this year, but it is too early to tell what momentum
    will flow from those deals. I welcome the recommendations our
    witnesses have to bring back private capital into this critical
    segment of our economy while protecting the U.S. taxpayer from
    a future bailout scenario.
        In particular, I am interested to hear your views on
    whether the private label inactivity is rooted in a lack of
    confidence in the transparency, in risk mitigation, and
    alignment of interests in the mortgage chain. Could a lack of
    confidence in the private label space drive investors to
    overvalue the Federal support afforded through GSEs by
    comparison? What commonsense reforms can we put in place to
    restore investor confidence?
        I have heard that a lack of standardized documentation for
    securities issuance and process for the review of mortgages
    within securitized pools is a reason why investors are hesitant
    to reenter the private label market. What reforms are necessary
    to achieve adequate uniformity? What kind of progress has there
    been for private label market participants to come to
    administration on standards for issuance of review of
    mortgages, including representations and warranties or other
    issues?
        I have heard that the question of eminent domain has
    created a lot of uncertainty with respect to investors'
    willingness to enter the private label market. What are the
    impacts that you see in the private label space from these
    eminent domain policies? I would also like to hear our
    witnesses' views on what they anticipate the private label
    market will look like in the future.
        I hope that as we proceed with these reforms we will build
    upon the momentum that has recently been generated on both
    sides of the Capitol and the White House.
        Time is of essence, and the GSEs continue in an
    unsustainable conservatorship, and the FHA's financial
    condition continues to deteriorate. Chairman Johnson and I
    moved the FHA solvency bill out of Committee earlier this year,
    and it is time for us to engage on broader reforms. And I want
    to take this opportunity to thank the Chairman for his eager
    willingness to work with us to build a bipartisan solution and
    to move forward expeditiously.
        I remain strongly committed to working with the Chairman
    and all of my colleagues toward a bipartisan solution and a
    process to fix these difficulties soon.
        Thank you, Mr. Chairman.
        Chairman Johnson. Thank you, Senator Crapo.
        Are there any other Members who would like to give brief
    opening statements?
        [No response.]
        Chairman Johnson. I would like to remind my colleagues that
    the record will be open for the next 7 days for additional
    statements and other materials. Before we begin, I would like
    to introduce our witnesses.
        Mr. Martin Hughes is the chief executive officer and member
    of the board of directors of Redwood Trust, Inc.
        Mr. John Gidman is an executive vice president and chief
    information officer at Loomis, Sayles & Company. Mr. Gidman is
    also president of the Association of Institutional Investors.
        And, finally, Mr. Adam Levitin is a professor at the
    Georgetown University Law Center and is the Chair of the
    Mortgage Committee of the Consumer Financial Protection
    Bureau's Consumer Advisory Board.
        Mr. Hughes, you may proceed.

    STATEMENT OF MARTIN S. HUGHES, CHIEF EXECUTIVE OFFICER, REDWOOD
                              TRUST, INC.

        Mr. Hughes. Good morning, Chairman Johnson, Ranking Member
    Crapo, and Members of the Committee. I appreciate the
    opportunity to be here today. My testimony will focus on the
    current state of the private MBS market and actions that can be
    taken to fully accelerate its return.
        Redwood currently operates a prime jumbo loan conduit where
    we acquire mortgages from originators for pooling and sale
    primarily through our Sequoia private securitization platform.
        In addition, we recently received our seller/servicer
    licenses from Fannie Mae and Freddie Mac. This will enable us
    to work with the enterprises to find ways for Redwood to invest
    in the first loss credit risk and the loans we sell to the
    enterprises, thereby putting the enterprises in a second-loss
    credit position.
        The private sector of the U.S. secondary mortgage market
    consists of portfolio lenders who are primarily banks and
    private label issuers such as Redwood, although banks may be
    issuers as well. I firmly believe over the long term private
    label mortgage securitization will remain a very necessary and
    efficient form of mortgage financing.
        Many have speculated on why the private label MBS market is
    not fully flourishing today. There is no single answer to this
    question, and there are a variety of factors that must be
    considered. Some of these factors will be self-correcting over
    time while others will require structural or legislative
    change. I have specific changes to recommend, but I would first
    like to offer the following broad observations that explain the
    current state of the private market.
        First, as a result of the increase in the conforming loan
    limit, there are simply fewer jumbo loans being created today.
        Second, the enterprises have had a significant pricing
    advantage over the private MBS market. This advantage has been
    reduced somewhat as guarantee fees have been increased over the
    past 2 years.
        Third, and importantly, major banks, which were significant
    issuers of private MBS, have made a business decision to hold
    significantly more jumbo loans in portfolio rather than
    securitize them or sell the loans.
        Fourth, AAA investors still have questions of confidence in
    whether their rights and interests in the securities they
    purchase would be respected and, consequently, that their
    investments would be safe and secure.
        And, fifth, it is a Catch-22, and that is, in order to for
    the private label market to attract more investors, the asset
    class needs to be larger and more liquid. On the other hand,
    the private lable MBS asset class cannot achieve a larger
    liquid critical mass as long as it is too small for investors
    to justify allocating analytical and monetary resources to
    private label MBS.
        These issues are solvable. Market and Government policy
    makers can work together to fully restore the private label MBS
    market. The key to our success will require a primary focus on
    the needs of institutional investors that buy the senior
    classes of mortgage-backed securities. Simply put, these
    investors have the money, and without their participation,
    there is no market.
        Fortunately, addressing investors' concerns is not a
    complicated task. It requires better risk mitigation,
    transparency, and alignment of interests throughout the
    mortgage chain. We can achieve this by correcting the
    structural deficiencies and conflicts in securitization that
    became apparent in the wake of the financial crisis.
        My written testimony goes into more detail about the
    following recommendations: We must establish best practices for
    representations and warranties and other key securitization
    terms. We must establish binding arbitration as the minimum
    standard for dispute resolution of representation and warranty
    breaches. We must require that securitization trusts create the
    position of a credit risk manager. We must address servicer
    responsibilities and conflict of interest issues. We must also
    control the systematic and loan-level risk of second-lien
    mortgages by giving first-lien holders the ability to require
    their consent to a second lien if the combined loan-to-value
    with all other liens will exceed 80 percent. And we must reduce
    the Government's participation in the mortgage market by
    reducing the enterprises' conforming loan limits on a safe and
    measured pace.
        In conclusion, the U.S. mortgage market is a complex system
    with many parts and key participants. Each plays a supportive
    role in creating a highly liquid and efficient market. The
    private label MBS market will once again assume a major role,
    alongside the Government-supported sector, as the issues I have
    discussed begin to get resolved.
        Thank you, and thank you for being here on this important
    day.
        Chairman Johnson. Thank you.
        Mr. Gidman, please proceed.

          STATEMENT OF JOHN GIDMAN, PRESIDENT, ASSOCIATION OF
                        INSTITUTIONAL INVESTORS

        Mr. Gidman. Thank you. Chairman Johnson, Ranking Member
    Crapo, and Members of the Committee, thank you for inviting me
    here today to testify regarding the fundamentals of a
    functioning private label mortgage-backed securities market.
        My name is John Gidman. I am an executive vice president of
    Loomis, Sayles & Company in Boston, Massachusetts, but I am
    testifying here today in my role as president of the
    Association of Institutional Investors. The association is an
    organization of some of the oldest and largest institutional
    investment advisers in the United States. All our firms have a
    fiduciary duty to put our clients' interests first. Put simply,
    it is not our money.
        Collectively, the association's members manage investments
    for more than 80,000 pension plans, 401(k)s, and mutual funds
    on behalf of more than 100 million American workers and
    retirees. Our clients include companies and labor unions,
    public and private pension plans, mutual funds, and families
    who rely on us to prudently manage their investments, in part
    due to the fiduciary duty we owe these organizations and
    families.
        We recognize the vital role housing finance markets play in
    our society. These markets have traditionally provided
    generations of families pathways to gain home ownership. For
    decades, this defined the American Dream. Much of this mortgage
    financing has ultimately been provided by our clients who
    relied on the strength and depth of these markets to provide
    them the income they needed for retirement.
        The PLS market has improved since the bottom of the
    financial crisis. However, the absolute volume remains a very
    small fraction of what it was before the crisis. And there is a
    vast gulf between the types of loans funded by the private
    label securitization market and those that are supported by the
    GSEs.
        Typically now PLS loans average approximately 66 percent
    loan-to-value and a 760 FICO score, with very few second liens
    and no mortgage insurance. Borrowers have 20 to 50 percent
    equity in the property, and the average home price of these
    mortgages is over $1 million. These high prices, combined with
    large downpayments and very high credit quality, have led to a
    situation where the current PLS standards cannot be used to
    finance mortgages for the majority of Americans.
        Institutional investors want to be able to invest in the
    full range of the mortgage sector on behalf of our clients.
    There is pent-up demand. However, as fiduciaries, we cannot
    increase our conviction in this market without meaningful
    structural reform. Therefore, we fully support Congress'
    efforts to reform the mortgage market. The recently introduced
    Housing Finance Reform and Taxpayer Protection Act has moved
    the debate in the right direction. The bill's risk-sharing
    mechanisms offer a promising solution that we believe could
    work if investors' concerns are addressed.
        The legislation also provides helpful language regarding
    issues like standardization of documentation and enforcing
    representations and warranties. The bill, however, does not
    address three fundamental investor concerns which we would like
    to touch on today.
        First, any mortgage market reform legislation should
    include, in our view, trustee fiduciary duties to oversee the
    maintenance of trusts and enforce put-back obligations for
    faulty loans with regulatory oversight and private causes of
    action for breaches. Situations like last year's AG mortgage
    servicing settlement, where trustees and servicers were able to
    sacrifice the assets of trust investors' pension plans in favor
    of their bottom line, underscore the need for these duties.
        Second, we believe the ability-to-repay rulemaking will
    lead institutional investors to avoid the PLS market. We agree
    with holding originators accountable for predatory lending by
    allowing defaulting borrowers to sue lenders for irresponsible
    lending. However, the rule includes assignee liability which we
    believe allows the borrower to sue any subsequent buyer of the
    loan, even if they were not the lender who made the bad loan in
    the first place.
        And, third, certain jurisdictions are considering
    implementing a program designed and aggressively marketed by a
    private fund. Under the program, the city would rent out its
    local eminent domain power to seize performing mortgages, held
    in interstate trusts, in order to restructure the mortgages at
    a profit for the fund's investors. If mortgage market reform
    does not address this scheme and eminent domain is used, we
    will have to weigh the possibility that all future mortgage
    contracts might not be upheld, and our clients could lose their
    value in those investments.
        As the Committee continues to consider housing finance
    reform, we hope these perspectives support your efforts. Each
    suggestion is intended to help rekindle a vibrant secondary
    mortgage market, accomplish your goal of reducing the
    Government footprint, and avoid adverse consequences that will
    ultimately affect the millions of Americans who rely on these
    markets to save for their families' needs.
        Thank you for your time today, and I look forward to
    answering your questions.
        Chairman Johnson. Thank you.
        Professor Levitin, you may proceed.

      STATEMENT OF ADAM J. LEVITIN, PROFESSOR OF LAW, GEORGETOWN
                         UNIVERSITY LAW CENTER

        Mr. Levitin. Good morning, Mr. Chairman Johnson, Ranking
    Member Crapo, and Members of the Committee. Thank you for
    inviting me to testify this morning, and thank you for
    continuing today with your important work on housing finance
    reform.
        Housing finance is a huge market, some $11 trillion of debt
    outstanding, and it is vitally important to our economy as it
    affects things ranging from the home-building and home-
    furnishing industries to the value of what is the single
    largest asset for many families.
        There is widespread recognition that reforms are needed in
    the housing finance market, and yet this is also an area in
    which reforms must proceed with caution as there are
    potentially serious consequences from getting it wrong. Rule 1
    in housing finance reform should be, ``Do no harm.''
        Now, there is reasonable disagreement on the details of
    reform, but the overwhelming evidence makes clear that we
    cannot rely on private label mortgage-backed securities, or
    PLS, to be the backbone of the housing finance system.
        PLS are mortgage-backed securities that lack any sort of
    Government or GSE guarantee whatsoever. I want to make clear
    that when I refer to PLS, I am not talking about what S.1217
    envisions for the FMIC guaranteeing with a 10-percent first-
    loss piece.
        Historically, prior to 2004, PLS were a small part of the
    housing finance market, never accounting for more than 15
    percent of the financing in the market. Between 2004 and 2007,
    however, PLS provided the high octane rocket fuel that drove
    housing prices into the stratosphere before the bumpy reentry
    that we all know all too well.
        The PLS market has not rebounded. Indeed, it remains
    basically dead. There have only been around 17,000 mortgages
    that have been financed by the PLS market since 2008. That is
    fewer than the number of mortgages financed in the District of
    Columbia last year. And as Mr. Gidman laid out, these have been
    ultra, ultra prime mortgages.
        There are many reasons why the PLS market has not
    rebounded, but key among them is it has not solved many of its
    internal market structure and incentive problems relating to
    the roles of trustees, servicers, and enforcement of
    representations and warranties. And there are reforms, as I
    discuss in my written testimony, that can be undertaken to
    improve PLS.
        Ultimately, though, even an improved PLS market cannot
    change the fundamental math. By a very generous estimate,
    capital markets will be able to support no more than around
    $500 billion annually in mortgage credit risk. The U.S. housing
    finance market needs anywhere between $1.5 trillion and $4
    trillion in annual financing, depending on market conditions.
        Capital markets are insufficient to support the amount of
    credit risk needed to sustain the U.S. housing market. They can
    plan an ancillary role, but they are simply incapable of
    providing the foundation for the market.
        Instead, a discussion of how to rebuild the housing finance
    system needs to be based around some form of a hybrid public-
    private structure with first-loss private capital sitting in
    front of a public guarantee.
        A rebuilt housing finance system also needs to have the
    capacity for the Federal Government to step into the breach as
    needed during countercyclical events when private capital flees
    from the market.
        And I would say there are really two salient lessons that
    we should have in mind from the recent financial crisis and how
    the housing market responded. The first is that when things
    started getting hairy in 2007 and 2008, private capital fled.
    But for the continued operations of the GSEs and FHA, the
    market would have entirely collapsed, and we would have been in
    another Great Depression.
        But there was a consequence from the Federal Government
    stepping into the breach, and that is the second lesson: that
    the Government is on the hook for the losses in the system, and
    herein lies the challenge, I think. There is a fine line to
    walk between needing to preserve the stability of the housing
    finance market, particularly in times of economic crisis, and
    that is something that only a Federal guarantee can really do
    credibly; but also wanting to avoid the problems that come from
    public allocation of capital, such as politicized underwriting
    and the socialization of losses.
        There are reasonable disagreements on how exactly to craft
    a solution to that, but I think it is going to have to take the
    form of some sort of hybrid public-private housing finance
    system. S.1217, the Corker-Warner bill, represents one possible
    template for doing so. Another possible template would be based
    on amending the charters for the existing GSEs and, among other
    things, requiring first-loss private capital on their MBS.
        I believe there is more work to be done on these proposals,
    but bills like S.1217 are moving in the right direction. I am
    happy to discuss the technical details of S.1217 and other
    proposals, but I would emphasize that it is important not to
    lose sight of the forest for the trees in housing finance
    reform. The structure of a housing finance market is a means
    toward housing policy, not an end in and of itself, and,
    therefore, it is critical that any redesigned system be
    charged, I think explicitly, with preserving the widespread
    availability of the 30-year fixed-rate mortgage, the continued
    existence of a TBA market that allows for interest rate risk
    hedging and preclosing rate locks, as well as fair access and
    affordable housing and multifamily housing options.
        I look forward to your questions.
        Chairman Johnson. Thank you all very much for your
    testimony.
        As we begin questions, I will ask the clerk to put 5
    minutes on the clock for each Member.
        Professor Levitin, what is the one key lesson the market
    learned about MBS investing after the financial crisis?
        Mr. Levitin. I think the key lesson we learned is just how
    flighty private capital can be. The housing finance market
    needs constant reinvestment flows in order to sustain housing
    prices in the market. And what we learned from 2008 is that
    private capital will flee to safe assets in times of economic
    uncertainty, and this can actually have the effect of worsening
    an economic downturn because of the critical role of the
    housing market in the economy.
        So I think the critical lesson we have learned is that we
    need to have some sort of Government and I think explicit
    Government role in the market for market stability purposes.
        Chairman Johnson. Mr. Hughes, would standardization of
    private label MBS terms and documentation be an effective means
    of bringing private capital back into the market?
        Mr. Hughes. Yes. I would think--you know, there has been
    some standardization so far. I think there needs to be farther
    to go both on representations and warranties, both the
    definition of what those representations are, and then, more
    importantly, what the enforcement mechanisms are.
        But I think there is a number that I lay out in my written
    testimony where I think the securitization terms, reps,
    warranties, can be improved and standardized.
        Chairman Johnson. Mr. Gidman, in MBS pools with troubled
    loans, how do we address conflicts or barriers affecting
    private label MBS mortgage trustees and servicers?
        Mr. Gidman. I think in terms of lessons learned from the
    financial crisis, many of those have been talked about today by
    other witnesses and alluded to in your opening statement and in
    others. The central issue for us in GSE reform going forward is
    really the role of the trustee and also the role of the
    servicer. For us, we believe that transparency in their
    activities and alignment of interests, specifically with an
    enumerated fiduciary duty, is a critical gap in the existing
    PLS market that has not yet been fixed, and without it being
    fixed going forward, it is hard to see how investors could come
    back into the PLS market in a meaningful way.
        Chairman Johnson. Professor Levitin, is there enough stable
    private capital to stand in front of a Government guarantee for
    MBS in good and bad economic times? Is this compatible with the
    TBA market?
        Mr. Levitin. Well, the answer really depends on how much
    private capital you want, first-loss private capital you want.
    If you are looking for 10-percent first-loss private capital,
    such as envisioned in the Corker-Warner bill, I think there is
    a bit of a question about that, whether there is enough private
    capital, and part of the answer depends on how you are going to
    define capital. Does it have to be real capital in terms of,
    you know, dollars or Treasury securities in an escrow account
    backing something up? That I am skeptical that there is enough
    if we define capital in very strict terms.
        If we define capital more loosely, allowing derivatives to
    be counted as capital, for example, then, yes, there would be,
    but there are risks because that is not the same quality of
    capital if we do that.
        As far as a TBA market goes, the critical thing for having
    a TBA market is having interchangeable liquid securities. A TBA
    market is a market in forward contracts on mortgage-backed
    securities. So parties are buying and selling these securities
    before they come into existence.
        If there is geographic information about the loans in an
    MBS pool, it is not possible to have a TBA market, and this
    means there is a real conflict between private label securities
    which do not have a TBA market and actually having a TBA
    market, because private label securities include information
    about geographic--about the geography of the loans in the pool
    because investors know that affects credit risk. But when you
    have credit risk in the equation, you cannot have a TBA market.
        Chairman Johnson. Mr. Gidman, the GSEs have started a
    credit risk sharing program for their mortgage pools. What is
    attractive and unattractive to private investors in these
    deals?
        Mr. Gidman. We think generally the approach that has been
    advocated in the recent housing reform package that has been
    drafted and circulated to the members and in the industry is a
    promising approach. Referencing specifically, I think, the
    STACR deal that recently came out, we found that to be
    promising in many ways structurally. The sole deficiency that
    prevented firms like mine from taking a substantial position
    really related to the absence of a rating because our
    investment guidelines require that. But generally the structure
    of the approach we think is attractive and interesting and
    merits further development.
        Chairman Johnson. Senator Crapo.
        Senator Crapo. Thank you, Mr. Chairman.
        Mr. Hughes, I noted in my opening statement that it is time
    for the Government and, thus, the U.S. taxpayer to reduce their
    footprint in the mortgage market. In your testimony, you note
    that the Government should begin to reduce its participation at
    least in one way by the reduction of conforming loan limits.
        As we consider appropriate transition away from the status
    quo, do you have suggestions as to what rate and on what
    timeline we should proceed? Do you believe that the private
    market could readily absorb a larger percentage of the mortgage
    market now?
        Mr. Hughes. Yes, I would think it would have to be done on
    a safe and measured basis. You know, I can see it coming down--
    if it came down by 5, 10 percent each year for several years,
    to bring it back down in line. I think the conforming loan
    limit, if we went back to the old OFHEO standards on how it
    would be calculated, the loan limit today would probably be
    $330,000. So I think it is--but it needs to be done on a basis
    where there is not a shock to the system, and I do think
    private capital steps in in one of two ways: either through
    banks' balance sheets or through private securitization.
        Senator Crapo. Thank you. And, again, Mr. Hughes, on
    another matter, investors in the mortgage markets need
    certainty. Senate bill 1217 in Section 223 calls for the
    development of uniform securitization agreements and
    definitions of reps and warranties for securities that are
    covered by the guarantee.
        As one of the few people who have been able to put together
    a private label deal in this crisis, could you please describe
    how you have approached these issues?
        Mr. Hughes. Yes. So when we initially opened up or tried to
    open up private securitization, we reverse-engineered from
    investors to figure out what would be best practices. And for
    us, best practices are, again, a complete rewrite of reps and
    warranties, binding arbitration, and another feature that
    Redwood has is that we invest in the credit securities. So you
    as a senior investor know that the person that is actually
    selling you the securities has, in Dodd-Frank parlance, ``skin
    in the game.'' But we have found that, you know, investors will
    come back to the extent that there are best practices.
        Senator Crapo. Thank you.
        And, Mr. Gidman, you noted in your testimony that some
    local governments are exploring utilizing eminent domain to
    seize underwater mortgages from private investors and
    restructure them into more favorable terms for the borrowers.
    In fact, one municipality--Richmond, California--has even voted
    to move forward with the idea and is actively recruiting other
    cities to join it.
        As a long-time industry participant in the mortgage-backed
    securities market, what have you observed to be the impact of
    this proposed use of eminent domain on prospective investors in
    private mortgage securities?
        Mr. Gidman. Thank you, Senator. I think there has not been
    an impact yet because our industry generally believes that it
    is highly unlikely to occur. However, the recent action you
    alluded to in California, it certainly becomes more possible.
        Speaking specifically about the legacy PLS issue and the
    challenges that homeowners face with mortgages that are
    underwater and struggling to pay those mortgages every day, we
    strongly advocate for the expansion of HARP to private label
    securities. We think that provides a transparent, public
    policy, standardized mechanism to address many of these needs.
        With regard to eminent domain, when we look at the recently
    introduced Housing Finance Reform and Taxpayer Protection Act,
    it is well structured. It is comprehensive. It aligns
    interests. It promotes transparency. But a critical component
    of it is investors taking first-loss risk. If the Federal
    Government allows, in our view, the use of local eminent domain
    powers to undermine national housing policy going forward,
    investors will not be able to take on the first-loss risk in
    the future.
        In our view, in order for GSE reform to have a chance at
    success, the Federal Government needs to use its tools now
    preemptively to protect the housing finance market.
        Senator Crapo. Thank you, Mr. Gidman. And one more question
    for you on another topic--assignee liability. You noted in your
    testimony that Dodd-Frank expanded legal vulnerabilities that
    creditors, assignees, or other holders of a residential
    mortgage loan may be subject to if they initiate foreclosure.
    This creditor or assignee liability has been cited by many
    experts and participants, such as you, as being one current
    impediment to the return of private investment in mortgage-
    backed securities.
        Could you please explain further why you believe the
    assignee liability issue is so negatively impactful on how
    private capital views the mortgage market?
        Mr. Gidman. So I think this really goes back to the central
    role and the question of the trustees and whether or not they
    have a duty to act solely in the best interests of the trust or
    whether or not conflicts inherent in vertically integrated
    financial services organizations that provide origination,
    issuance, servicing, and trustee services will be so conflicted
    that they are not able to act in the best interests of the
    trust.
        We believe that, given our recent experience with the AG
    settlement, where originators of bad loans, organizations that
    were involved in predatory lending were able to pay with funds
    by trust investors, including pension funds and other
    institutional investors. There has been a recent case that is
    in the press which is not yet settled, but we are very
    skeptical about where $4 billion of those dollars might come
    from, because we saw what happened in the AG settlement.
        And so the shame for us is that without greater
    transparency and alignment of interests, particularly around
    the role of the trustee but also the servicer, it is really
    putting a gate in front of the entire trillion dollar PLS
    market potential.
        Senator Crapo. Thank you.
        Chairman Johnson. Senator Warren.
        Senator Warren. Thank you, Mr. Chairman, and thank you,
    Ranking Member Crapo, for having this hearing.
        And I particularly want to welcome Mr. Gidman. Thank you. I
    am glad you are here from Massachusetts. I understand you are
    from Hull, and so welcome and thanks for your work with the
    Association of Institutional Investors. It is really important
    work.
        I want to ask a question about countercyclicality. You
    know, we have seen that the housing market is naturally
    procyclical, that when things are going well, lending becomes
    overextended; and when things are going poorly, lending
    decreases dramatically.
        So I believe it is important for regulators to have the
    authority to exert countercyclical pressure on the housing
    market. Peaks will not be so high, but the valleys will not be
    so low, and that reduces the risk of a future taxpayer bailout.
        So one way to exercise countercyclical pressure is to raise
    Government guarantee fees during boom periods and lower them
    during declines in the market. But that will not work unless
    the regulators have authority to exert countercyclical pressure
    on the private label market as well. Otherwise, when guarantee
    fees go up during the boom period, it will just drive everyone
    over to the private label market.
        So my concern is how regulators can exert countercyclical
    pressure on the private label market. Professor Levitin, could
    you weigh in on that?
        Mr. Levitin. Sure. There is a tool missing in the
    regulatory toolbox, and that is that regulators do not have the
    ability to control the amount of leverage in the housing
    finance market. In other words, the tool regulators need to
    have is the ability to limit combined loan-to-value on new
    mortgages being originated at any point in time.
        So regulators can affect the housing market by interest
    rates, but that affects--that is a blunderbuss. It is not a
    surgical tool for the housing market. It affects other markets.
    Controlling loan-to-value limits, if you gave it to a
    regulator--I am not sure which, but let us say the Federal
    Reserve--that would give them a targeted tool for dealing with
    overheating of the housing finance market, and this is
    something that is actually done outside of the United States in
    some countries. Hong Kong--it is a small market, but Hong Kong
    does this. Canada and Spain have systems that get to a similar
    result even though it is not formally through LTV limits that
    apply to originators.
        Senator Warren. Yes. So let me just ask, Mr. Hughes, do you
    agree as an issuer of private label securities that the
    Government should address the inherently procyclical nature of
    private label housing finance market?
        Mr. Hughes. I would agree.
        Senator Warren. And would you agree with Professor
    Levitin's suggestion of a tool doing it by regulation of loan-
    to-value ratios, or would you do it a different way?
        Mr. Hughes. I think loan-to-value ratios are important.
    They have been overlooked in QM or QRM. I think, you know, what
    investors look at from an investor side, the most important
    criteria in determining whether there is a risk of default, it
    is the amount of equity in the property. Yes, I think that
    would be one important way of----
        Senator Warren. So you would support some regulation in
    this area.
        Mr. Hughes. Correct.
        Senator Warren. And, Mr. Gidman, would you like to weigh in
    on that?
        Mr. Gidman. I agree with your observation completely. The
    GSEs or the Federal Government play an important role in
    housing finance to provide that countercyclical capability. You
    know, I think QM and the LTV ratios have been discussed as a
    key component, but another one could be in terms of levers that
    are available to the Federal Government is capital ratios with
    the originators.
        Senator Warren. Got it.
        Mr. Gidman. But there are tools, there are mechanisms, and
    what we do not want to happen is for GSE reform to be
    procyclical rather than provide the backstop that is necessary
    in terms of crisis.
        Senator Warren. Right. Thank you very much.
        Let me ask one other question. Even if the private label
    market represents only 20 percent ultimately of the overall
    housing market, it still would be a multi-trillion-dollar
    market that it is dealing with. Given the size and importance
    of the market, I worry that there will still be an implicit
    Government guarantee that will affect the risks taken on by
    private actors.
        So I hear from a lot of people that the new QM and QRM
    rules, along with the SEC's eventual revisions to Regulation
    AB, will adequately limit the risk that can be taken on by
    participants in the private market.
        Professor Levitin, do you agree with that?
        Mr. Levitin. I am not sure, but I have concerns. We do not
    know exactly what the final QRM rule will look like, much less
    Reg AB, which seems much less advanced in its promulgation.
        To the extent that loans are QM, it will significantly
    limit market risk by ensuring the borrowers have the ability to
    make monthly payments, but there is not an LTV component to QM,
    as noted.
        What makes me more skeptical--what makes me skeptical here
    is that I think that a fair amount of the market eventually
    will not be QM. My impression is that a lot of the financial
    services industry does not fully understand QM and the
    consequences of a mortgage not being QM. There is actually a
    fairly weak remedy provision.
        If a mortgage is underwritten without ability to repay--I
    guess it is not underwritten in that sense--and it does not
    happen to meet the QM safe harbor, there is no penalty just for
    that. There has to also be a default on the mortgage. There has
    to be a foreclosure following that default. The homeowner is
    going to have to be willing to litigate the foreclosure. So we
    are talking about really a very small number of cases. And then
    if that happens, the homeowner has a defense in the way of set-
    off against the amount of money owed, but it is actually a very
    small set-off by statute. I think there is some interpretive
    room in the statute, but I think in most cases we are probably
    talking basically about set-off of attorneys' fees plus $4,000.
    That is not a lot. There really is not much risk from a
    mortgage not being QM. I think once the market understands
    that, a lot of mortgages will not be QM.
        Senator Warren. All right. Well, I am very concerned about
    this, but I see that I am over my time, so I am going to--I
    very much want to hear from the others. I will submit questions
    for the record.
        Thank you, Mr. Chairman.
        Chairman Johnson. Senator Corker.
        Senator Corker. Thank you, Mr. Chairman, and I thank each
    of you for coming in and for meeting with members of the staffs
    and members here just about the best way to go forward and for
    the work of your organizations.
        I think what all of you have said is that the model that a
    large group on the Committee are looking at that puts private
    capital in front of any kind of Government backstop is a very
    good model to go alongside private label financing. Is that
    correct? And would you like to expand? Go ahead.
        Mr. Hughes. Yes, I do think it is a good model. Obviously,
    you know, if we develop into three markets where you have a
    totally Government-supported market, a hybrid market where
    private capital takes the first risk, and then a totally
    private--you know, through private label securities, I think is
    the right blend of mortgage tools to have adequate liquidity in
    the marketplace for borrowers.
        Mr. Gidman. When we look at the mortgage markets, we look
    at it as a whole. We think there is a component which is a GSE
    and an explicit Government guarantee, and there is a purely
    private, but they need to work hand in glove. And when we look
    at the framework that has recently been introduced, we think it
    is thoughtful, and it is well structured, and it provides a
    mechanism that would naturally provide that to happen.
        Going with, you know, reducing conforming limits on their
    own, no matter how measured the pace, will not bring private
    money back into the market without the kind of structural
    reforms specifically around the role of the trustee, reps and
    warranties, and transparency and timeliness of loan-level data.
    But we think there is more than enough room and there is
    certainly pent-up demand.
        Senator Corker. OK.
        Mr. Levitin. I would agree with everything that Mr. Hughes
    and Mr. Gidman said, that we have three markets: the
    Government, the hybrid, and the private label market. All of
    them need reform. I think the Committee is quite well aware of
    the issues with FHA right now, but the core part of the market
    is going to be the hybrid, and that is I think where we need to
    pay a lot of attention, but we still need to also do reforms,
    as Mr. Gidman noted, for PLS
        Senator Corker. So one of the things the bill seeks to do
    is to create uniform PSA to have a clear definition of reps and
    warrants, to have electronic registration so that it is
    regulated, create uniform data so investors can actually
    analyze data sets, and very importantly, I think, make sure
    that second liens cannot just be piled on the first liens
    without the first-lien investor being aware of that.
        Are these helpful, are these steps that are in this bill,
    proposed bill--an actual bill, I guess, are these helpful in
    bringing in private capital? And would they also be helpful if
    some of those standards, as I think Ms. Warren was alluding to,
    if those standards were also evident in the private label
    market itself?
        Mr. Gidman. We think that that language and those
    provisions that you mentioned are extremely helpful, but they
    are not sufficient without some of these other structural
    reforms that all of us have talked about.
        We think that, you know, it is a really promising approach.
    It is very well engineered in terms of the overall bill, and it
    addresses almost all the concerns that institutional investors
    would have.
        Senator Corker. OK.
        Mr. Hughes. I would echo that. I also thank you for putting
    in the second-lien provisions. But we would be an investor. We
    invested in the Freddie Mac transaction in STACRs. We are a
    company looking to take and invest in mortgage credit risk. And
    there are different ways to express it. If we can express that
    through the private label market, totally private, we will do
    it there. But we would also, you know, be very open to putting
    private capital ahead in a hybrid type model.
        Senator Corker. OK. Well, listen, thank you for your
    testimony, and especially mentioning some of the things that
    you think can make legislation even better. I think all of us
    who have been working on this for some time realize there are a
    lot of improvements that can be made, and we appreciate your
    testimony and look forward to trying to incorporate some of the
    suggestions you have made into the bill that has been produced.
    So thank you very much.
        Chairman Johnson. Senator Reed.
        Senator Reed. Well, thank you very much, Mr. Chairman, and
    thank you, gentlemen, for your testimony.
        Mr. Hughes, you suggest in your testimony the need for
    service performance triggers, servicers, so that servicers
    effectively can be, you know, removed if they are not
    functioning properly. And Chairman Johnson and Senator Crapo
    were very helpful in getting language in the FHA Solvency Act
    which would have a similar situation where a servicer could be
    removed and an approved servicer would replace them.
        Can you comment on just the need for these triggers for
    servicers?
        Mr. Hughes. Yes. I think it is critically important that
    from an investor's standpoint, if a servicer is not following
    their responsibilities under the agreement, that there is some
    mechanism to remove them. If there are conflicts, if they are
    not resolving problem loans on a timely basis, if they are not
    giving good service, you know, like under any other contract, I
    think there should be provisions, if you do not live up to the
    terms of the contract, you should be in a position where you
    could be removed.
        Senator Reed. Thank you.
        Professor Levitin, I want to get back to a point that you
    raised with the Chairman, and that was--and I think both
    Senator Corker and Senator Warner have done a superb job in
    sort of advancing dramatically the progress on the bill. But
    one of the premises is 10-percent private capital up front. The
    question is: Is that sufficient? Or is it too much?
        The other question is: It could be private capital in the
    transaction investing into the entity, but it could be raised
    by debt on the other side, which would--essentially be a lot of
    leverage that is--we saw that in the crisis. Do we have to
    worry about both those things?
        Mr. Levitin. I think potentially we do. Whether 10 percent
    is the right amount, I do not have an opinion on that. I think
    we would want to get as much first-loss private capital as we
    can. You know, the higher you raise it, the better that would
    be in terms of protecting the public fisc. But it is also a
    question of what constitutes that first-loss capital and what
    is really backing it up. And I think you are right to be
    concerned about the need to look through what is capital for,
    let us say, FMIC purposes in S.1217 and say, well, really, that
    is only backed up by more borrowing. Are we just building a
    pyramid of leverage? I think that is a concern.
        And one area that I think S.1217 could be improved in is
    being more explicit in what constitutes capital for bond
    guarantors and for any kind of private label execution of the
    10-percent first-loss piece.
        Senator Reed. There is another aspect, too, as you alluded
    to in your responses, that there are times when the market can
    provide adequate capital, the market is, you know, actively,
    and eagerly looking. And then there are times of economic
    distress when there has to be more sort of Government
    involvement. So that would suggest that this capital number
    would have to be sort of adjusted, if you will, for public
    policy purposes by the Government.
        Is that a fair, general assumption?
        Mr. Levitin. I think it is, and I think that there is
    reason to have some concern about that, because to the extent
    that you have an accordion-like Government commitment to the
    market, that raises the possibility of--it raises the question
    of who is exercising--who is playing the accordion and how
    politicized is the accordion going to be played.
        The Corker-Warner bill is cognizant of the need--you know,
    of the need for the Federal Government to step in if the market
    runs into real trouble. There is a provision in the Corker-
    Warner bill; it is a limited provision, though. It lets FMIC
    step in and waive the 10 percent for, I believe, 6 months.
    Hopefully that would be enough time, if necessary, for FMIC to
    get an extension from Congress. But I worry about any bill that
    requires the system to come back to Congress. I mean
    particularly with what is going on right now----
        Senator Corker. Yes.
        Mr. Levitin. ----I worry about whether the political system
    is going--will function.
        Senator Warner. Shocked. Shocked.
        [Laughter.]
        Senator Reed. I have another question, but I think you have
    answered all the questions with your last response.
        I think one of the issues that we are trying to
    collectively come up with an appropriate response to, is how do
    we have a system that is, you know, independent of pressures
    other than responding to the market conditions. I mean, one of
    the examples that we have lived through, the long, long, slow
    rise of the mortgage market from the depths of 2008, 2009, if
    there had been a 6-month statutory window, that window might
    have been too small.
        So, again, I think we have got to think harder on some of
    these issues. But what Senators Warner and Corker have done
    already has been extraordinarily helpful.
        Thank you.
        Chairman Johnson. Senator Toomey.
        Senator Toomey. Thank you, Mr. Chairman, and thank you to
    the witnesses for being here.
        In the interest of time, maybe I could just posit an
    assumption--and by all means, correct me if I am wrong--that
    all three of the panelists would agree that if municipalities
    did begin to claim eminent domain as a power, a justification
    for confiscating mortgages, that that would have a chilling
    effect on the ability to attract private capital into the
    mortgage market. Mr. Hughes, do you agree with that premise?
        Mr. Hughes. Absolutely.
        Senator Toomey. Mr. Gidman, I think you generally did in
    your response to Mr. Crapo's----
        Mr. Gidman. You would have no need to proceed with GSE
    reform.
        Senator Toomey. OK. And----
        Mr. Levitin. I am not prepared to totally agree.
        Senator Toomey. OK.
        Mr. Levitin. I think it really depends on the scale that we
    see. To the extent that there are eminent--I am not a supporter
    of the eminent domain proposals that exist. But I think it is
    important to recognize why they exist. They exist because of a
    failure in the servicing of mortgage loans, and that needs to
    be addressed. Once it is, we will not have the eminent domain
    proposals.
        Senator Toomey. And presumably one of the reasons for
    concern about using eminent domain this way is the rule of law
    and the sanctity of the contract and the importance that--well,
    our entire society, but in particular private investors would
    place on being able to rely on a contract. So I wonder if
    anybody has any concerns about the FHFA's third amendment to
    the preferred stock agreement where it could be argued that the
    Government unilaterally changed the terms of an agreement that
    had been in place. I want to give a quick quote and ask your
    reaction.
        Randy Guynn is the head of the Financial Institutions Group
    at Davis Polk and an expert on bankruptcy and related matters
    for decades. He stated last week at an NYU seminar on the
    GSEs--and I will quote. He said, ``If the Government gets away
    with the dividend sweep of Fannie and Freddie, it will
    establish a dangerous precedent for the rights of analogous
    stakeholders of failed banks and systemically important
    financial institutions under the FDIA and the OLA.'' And I
    might add to that list any potential successor to Fannie and
    Freddie.
        Do any of you share a concern about that? Mr. Hughes.
        Mr. Hughes. I am not an expert in the area. I really do not
    have any insights.
        Senator Toomey. OK. Mr. Gidman.
        Mr. Gidman. I do not either. I am sorry.
        Mr. Levitin. I do share your concerns on this, and I would
    note it does not just affect investors, but it also affects the
    Affordable Housing Trust Fund, which the Federal Government has
    not been paying into.
        Senator Toomey. Thanks. Then let me switch topics here
    since we did not get too much discussion on that topic.
        Dr. Levitin, you indicate in your testimony that you
    believe that the capital markets would be able to support no
    more than $500 billion annually in mortgage credit risk, which
    considering the size, the multi-trillion dollars of credit risk
    that investors routinely take, private investors take in
    corporate bonds, commercial paper, financial--you know, short-
    term financial paper, consumer credit of various kinds, how do
    we know that there is only $500 billion worth of demand for
    credit risk in the mortgage market?
        Mr. Levitin. Sure. I cannot say precisely that it is $500
    billion and not 499. This is a ballpark figure. But I think
    that we can see the ballpark figure is not even close.
        The reason that we--the basis of my analysis is looking at
    the private label market in the past, that before 2004, we had
    a private label securitization market, and it never amounted to
    more than 15 percent of----
        Senator Toomey. But didn't it always have to compete with
    the Government-guaranteed market, at least implicitly?
        Mr. Levitin. Sure, but to the extent that you do not have a
    Government-guaranteed market, if you just got right of it----
        Senator Toomey. Right.
        Mr. Levitin. ----the money that is invested in the
    Government-guaranteed market is not money that is investing
    in--that is taking on credit risk. Those are interest rate risk
    investors. Some of them might be willing to take the A piece in
    a private label securitization, sort of the senior piece, but
    placing the B piece is much more difficult, and it is just
    not--I do not see any indications that there is a large pool of
    money willing to take on first-loss credit risk on U.S.
    mortgages.
        Senator Toomey. Isn't it true that the nature of the credit
    risk on a mortgage declines over time? I mean, if you--the
    duration of a mortgage, the average life weighted by any
    reasonable measure, is typically less than 10 years. By the
    time you are approaching 30 years on a mortgage, credit risk is
    often becoming de minimis because the loan-to-value ratio is
    becoming so good.
        Mr. Hughes, do you agree that there is only $500 billion
    worth of private capital willing to take credit risk in
    mortgages?
        Mr. Hughes. I think it is probably not a--probably a fair
    estimate, but the real questions are--you know, the way I would
    look at it is if you did some tranching of the 10 percent, such
    that you could get people like Redwood, who would be, you know,
    happy to come in and try and take the first-loss credit risk
    and then tranche it up so that you access different pockets of
    investors with different risk profiles rather than just say put
    everybody in the 10 percent.
        You know, having said that, the 10 percent is a pretty
    large number, and I look forward to understanding more about
    how much that is going to be capital, can you use any kind of
    leverage, and how would it work. But I think in particular,
    some tranching of that so that those people best able to take
    the risk, the deep credit risk, are in that position.
        Senator Toomey. I see I am out of time, Mr. Chairman, but I
    would just observe that we have private investors who routinely
    take trillions of dollars worth of credit risk year in and year
    out across an enormously wide range of securities, and why we
    would assume that suddenly there would not be a willingness or
    ability to match investor demand with the corresponding section
    of the mortgage industry, I find that baffling.
        Chairman Johnson. Senator Warner.
        Senator Warner. Thank you, Mr. Chairman. I want to thank
    you and Ranking Member Crapo for your work in holding these
    hearings.
        Picking up on Professor Levitin's comment about our
    functionality, or lack thereof, I just want to again make the
    appeal to you--and I know the staff is working very hard on
    this issue--that time is not on our side in GSE reform, that
    this may be the one area under your leadership where there is
    broad bipartisan agreement and we could actually not only get a
    bill out of Committee but on to the floor.
        I am afraid that the forces of the status quo at some
    point, and the notion that we would have a system, when you
    kind of reflect back, that has a private entity in the old
    model, that has shareholder value, appreciation goals,
    Government backstop, and public service goals all wrapped into
    one in any kind of ongoing, functioning entity just, you know,
    as somebody who has looked at this, does not seem like it makes
    a lot of sense.
        I do want to make a couple comments following up on Senator
    Toomey's comment. Professor Levitin, I do not know whether your
    $500 billion number is right or not. It seems relatively
    reasonable to me. I would argue that in the hybrid proposal,
    S.1217 has suggested we expect to see a growing PLS market.
    That is going to take private capital. And with the 10-percent
    private capital risk guarantee on the hybrid model, that is
    going to take capital, too. So I think, you know, that number
    may expand a bit, but I think that it is kind of a reasonable
    assumption. And I will come to a question here ultimately.
        I guess the other part I would make--and I think that both
    Senator Reed and Senator Warren raised this issue on the
    countercyclical, and I think there are ways perhaps it could be
    improved, but there is this notion--I think there is a
    recognition that 1217 has, that there are ability of three
    keys--we put the Fed, FMIC, and Treasury to turn that down if
    private capital flees. So we do not have a system where we are
    kind of left without any tools at all. Maybe there are ways to
    improve it. And I think Senator Reed's comments were good as
    well, and I want to again come to Mr. Hughes.
        One of the things that I have thought--and we have had a
    lot of discussion on the 10-percent number. We all believe skin
    in the game. You have talked about the value of private label,
    Mr. Gidman has as well, skin in the game. Clearly, 1217 puts a
    lot of skin in the game, which, again, better guarantees that
    that Government backstop will never be hit. That is more than
    double what would have been required in the last crisis. And
    Professor Levitin has raised I think the appropriate question.
    You know, does 1217 get the definition of capital right? Which
    is terribly important, and I am anxious to hear more feedback.
        But I want to come back to Mr. Hughes and maybe all three
    of you to comment, not only definition of capital, but if you
    have got that 10 percent--let us assume for argument's sake
    that we have struck a bit too high, which I would rather err on
    the side of safety. But shouldn't there be an ability perhaps
    to tranche part of that? Can't the market be a better--have a
    better ability to figure that out--and, respectfully, as smart
    as these Senators are and our staff are--than a group of
    legislators? So can you drill down a bit more on that tranching
    idea? And I would like to hear from each of you.
        Mr. Hughes. Yes, I think it is incredibly important to do
    some tranching because investors have different risk profiles,
    and on the private side, totally private side, in, you know, a
    PLS transaction, the senior investors are bringing most of the
    capital, but most of the risk is in the subordinate securities,
    you know, below that. So, again, I would think, you know, if
    the number was 10 percent, or something, breaking that down
    probably--if you would expect in this pool of loans probably
    you are going to have--25 basis points of loss would probably
    be a reasonable assumption for well-underwritten that maybe,
    you know, you tranche out the first 2 percent, which would be 5
    times--which would be 10 times coverage and then, you know,
    move up from there. But, yes, I think it would be a very
    appropriate way of attracting capital.
        Mr. Gidman. So we think we agree that the tranching is
    particularly important, but in terms of the absolute number or
    prescribing the number at 10 percent, we really believe that it
    is an important lever, countercyclical lever for the market,
    and that it should not be necessary to come back to Congress to
    change that lever. We think that it is something that the
    Federal Mortgage Insurance Company should have as a tool in its
    toolkit.
        Mr. Levitin. There are certainly ways to tranche the 10
    percent. It could be tranched on the initial issuance, or it
    could be tranched subsequently. Basically you could--someone
    could buy that 10 percent and resecuritize it, issue tranched
    credit link notes. There are lots of ways to allocate that 10-
    percent credit risk within the market.
        I am not real concerned about that, even though there may
    need to be some adjustments to the QRM rulemaking to make sure
    that if the market wanted to retranche the credit risk, it
    would not--there would not have to be extra capital help
    because of that.
        Senator Warner. Well, again, I want to thank all the
    witnesses for their testimony and the fact that they have
    endorsed the directional approach, and I am, again, looking
    forward to working with the Chairman and the Ranking Member to
    fine-tune and get this right. Again, I just hope and pray that
    we do not miss this window.
        Thank you, Mr. Chairman.
        Chairman Johnson. Senator Johanns.
        Senator Johanns. Mr. Chairman, thank you, and let me, if I
    might, join with the comments of Senator Warner. I think we
    have a window of opportunity here, but I think that window
    closes for a whole variety of reasons that I will not go into.
    But I really appreciate what the Chair and Ranking Member are
    doing here because I think they are laying out a process by
    which we take some bipartisan ideas and then build a final
    piece of legislation.
        In that vein, some months ago the Chairman brought us all
    together in kind of an informal work session and went around
    the room to the Banking Committee Members and said basically,
    ``Tell me what you would like to accomplish through GSE
    reform.'' And we had an opportunity to list the three, four,
    five, six things, whatever, that were important to us.
        I would suggest in a pretty bipartisan way members listed
    the 30-year mortgage as one of the things that they would like
    to preserve at the end of GSE reform.
        We have not touched on that today that I recall, and I
    would like to hear your thoughts on the importance of making
    sure that whatever structure we end up with keeps that 30-year
    mortgage opportunity in place. And, Mr. Hughes, I will start
    with you, but we will just go right on down the table.
        Mr. Hughes. Yes, I think keeping a 30-year fixed-rate
    option available to borrowers I do think is very important.
    There are all sorts of other options down the spectrum that you
    can get through hybrid loans, whether it is 5 years, 10 years.
    But I think giving a borrower the option where they can be
    fixed for 30 years, if that is what they want, is important.
        Senator Johanns. Great.
        Mr. Levitin. From a policy perspective, we agree that a 30-
    year mortgage is an important vehicle for borrowers.
        Senator Johanns. Great. Professor.
        Mr. Levitin. A 30-year fixed-rate mortgage is the keystone
    of the American housing finance system. It is a uniquely
    American product, and it is one that has served the American
    people very well for nearly 75 years now.
        It is important to recognize that the private label
    securitization market has never produced 30-year fixed-rate
    mortgages on a wide scale by itself. Basically, if you want to
    do lots of 30-year fixed-rate mortgages, you need to have some
    sort of Government guarantee. That is how the 30-year fixed was
    created in the first place.
        Senator Johanns. Mr. Gidman, do you have something to offer
    on that? I noticed that you were listening to that testimony
    closely.
        Mr. Gidman. Well, I think the professor is generally right
    in terms of the history, but I think there is room in the
    market for private label securitization out, you know, well
    beyond 10 years. But as a foundation of the housing finance
    market in the United States and uniquely American, the 30-year
    mortgage is very important.
        Senator Johanns. Great. There has been a lot of discussion
    as the legislation was put together about the 10-percent--I do
    not know what you would call it--``skin in the game''
    provisions or whatever. We had a witness a few weeks ago that
    talked about 5 percent, you know, and I guess you can debate
    those numbers.
        I am fascinated by this idea of tranching, and I would like
    to hear from somebody a little more thoroughly on how that
    would be set up, how that would work, because the one thing I
    want to avoid from my vantage point is, you know, the wizard
    adjusting the dials on the economy and dial this and dial that.
    I want more market forces involved in this. So talk to me about
    how the tranching--Mr. Hughes, we will start with you again.
        Mr. Hughes. I would envision very similar to how the PLS
    market works right now. So in our transactions, there is
    tranching of bonds of--up to probably 93 percent is AAA.
        Senator Johanns. OK.
        Mr. Hughes. And then 7 percent below that is a series of
    securities. The deepest credit securities is probably 2
    percent, and then you work your way up from BBB, A, AA
    securities. And really what happens and why tranching is
    important is losses go from the bottom such that if there are
    losses in a Redwood deal, the first bond that gets torn up is
    our bond, but the bond above us is protected until our bond
    goes away.
        So, therefore, investors have a different risk depending on
    where they are on that tranching. So somebody may be more
    comfortable at the AA level. Where we would be more
    comfortable, you know, we think there is more yield and
    opportunity at the deep credit level.
        Mr. Levitin. The one concern I would raise with tranching
    is that tranching creates conflicts between investors
    potentially, that when you have a security that is not a
    complete pass-through for all investors, you are binding longs
    and shorts together in the same deal, and they are not going to
    want the same things, be it on interest rates, on things like
    cleanup calls and deals, on servicing, and I think that puts a
    lot of pressure then on making sure that the trustee and
    servicer provisions and the deals are done right, and there is,
    I think, a very important set of reforms that need to be done
    in that space.
        Senator Johanns. OK. Mr. Gidman, did you have anything to
    offer?
        Mr. Gidman. I do, yes. Tranching opens up the deals to a
    greater world of investors because it allows you to taper the
    risk and target it to the investors that have the appropriate
    appetite. But what the absolute number is and how that tapering
    or tranching occurs I think is a market force that could be
    guided by a Federal institution.
        Senator Johanns. OK. Thank you, Mr. Chairman.
        Chairman Johnson. Senator Heitkamp.
        Senator Heitkamp. Thank you so much, Mr. Chairman and
    Ranking Member. I think these hearings have been
    extraordinarily helpful to me as we kind of work through this
    process.
        My questions are really just twofold, and one is about the
    timing of reform. And I think what you hear is a sense of
    urgency in this room that if we do not do this fairly soon, we
    will not have the opportunities for reform, even in a year,
    that we have today. And I just want to get kind of affirmation
    of that because I sense some urgency, but like we know, nothing
    very--nothing happens very quickly in this place, as I am
    finding out as a new Member.
        Professor, can you tell me what you think is right now the
    window for the maximum number of options that we have to do
    reform correctly?
        Mr. Levitin. I want to be careful that I do not expressing
    my opinions on what is politically feasible.
        Senator Heitkamp. Just imagine the moon. Imagine the moon.
    They will do whatever we want to do.
        [Laughter.]
        Mr. Levitin. We need to fix this market. It is not in an
    acute condition where it needs to be fixed tomorrow. I think it
    is more important that we get this right than that we do it
    sooner. I would, therefore, probably err on the side of
    caution.
        Senator Heitkamp. What timeframe?
        Mr. Levitin. Timeframe, I mean ideally, you know, all else
    being equal, you want this done as soon as possible, but I
    think it has to be done right. I do not think I can really lay
    out a timeframe for doing this.
        Senator Heitkamp. Mr. Gidman.
        Mr. Gidman. Our view really is that the time is now. The
    framework that has been laid out there is very thorough, it is
    comprehensive, it is well engineered. The structural fixes that
    we have sort of identified we think are--there should be
    bipartisan agreement on that.
        The thing that we are concerned about that makes this more
    timely from our standpoint, again, is back to the eminent
    domain issue. If a single municipality exercises eminent domain
    to seize performing loans, regardless of the public use
    arguments, regardless of fair value arguments, if they do that,
    it will make it very difficult for institutional investors to
    remain in that market let alone increase our involvement in
    that market, which could make efforts toward GSE reform moot.
        Senator Heitkamp. If I could just, before we move on to Mr.
    Hughes, make the point, I think you said earlier in your
    testimony that there have not been adjustments for the eminent
    domain issue as of yet because you do not see this as catching
    fire and spreading across the country in a large way today. Is
    that correct?
        Mr. Gidman. We think it is so harmful to the national
    mortgage markets that ultimately the Federal Government will
    step in with its tools to make sure that it does not happen.
        Senator Heitkamp. So your risk evaluation on the eminent
    domain issue is more based on being able to come here and, you
    know, create a firewall, so to speak.
        Mr. Gidman. Well, we look at the recent letter from the
    FHFA, which directed the GSEs and how they should act with
    regard to the municipality. But we think it is really not an
    issue of a single municipality or a single approach. We think
    it is a national housing finance policy that you all would be
    highly incented to protect.
        Senator Heitkamp. Mr. Hughes, your thoughts on timing?
        Mr. Hughes. Yes, I have a high sense of urgency to get
    something done. I would think you would want to do changes to
    the PLS market hand in glove with anything that may get done
    with the enterprises. I think there will always be arguments it
    is too complicated, the TBA market is not going to do it, and
    there will be all sorts of bogeymen out there. But at the end
    of the day, you need to tackle it. You need to start it. You
    need to begin a process and to resolve those things.
        Senator Heitkamp. One last question, and it is directed to
    you, Mr. Gidman. You had suggested that there was room in the
    private market for the 30-year fixed-rate mortgage. Can you
    tell me what the impediments are today for the private market
    to get involved in the 30-year fixed-rate mortgage and explain
    why it is that in your earlier testimony you were talking about
    million-dollar houses with 50-percent equity? You know, why
    aren't you taking the $300,000 home on a 30-year fixed-rate
    today?
        Mr. Gidman. Well, I think, you know, the critical factors
    for us are not the size of the loan. It is the quality of the
    loan, it is the amount of equity in the property, it is the
    lack of other liens and weights on that loan. And I think
    without the structural repairs with regard to the role of the
    trustee, the uncertainty around assignee liability or eminent
    domain, it is very difficult for us on behalf of our clients to
    embrace innovation further down the range of the mortgage
    market.
        Senator Heitkamp. Just begging the indulgence of the Chair,
    so if some of these issues were addressed, you would see more
    active participation.
        Mr. Gidman. Yes, I think you would.
        Senator Heitkamp. Thank you.
        Thank you, Mr. Chairman.
        Chairman Johnson. Senator Brown.
        Senator Brown. Thank you, Mr. Chairman and Senator Crapo.
    Thank you both for doing this hearing.
        In 2011, Congressman Brad Miller of North Carolina and I
    introduced the Foreclosure Fraud and Homeowner Abuse Prevention
    Act to make the securitization process work better for
    investors and for borrowers. You have in your testimony
    supported some provisions of that bill which I would like to
    ask you about--mention and then ask you about: one prohibiting
    mortgage servicers from holding a second lien on property that
    has a mortgage they service. Senator Corker mentioned that. Mr.
    Hughes and Professor Levitin suggest that second liens can
    create perverse incentives, as you know, particularly when the
    same party is servicing the first lien.
        Like Mr. Gidman, I was concerned about the national
    mortgage settlement affecting mortgage investors. I warned
    Secretary Donovan that investors in pension funds for working
    Ohioans, for example, should not pay for Wall Street mistakes.
    Unfortunately that is what happened.
        My legislation with Congressman Miller would clarify that
    bond holder protections in the Trust Indenture Act apply to
    mortgage-backed securities investors, as Professor Levitin
    suggests.
        Mr. Gidman, you noted that vertically integrated financial
    institutions often serve as issuers, trustees, originators, and
    servicer, sort of the whole vertically integrated, if you will,
    creating conflicts of interest and incentives not to identify
    deficiencies that harm investor trust. If all three of you
    would briefly in a minute or so discuss why the reforms that
    you have proposed that are in our bill are important
    protections for investors, including applying the Trust
    Indenture Act, and how these reforms will address these clear
    conflicts. Mr. Gidman, do you want to start?
        Mr. Gidman. Yes, I think that the current language that has
    been proposed goes a long way toward addressing those
    structural issues that we have all talked about, whether it is
    standardization of reps and warranties, ready availability and
    timely access to loan-level data, and alignment of interests.
        Mechanically--you know, we use the term ``fiduciary duty''
    in my industry because that is what we know, that is what we
    live under. Whether it is a fiduciary duty or whether it is a
    fix to the Trust Indenture Act, I am not sure what the right
    mechanics are. But we certainly know that the trustee needs to
    act solely in the best interest of the trust, and they need to
    have the capacity to have effective oversight of their
    servicers and there needs to be mechanisms for the end
    investors to be able to have enforcement that has teeth and
    rights of private action for breach. We think all of those are
    important.
        Senator Brown. OK, and the fiduciary duty is part of this.
        Mr. Hughes.
        Mr. Hughes. I would echo most of that. I do believe you
    need a mechanism within the trust to actually enforce rep and
    warranty claims. I would say to me the biggest single failure
    of private label was the fact that the reps and warrants either
    were weak, they became unenforceable, and it was the basis for
    all the lawsuits that we have today. So I think having
    discipline beforehand very clear on servicers'
    responsibilities, representations and warranty, what the
    authority of the trustee is, what the authority of a credit
    risk manager is, is incredibly important in bringing back
    institutional money to this space.
        Senator Brown. Professor Levitin.
        Mr. Levitin. Yes, there is really nothing new under the sun
    in the financing world. The Trust Indenture Act was a response
    to vertical integration in the mortgage bond market in the
    1920s. There is a huge SEC report from 1936 written by William
    O. Douglas and Abe Fortis, two future Supreme Court Justices,
    detailing all of the abuses. It reads like the playbook for
    what we have seen going on in the last few years.
        I think the ultimate--you know, fiduciary duties are
    important, but trustees have fiduciary duties after there is an
    event of default for a trust. The problem is getting to that
    event of default, and I think what the--part of the solution
    needs to be to split up the different duties the trustees do.
    They have some ministerial functions, they have some financial
    guarantor functions, and they also have an enforcement
    function. The enforcement function needs to be split off from
    the other functions and given to a party with no conflicts
    whatsoever, and also fiduciary duties.
        Senator Brown. Thank you. Let me ask Mr. Gidman and Mr.
    Hughes a question about PLS accountability in terms of both
    employees and institutions, and I want to read something that
    was in Mr. Levitin's written testimony: a ``study by the Center
    for Public Integrity found that senior executives from all of
    the 25 top subprime lenders during 2005-2007 were back in the
    mortgage business as of 2013 . . . it is easy enough to move
    from the securitization desk of a failed investment bank to
    another or to an investment fund. The lack of SEC and DOJ
    prosecution of either individuals or institutions related to
    pre-2008 PLS merely underscores the lack of consequences of
    securitizing noncomplying mortgages . . . it is unlikely that
    reputational sanctions are sufficient to keep the PLS market in
    check.''
        Just briefly, do you agree or disagree, Mr. Gidman and Mr.
    Hughes?
        Mr. Gidman. I had not heard that statistic before. What I
    do know is that greater transparency and alignment of interests
    can go a long way toward protecting the integrity of the market
    going forward, and those are lessons that we should have
    learned from the crisis.
        Senator Brown. Mr. Hughes.
        Mr. Hughes. A couple things. First, I sign a certificate
    with each securitization we do that goes out under my
    signature.
        And I would say, second, I think a very important part of
    it from a Redwood Trust standpoint is that we actually hold
    skin in the game. We actually hold the credit securities as
    incredibly important because, you know, we represent
    shareholders. If we are putting together a bad pool and there
    are consequences to investors for that pool, the person that is
    going to bear the most risk for that pool is Redwood Trust.
        Senator Brown. Thank you, Mr. Chairman.
        Chairman Johnson. Senator Merkley.
        Senator Brown. He is not here.
        Chairman Johnson. Senator Hagan.
        Senator Hagan. Thank you, Mr. Chairman and Ranking Member,
    and I do appreciate you holding the hearings, and I, too, agree
    that there is a sense of timing for GSE reform, and I
    appreciate this hearing.
        I wanted to follow up on Senator Heitkamp's question on
    eminent domain, and I know that Senator Toomey also started
    talking about eminent domain. Mr. Gidman, you reiterated to
    Senator Heitkamp your thoughts. I was just wondering, Mr.
    Hughes, if you could talk about the eminent domain proposals
    that are out there and how that could be bad for investors and
    for businesses--and for borrowers.
        Mr. Hughes. You know, if it went through and that became a
    way of taking over property that would belong to investors, I
    think it would have a dramatic effect on private
    securitization.
        Senator Hagan. And when you say ``dramatic effect,'' can
    you expand on that?
        Mr. Hughes. I think if you are an investor and you now have
    a risk that someone could take your collateral out of your pool
    and you do not get adequate compensation for that, yes, I think
    that would be a risk that you had not planned on.
        Senator Hagan. Mr. Gidman.
        Mr. Gidman. It would lead us to have to price that risk
    into our decision making, and given a world of asset classes to
    invest in, I think it would have an immediate and chilling
    effect on the entire asset class.
        Senator Hagan. And how do you correspond that with the use
    of eminent domain today?
        Mr. Gidman. In the case eminent domain today--we will use
    the Big Dig as the example. It was real property. There was an
    unquestioned public interest and public use, and the owners
    were compensated according to objective measures of fair value.
        In the case of eminent domain that has been most recently
    discussed, you know, a local municipality is seeking to use
    eminent domain to seize assets that are held by retirees and
    pension participants across the United States, and it is
    unclear both of the public use in terms of the likely effect of
    that action within the municipality, and then because it is a
    private for-profit enterprise driving the deal, it is hard to
    see how fair value could be paid and have it work out.
        We think that this issue is really a public policy issue,
    and expanding HARP is the approach to keep homeowners in their
    homes and really have that effort be in lockstep with a broader
    housing market finance reform.
        Senator Hagan. Thank you.
        Mr. Levitin, in your testimony you indicated that the PLS
    can only provide the financing for at most an eighth of the
    U.S. housing market's peak annual financing needs. Can you
    discuss what constrains the size of that market? And how can
    Government guarantees work together with the private label
    securitization?
        Mr. Levitin. There is a limited amount of market demand for
    credit risk on mortgages that--you know, I might be wrong on
    the actual number there, but----
        Senator Hagan. How did you come up with that number?
        Mr. Levitin. By looking historically at the level of
    investment in the private label securitization market before
    the bubble, basically taking even--I am assuming that the
    bubble starts in 2004. Some people might disagree with me. But
    at 2004 levels, we would only get up to around $500 billion in
    investment in private label securities.
        Even if I am wrong by a factor of 2 or 3, the problem is
    the math is not even close, that if in peak years we have
    needed as much as $4 trillion of investment, private label just
    is never going to be able to support that. It may be an
    important component of the market, but it is not going to be
    the backbone of the market. And I think that we need to try and
    improve the private label component, but we also have to
    remember that it is not going to be the core of the market.
        Senator Hagan. Mr. Hughes, you mentioned in your testimony
    that Redwood recently invested in Freddie Mac Structured Agency
    Credit Risk notes. Can you discuss the benefits of that
    transaction in more detail? And how are the products able to
    distribute the credit risk from the GSEs into the private
    sector?
        Mr. Hughes. Yes, we participated in the transaction. Again,
    we are in the business of investing in credit risk. We found
    the bonds to be attractive.
        I would note that one of the things in that transaction
    that I would hope in future transactions they could fix is that
    they kept 30 basis points of risk at the Freddie Mac level. If
    you think 30 basis points of risk is the risk in the pool,
    well, then, it really did not sell the actual risk. And I know
    part of it was to facilitate getting a transaction done,
    getting investors in, ``Hey, investors, you do not have to
    worry.'' My hope would be over time that they would begin to
    sell first-loss credit risk to private investors----
        Senator Hagan. Thank you, Mr. Chairman.
        Mr. Hughes. ----I think second getting a rating on the
    bonds would also bring more liquidity because more investors
    could participate.
        Senator Hagan. Thank you.
        Chairman Johnson. I would like to thank the witnesses for
    being here today. This hearing is adjourned.
        [Whereupon, at 11:27 p.m., the hearing was adjourned.]
        [Prepared statements and responses to written questions
    supplied for the record follow:]
                     PREPARED STATEMENT OF MARTIN S. HUGHES
                  Chief Executive Officer, Redwood Trust, Inc.
                                October 1, 2013
    Introduction
        Good morning Chairman Johnson, Ranking Member Crapo, and Members of
    the Committee. My name is Marty Hughes, and I am the CEO of Redwood
    Trust, Inc., a publicly traded company listed on the New York Stock
    Exchange. I appreciate the opportunity to testify on what can be done
    to accelerate the return of a robust private secondary mortgage market.
    Background on Redwood Trust
        Redwood Trust commenced operations in 1994 as an investor in
    residential mortgage credit risk. We do not originate or directly
    service residential mortgages. We currently operate a prime jumbo loan
    conduit through which we acquire individual closed loans from banks and
    mortgage companies, primarily for pooling and sale through our Sequoia
    private securitization platform, which creates and issues mortgage-
    backed securities (MBS).
        Senior investors in MBS issued through our platform have protection
    from credit risk as a result of our investment in the subordinate
    securities issued in each securitization, which enables the senior
    securities to obtain triple-A ratings. Although this has not been the
    case for most issuers of MBS, in Dodd-Frank parlance, having ``skin in
    the game'' has always been a component of our business model, which
    demonstrates our alignment of interest with senior investors.
        From 1997 through 2007, Redwood securitized more than $35 billion
    of mortgage loans through 52 securitizations. The average loan size was
    $372,000 and, interestingly, 27 percent of the securitized loans were
    prime loans with balances under Fannie Mae and Freddie Mac's (the
    ``GSEs'' or the ``Agencies'') conforming loan limit. Since we resumed
    the securitization of newly originated jumbo mortgage loans in 2010, we
    have securitized an additional $8 billion of loans in 20 transactions.
    As a result of our securitization and investment activities, we feel
    well qualified to comment on the state of the private residential
    mortgage market and the steps needed to increase the participation of
    the private sector in the broader housing finance market.
        To supplement our jumbo mortgage loan business, we recently
    received our Seller/Servicer licenses from both Fannie Mae and Freddie
    Mac and we intend to add Agency conforming loans to our product menu.
    Additionally, we invested in Freddie Mac's recently issued Structured
    Agency Credit Risk (STACR) notes. This was the first Agency transaction
    completed as part of the strategic initiative of distributing credit
    risk from the GSEs into the private sector. Furthermore, we look
    forward to working with the Agencies to find ways for Redwood to invest
    in the ``first loss'' credit risk on the loans we sell to the Agencies,
    thereby putting the Agencies in a ``second loss'' credit position.
        If we achieve our goals, our business would include investing in
    the credit risk on both jumbo prime loans (through private
    securitization) and Agency conforming loans (through contractual
    arrangements with the Agencies and investments in STACRs and similar
    investments).
    Overview
        Broadly speaking, I view the mortgage market as having two distinct
    sectors. The first is the Government supported sector, which includes
    the FHA/VA, Fannie Mae, and Freddie Mac. The other is the private
    sector, which consists of portfolio lenders, primarily banks, and
    private label MBS issuers, such as Redwood Trust.
        Each of these sectors has made vital contributions to the
    development of the mortgage market over time, for the benefit of
    millions of homeowners. However, in the wake of the financial crisis,
    Congress is now appropriately considering how to reform and improve
    each sector. My testimony will focus on the private label MBS sector of
    the mortgage market, although it is not possible to discuss reform of
    one sector in isolation of consideration of reforms in the other
    sector, as the two impact each other significantly.
        The U.S. mortgage market needs multiple financing sources to ensure
    there are deep sources of liquidity for good borrowers to readily
    obtain affordable mortgage loans. I would argue that it is critically
    important for private label MBS to return and play a significant role
    in mortgage finance, as it has in the past. This can be accomplished by
    bringing traditional institutional senior investors back to the private
    label MBS market to efficiently address borrowers' credit needs.
        I firmly believe that over the long-term, private label mortgage
    securitization is a very efficient form of mortgage financing. As a
    Federal Reserve staff working paper described securitization, it ``has
    the potential to lower the cost of credit to businesses and households
    by reducing financial institutions' funding costs'' and ``it can
    produce securities that cater to the risk-return preferences of
    investors.'' Through the securitization process, an investor is able to
    buy assets that match their appetite for risk, using variables such as
    duration, interest rate risk, and high or low credit risk. This
    tailoring of risk is what draws trillions of dollars into the U.S.
    mortgage market.
        Many have speculated on why private label MBS is not fully
    flourishing today while other asset-backed markets for commercial MBS
    and credit cards have rebounded. There is no single answer to this
    question. There are a variety of factors that must be considered to
    explain the current state of the private label MBS market. Some of
    these factors will self-correct over time, while others will require
    structural and legislative change.
        Later in this testimony, I will offer specific recommendations for
    possible structural and legislative changes. But first, I would like to
    offer the following broad observations about the market:

        As a result of increases in the conforming loan limit,
            there are fewer non-Agency jumbo loans being created.

        The GSEs have had a significant pricing advantage over the
            private MBS market. This advantage has been reduced as
            guarantee fees have increased over the past 2 years.

        Pre-crisis, major banks were significant issuers of private
            jumbo MBS (especially for 30-year fixed-rate loans). These
            banks now have over $2 trillion in excess reserves at the
            Federal Reserve and have made an investment decision to hold
            significantly more jumbo loans in portfolio to build their
            asset base and increase net interest income, rather than
            securitize or sell the loans. For example, in 2012, jumbo loan
            originations totaled $200 billion and private label MBS
            securitizations totaled only $3.5 billion.

        Traditional senior investors still have questions of
            confidence regarding whether their rights and interests in the
            MBS they purchase will be respected and, consequently, that
            their investments will be safe and secure.

        My last observation is a Catch-22. For private label MBS
            financing to attract more investors willing to invest at
            attractively priced levels, the asset class needs to be larger
            and more liquid. But in order to attract more investors, the
            asset class first needs a larger critical mass, so investors
            will see the value in dedicating resources to analyze and
            monitor the sector.
    The Current Private MBS Market
        The mortgage loans that are currently being securitized through our
    platform are probably more similar than many perceive to the loans
    currently being guaranteed by the GSEs, except for the average loan
    amount, as noted in the table below.

        The GSEs have done a very good job of building loan quality. A
    large percentage of the loans currently guaranteed by the GSEs would
    meet Redwood's guidelines and, while our primary focus has been on the
    prime jumbo mortgage market, we are prepared to securitize prime loans
    of any size if the conforming loan limits are reduced.
        We believe that if and when the conforming loan limits are lowered,
    both banks and securitization sponsors will step in to finance loans
    above the lowered limits at affordable rates, and the typical jumbo
    loan characteristics will increasingly resemble conforming loan
    characteristics. As for credit quality, the credit performance of our
    post-crisis securitizations has been stellar. No investor in the senior
    securities has incurred a credit loss and currently we have only one
    loan that is more than 60 days delinquent.
        Interest rates to borrowers on conforming versus jumbo loans are
    narrowing closer to historical norms. On September 25, 2013, Redwood
    was purchasing prime 30-year fixed-rate jumbo mortgages within a rate
    of 4.875 percent. This compares to Wells Fargo's prime 30-year fixed-
    rate Agency conforming rate of 4.375 percent for the same date. The
    spread between these two rates of 0.50 percent is about 0.25 percentage
    points higher than the historical average. That also represents a
    dramatic improvement from the 2.00 percentage point spread that was in
    effect at the peak of the financial crisis in 2008. The current spread
    is solid evidence that private capital will provide borrowers with
    loans on reasonable terms if investors are presented with well-
    structured securitizations that also have a proper alignment of
    interests between the sponsor and the senior investors.
    How To Build a Robust Private MBS Market
    Focus on Investor Concerns
        Investors are the single most critical variable to consider as you
    take steps to promote a robust private MBS market. Simply put,
    investors have the money, and without their participation, there is no
    market. Many potential senior MBS investors, who previously had
    significant asset allocations to invest in private MBS, now have little
    or no participation at all. This is unfortunate because the financial
    world has ample liquidity and investors are combing through different
    asset classes in search of safe, attractive yields. On a relative value
    basis, there is no logical reason why private MBS should not play a
    much larger role as an attractive investment class, as it was in the
    past.
        So how is confidence restored among investors? Broadly speaking, I
    believe we need to first address investors' demands for better risk
    mitigation, transparency, and alignment of interests throughout the
    mortgage chain. Redwood's transactions prove that it can be done. We
    have listened to investors and worked hard to meet their new
    requirements for investing in private MBS by putting together
    transactions that included comprehensive disclosures, better and
    simpler structures, new enforcement mechanisms for representations and
    warranties, and skin in the game.
    Correct MBS Structural Deficiencies and Conflicts
        The private market will have difficulty growing at the velocity
    needed without the combined efforts of market participants, Congress,
    and regulators to correct structural deficiencies and conflicts in
    securitizations. It is critical that we strengthen the structural
    foundation that supports securitization so that investor protections
    are given greater emphasis. In traditional securitization structures,
    investors have relied on a trustee and a servicer to administer a
    securitization. The governing documents have not always addressed or
    contemplated all of the potential situations that could face the
    servicer or trustee, nor have they always provided an investor-friendly
    mechanism for initiating and resolving disputes. The following
    recommendations will correct the structural deficiencies and conflicts:

        Establish best practices in representations and warranties
            and other key securitization terms through the creation of a
            Private Market Advisory Committee (with investors holding a
            majority of the membership) that is given responsibility for
            developing new best practice standards. The standards would not
            be mandatory, but each securitization would be required to
            clearly disclose any variation from the standards.

        In many cases, representations and warranties have been weak and
    inconsistent and have been difficult for investors to compare from one
    sponsor to another and from one transaction to another. In addition, it
    has been costly or difficult to enforce the originator's or sponsor's
    obligations to repurchase loans where there has been a breach. We
    believe the representations and warranties now required by the GSEs
    serve as a strong benchmark.

        Establish binding arbitration as a minimum standard for
            dispute resolution of representation and warranty claim
            disputes in private label MBS.

        The Agencies are large and powerful institutions that have the
    ability to effectively enforce representation and warranty claims
    relating to loans they purchase and guarantee. In the private label MBS
    sector, however, there has not been a comparable force behind the
    enforcement of representation and warranty claims. Some originators
    have resisted or stalled the process for legitimate claims, resulting
    in costly litigation. These circumstances have led to deep investor
    mistrust. Furthermore, investors unable to rely on this protection have
    fled the securitization market and continue to sit on the sidelines. In
    order to correct this problem, we recommend requiring a formal dispute
    resolution process for ensuring enforcement--specifically, a binding
    arbitration standard. New best practice standards for representations
    and warranties, coupled with binding arbitration, would provide
    investors with assurance that any allegation of a violation of
    representations and warranties will be thoroughly investigated and
    pursued in an efficient manner.

        Require that securitization trusts create the position of
            Credit Risk Manager to manage representation and warranty
            claims and monitor servicer performance and actions.

        The Credit Risk Manager (CRM) would be an independent third-party
    unaffiliated with any interest in the transaction and would have two
    primary responsibilities. The first would be to identify, investigate,
    and pursue claims for breaches of representations and warranties. This
    is important in the event the senior investors and the party that owns
    the first loss security disagree on whether or not to pursue a claim.
    The second responsibility would be to conduct ongoing surveillance of
    the servicer's activities and report to the trustee and investors the
    results of the review. Although a servicer is engaged to service
    mortgage loans in a securitization pool for the benefit of the
    investors, the investors have no real way of ensuring that the servicer
    is performing its duties because no independent review or quality
    control of the servicer's decisions currently exists. The
    securitization documentation should provide for the CRM to have the
    same access to loan information and original loan files as the servicer
    to ensure that the CRM has the information necessary to perform its
    responsibilities.

        Establish clear and objective uniform standards governing
            the responsibilities and performance of a servicer in its role
            as a fiduciary of the trust.

        When we focus on the role of servicers in the securitization
    structure, we note they have sometimes been placed in the position of
    having to interpret vague contractual language, ambiguous requirements,
    and conflicting directions. In their role, they are required to operate
    in the best interest of the securitization trust and not in the
    interest of any particular bond investor. In practice, without any
    clear guidance or requirements, they invariably anger one party or
    another when there are disagreements over what is and is not allowed--
    with the result of discouraging some senior investors from further
    investment in private MBS.

        Prevent servicer conflicts of interest by prohibiting the
            owner of a second lien mortgage from being the servicer of the
            first lien mortgage on the same property.

        Currently, most second lien mortgage loans are owned by the same
    banks that perform servicing on the homeowner's first lien mortgage.
    Because these banks generally do not own the first lien mortgage they
    are servicing, they have a strong incentive to place their financial
    interests as a second lien holder ahead of first lien investors when
    taking actions as servicer on behalf of a securitization trust. For
    example, a servicer could refuse to approve a loan modification or a
    short sale that would benefit both the first lien mortgage holder and
    homeowner, because doing so would directly harm their financial
    interest as the owner of the second lien mortgage loan.
        Fortunately, there is a simple fix to this problem. Simply prohibit
    the owner of a second lien mortgage from operating as the servicer of
    the first lien mortgage on the same property. Servicing a delinquent
    loan is a nuanced, complicated process and investors must believe that
    their servicers are acting as honest agents throughout. No amount of
    disclosure or other half-measures will alleviate these concerns. The
    only meaningful solution is to definitively break the economic link
    between first lien mortgage servicers and second lien mortgage holders.

        Establish servicer performance triggers to serve as
            benchmarks and as an objective means for possible removal of
            the servicer.

        Servicers need to live up to servicing performance standards and
    triggers should be established to give investors the ability to hold
    servicers to these standards. The triggers, which could be set by the
    Private Market Advisory Committee I proposed above, might include,
    among other things, average loss severity, adherence to foreclosure
    timelines, and average REO liquidation timelines. The triggers should
    be reviewed on a periodic basis. If a servicer fails a trigger,
    servicing could be terminated. Mechanisms must be established to
    facilitate collective action by investors when a trigger event occurs
    and there is a failure on the part of the trustee to take action.

        Control the systemic and loan level risks relating to
            second lien mortgages by giving first lien holders the ability
            to require their consent to a second lien if the combined loan
            to value (CLTV) with all other liens will exceed 80 percent.

        During the housing bubble, homeowners extracted record levels of
    home equity through second lien loans. Second lien loans also acted as
    a substitute for cash downpayments to purchase houses. At the peak in
    2006, these loans totaled $430 billion.
        The rise of home equity lending increased the monthly payment
    obligations for borrowers and reduced the amount of equity remaining in
    their homes, leaving borrowers vulnerable to home price declines. As a
    result, 38 percent of the borrowers who used these loans found
    themselves underwater (or owing more than the value of their houses),
    compared to only 18 percent of those who did not. Even for well-
    underwritten, prime loans, the presence of a second lien correlated
    with increased defaults by as much as 114 percent.
        The rise of second liens has had another, less-widely understood
    effect: it substantially increased losses for investors and chilled
    their interest in investing in newly issued MBS. To understand why, it
    is necessary to understand how investors evaluate mortgage loans. While
    a borrower's credit report, income verification, and other underwriting
    factors are important to investors in evaluating credit risk, perhaps
    the most important factor is the amount of a borrower's equity, or the
    borrower's downpayment. The amount of a borrower's equity is probably
    the most predictive factor of a borrower's future performance:
    borrowers with 20 percent or more equity have lower default rates,
    while those with no equity are quicker to default and walk away from
    their home.
        Second liens undermine an investor's ability to analyze risk by
    making downpayment information unreliable. Imagine this scenario: a
    borrower applies for a first mortgage with a 40 percent downpayment--
    this is a loan that would historically have very low default risk. As a
    result, the borrower is offered a great loan at a low rate. One week
    after taking out the loan, the borrower takes out a second mortgage
    from a different lender for the remaining 40 percent of the property
    value. The borrower no longer has any equity and the default risk and
    potential loss severity on the first lien is higher than before. This
    is not a fantasy scenario: approximately 70 percent of borrowers in
    prime, privately securitized mortgages issued between 2004 and 2007
    took out second liens subsequent to obtaining a first mortgage.
        This level of uncertainty has a highly consequential impact on how
    investors assess mortgage related investments. Since investors have no
    way of knowing which borrowers will cash out their equity, they must
    assume that everyone will. This uncertainty leads private investors to
    demand higher rates in return for the increased risk, and the cost of
    home ownership goes up for everyone.
        We believe that placing some reasonable restrictions on the
    origination of second lien mortgages will restore investor confidence
    and speed the transition of the mortgage market away from taxpayer
    exposure. We propose that first lien holders have the ability to
    require their consent to a second lien if the combined loan to value
    (CLTV) with all other liens will exceed 80 percent. If the consent is
    not given, then the borrower can still obtain a home equity loan, but
    will need to refinance the first mortgage (and pay off the first lien
    holder) using a standard cash-out refinance loan product. This proposal
    would allow borrowers to tap into their equity, while preserving a
    level of protection for investors in first liens. This new restriction
    is intended only to protect first-lien lenders, and investors, from
    excessive equity being extracted later, without their knowledge or
    consent.

        The Government should begin to reduce its participation in
            the mortgage market, gradually and at a measured pace by
            reducing the conforming loan limits.

        For many years prior to the financial crisis, the Government
    mortgage market (GSEs, Federal Housing Administration, and Veterans
    Administration) and the private mortgage market have coexisted to serve
    the needs of borrowers. In the aftermath of the financial crisis, the
    Government's share of the mortgage market has increased to
    approximately 90 percent. If the conforming loan limits are reduced, I
    believe the private market would aggressively compete for those loans
    that exceed the new limit without any market disruption, similar to
    when the temporary increase in the conforming loan limit (from $625,500
    to $729,750) was allowed to expire in September 2011.

        Remove the uncertainty caused by unfinished regulations.

        The incomplete status of regulations required by the Dodd-Frank Act
    has constrained the development and growth of the private MBS market.
    Markets require certainty about the rules of operation so that
    regulatory compliance can be assured. Investors will continue to be
    cautious about entering the private MBS market out of concern that
    final regulations might soon turn a good business decision into a bad
    one. Markets typically manage to adapt to new regulations and continue
    operating under the new rules. The private label MBS market is no
    different.
    Conclusion
        The U.S. mortgage market is a complex system with many parts and
    key participants. Each plays a supportive role in creating a highly
    liquid and efficient market. The private MBS market will once again
    assume a major role, alongside the Government supported sector, as the
    issues I have discussed begin to get resolved. Thank you.
                                     ______

                       PREPARED STATEMENT OF JOHN GIDMAN
               President, Association of Institutional Investors
                                October 1, 2013
        Chairman Johnson, Ranking Member Crapo, Members of the Committee,
    thank you for inviting me to testify here today in support of your
    overall efforts toward housing finance reform and specifically
    regarding fundamentals of a functioning private label mortgage backed
    securities (PLS) market.
        My name is John Gidman. I am an Executive Vice President of Loomis,
    Sayles & Company in Boston, Massachusetts, and am testifying here today
    in my role as President of the Association of Institutional INVESTORS
    (the Association). The Association is an organization of some of the
    oldest and largest institutional investment advisors in the United
    States. All our firms have a fiduciary duty to put our clients'
    interests first. Put simply, it's not our money.
        Our member firms manage investments for more than 80,000 pension
    plans, 401(k)s, and mutual funds on behalf of more than 100 million
    workers and retirees. Our clients include companies and labor unions,
    public and private pension plans, mutual funds, and families who depend
    on us to help them provide for their retirements, to have funds
    available to educate family members, and to support their financial
    aspirations.
        Our clients are able to rely on us to prudently manage their
    investments in part due to the fiduciary duty we owe these
    organizations and individuals. We recognize the significance of this
    role and my testimony today is intended to reflect not just the views
    of the Association but the financial interests of the companies, labor
    unions, municipalities, workers, and retirees we ultimately serve.
        We recognize the vital role robust housing finance markets play in
    our society. These markets traditionally provided generations of
    families, across a variety of income levels, pathways to gain home
    ownership. For decades, this defined the American Dream. Much of this
    mortgage financing has ultimately been provided by pension plans,
    401(k)s, and similar funds whose investors valued collateralized
    income. Through these investment mechanisms, workers and retirees
    relied on the strength and depth of these markets to provide them
    income they needed for retirement.
    Lessons Learned From the Housing Crisis
        Institutional investors, like all participants in the mortgage
    market, have learned many lessons from the financial crisis. We learned
    that the stress of high unemployment and the decline in housing prices
    exposed certain structural weaknesses in the securitization framework.
        We recognize the critical role trustees play in the functioning of
    PLS mortgage markets but believe that they were not and are still not
    legally compelled, nor financially incented, to appropriately safeguard
    the interests of the trusts they represent.
        We are keenly aware that the incentives of the originator and the
    buyer of the risk were not and are still not aligned, because the
    originator typically sells all, or nearly all, of their economic
    interest in the securitization. This is a fundamental difference from
    other securitization markets, such as automobile or credit card
    markets, where the issuer retains significant first-loss risk and has
    very strong incentives to underwrite conservatively.
        Institutional investors see that documentation was not and still is
    not standardized and that the strength of representations and
    warranties varies depending on the issuer.
        Institutional investors also consider that the enforcement of
    existing contracts was and is still weak, particularly where vertically
    integrated financial institutions often serve as issuers, trustees,
    originators, and servicers, creating conflicts of interests and
    incentives not to identify deficiencies that harm investors' trusts.
        As a result of these structural weaknesses, little has improved in
    legacy residential mortgage backed securities (RMBS) reporting,
    enforcement of representations and warranties, or oversight of servicer
    performance. A typical monthly report today for legacy RMBS securities
    is not transparent as to who is servicing the loans, on what basis
    particular actions were taken by the servicer, or even regarding
    reconciling cash that came in and out of the trust. Recently, large
    portions of the legacy RMBS market have also seen servicing duties
    transferred from one firm to another, without investor consent or
    effective challenges from trustees, even in situations where investors
    would have likely been opposed to such a change.
    Overview of the Current PLS Market
        The absolute volumes of new issuances remain a very small fraction
    of what they were before the 2008 crisis. However, today, the quality
    of the collateral underlying the PLS market has generally improved. New
    issue RMBS markets have reopened as of 2011, and grew in 2012 and 2013,
    but with issuances primarily in the ``Jumbo Prime'' space, or high
    credit quality loan balances well above the conforming limits.
        The fundamental structural and process weaknesses for nonagency
    RMBS securitization have not been fixed in the current PLS market. The
    issuance process itself is very opaque. Ratings continue to be shopped,
    issuers are still incentivized to water down representations and
    warranties, and continued variability in structures and documentation
    make the market more challenging for investors and raise the costs of
    funding.
        Additional uncertainty has also been added to the market due to
    concerns that make it harder for investors to price risk, which
    consequently makes it harder for investors to justify investing in the
    sector. Included among the factors increasing uncertainty are: (a) the
    potential use of eminent domain by local governments to seize mortgages
    held in interstate trusts; (b) assignee liability; and (c) settlements,
    such as the Department of Justice's and various States Attorneys
    General settlement--the National Mortgage Settlement--using PLS trusts'
    funds to remedy allegations of inappropriate, unlawful, or illegal
    behavior on behalf of the issuer or servicer--behavior in which
    investors had no role.
        We do not believe that the PLS market is robust enough, given the
    current structural risks, to sustainably absorb significantly more
    supply, especially if the supply includes deals with lower
    subordination levels or collateralized by loans from borrowers with
    less pristine credit and lower downpayments (higher loan-to-value
    ratios). In other words, we are talking now about the vast gulf between
    home mortgages averaging between $250,000 to $300,000, supported by the
    agencies, and those for homes over $1,000,000 owned by borrowers with
    pristine credit and high equity.
        Buy-and-hold institutional investors will either require much
    higher yields--yields that are likely to render credit unavailable to
    those middle-class borrowers most in need of it--or will likely not
    participate in sufficient size to support the market without
    significant structural reforms.
    Current PLS Market Borrowing Characteristics and Loan Level Data
        As I alluded to, from a credit perspective, the types of loans
    currently being securitized are of a very high quality. Typically, the
    loans have a 66 percent average loan-to-value and a 760 average FICO
    score, with very few second liens and no mortgage insurance, so
    borrowers have 20-50 percent equity in the property. In the majority of
    deals, only the senior (typically AAA-rated) part of the securitization
    is being sold, so the amount of risk being taken by the private market
    is relatively small. The average home price of the mortgages being
    securitized is over $1,000,000. These high prices, combined with large
    downpayments and very high credit quality, has led to a situation where
    the current PLS standards cannot be used to finance mortgages for the
    majority of Americans. It should be noted that the PLS market did
    provide loans of average and even below-average credit quality before
    the crisis and there is likely funding available to do so, if investors
    become convinced that the issues exposed by the financial crisis have
    been addressed.
        The following table shows the volume and average credit
    characteristics of Jumbo Prime issuance from 2011 through 2013.

        There is also a need for continued access to robust loan level
    data. Prior to the crisis, investors did receive some loan level data
    for RMBS. Today, data for new issue deals contains more information and
    more accurately represents credit risks. However, we do not have access
    to the actual loan documents. We believe that full access to actual
    loan documents is important and this data should not be restricted by
    requiring the use of expensive commercial data services. Immediate,
    free access to the actual loan documents should be reasonable, as the
    documents are readily available and investors in the trust legally own
    the documents as owners of the loans. However, even with complete data
    sets or access to the loan documents, we believe our information will
    never be as perfect as the originators' information. To level the
    playing field and promote an open and transparent market, we believe
    other factors, such the creation of a fiduciary duty for trustees,
    better quality reporting, and standardized representations and
    warranties are more important to investors than loan-level data.
    General Thoughts on Housing Reform
        While the PLS market has improved since the financial crisis, in
    our view, meaningful regulatory and operational changes must be made
    before the market can fully recover. Institutional investors want to be
    able to invest in the mortgage sector, on behalf of our clients, as the
    credit quality of newly originated mortgages has improved. However, as
    fiduciaries, we cannot put our investors' savings and assets at risk in
    bonds that have a significant and unquantifiable downside risk.
        Therefore, we fully support Congress' efforts to reform the
    mortgage market. In doing so, we believe Congress should consider the
    agency market and the PLS market as part of one interconnected mortgage
    finance system. We believe that any regulation or legislation that
    reforms one market needs to consider the impact on the other market.
    Today, institutional investors favor investing in the agency market
    because there are fewer unknowns and many of the key investor concerns
    are mitigated when dealing with that market. The PLS market can
    redevelop, but the private market's reliance on the Government-
    sponsored enterprises (GSEs) will not organically decrease unless there
    are safeguards put in place to protect the PLS market.
        S.1217, the Housing Finance Reform and Taxpayer Protection Act,
    which was introduced earlier this year by Senators Bob Corker (R-TN)
    and Mark Warner (D-VA), and is cosponsored by six other bipartisan
    Members of the Senate Banking Committee, addresses some of the
    Association's concerns and generally we think this legislation moved
    the debate in the right direction.
        The bill's risk-sharing mechanism offers a promising solution that
    we believe could work if investors' need for a fiduciary standard for
    trustees is mandated. In July 2013, Freddie Mac issued the first risk-
    sharing deal in the RMBS market, called STACR 2013-DN1. We believe it
    was a positive sign that institutional investors were willing to take
    subordinate credit positions on this portfolio of agency mortgages,
    indicating that institutional investors may also be willing to take on
    risk under a Corker-Warner system.
        The legislation also provides helpful language to address investor
    concerns with the PLS market regarding issues like standardization of
    documentation and enforcing representations and warranties. Title II,
    Subtitle C of S.1217, in particular, reflects many of the transparency
    and oversight principles that we believe are vital to increasing
    investor confidence in the mortgage market. We appreciate the inclusion
    of these provisions and hope they are part of any other GSE reform
    legislation considered by the Committee.
        S.1217, however, did not address several fundamental investor
    concerns. These issues include: (1) creating a fiduciary duty for
    trustees and servicers; (2) addressing the assignee liability
    provisions included in Section 1413 of the Dodd-Frank Wall Street
    Reform and Consumer Protection Act (Dodd-Frank Act), now implemented by
    the Consumer Financial Protection Bureau (CFPB) in its Ability-to-Repay
    Rulemaking; and (3) limiting the ability of local municipalities to use
    eminent domain to seize residential mortgages held in trusts across
    State lines. Some of these concerns were highlighted by the crisis;
    others have arisen since the crisis. Each must be addressed by any
    mortgage market reform package that progresses through Congress, if one
    of the goals of the legislation is to incentivize private capital to
    return to the PLS market and stay in times of market stress. Each of
    these issues is addressed below.
    Fiduciary Duty for Trustees and Servicers
        Investor confidence is a foundation of the PLS market, therefore
    investors should have proper recourse to the parties. However, since
    the financial crisis began, a failure in the structure of the PLS
    market has been apparent: trustees do not have a regulated fiduciary
    duty to bondholders.
        To address these concerns and create better investor confidence,
    any mortgage market reform legislation should include trustee fiduciary
    duties to oversee the maintenance of trusts and enforce put-back
    obligations for faulty loans with regulatory oversight and private
    causes of action for breaches.
        Recent developments have underscored the lack of trustee fiduciary
    duty as the ongoing critical gap in the PLS marketplace. Situations
    like last year's Attorneys General mortgage servicing settlement (the
    AG Settlement), where investors were not involved in the negotiations,
    and when faced with a significant conflict of interest, trustees and
    servicers were able to sacrifice the assets of trust investors in favor
    of their own bottom line. Without a clear fiduciary duty for trustees,
    trustees and servicers are incented to act as they did under the
    settlement. Servicers have overwhelmingly favored writing down loans
    owned by private PLS pension and fund investors rather than writing
    down principal on loans owned by the banks.
        The AG Settlement, while unprecedented, is also not an isolated
    example of a situation where trustees or servicers act in their
    financial interest rather than in the best interests of investors.
    Recently, for example, there have been media reports that a large
    vertically integrated bank may settle an $11 billion deal with State
    and Federal regulators related to investigations into the bank's sale
    of RMBS that were packed with bad loans. This amount reportedly would
    include $4 billion in relief for struggling homeowners, similar to the
    AG Settlement, and it is not clear at this point whether this
    settlement would allow that bank again to meet its obligations by using
    funds from PLS trusts. Like the AG Settlement, investors have not been
    involved in the negotiations, and if the settlement allows it, that
    bank would be incented to meet at least part of its obligations with
    trusts' assets, therefore assets of American savers, because no one has
    a fiduciary duty to act in the best interests of the trusts'
    investors--in effect, the $4 billion would be paid by American workers
    and retirees out of their pension assets.
        Implementing a fiduciary duty for trustees would also spur further
    investment in the market, because investors would be assured that the
    trustee was acting in the best interests of the trusts' investors and
    incentives were properly aligned. Further, a fiduciary standard would
    improve the quality of trusts, as only good mortgages would be placed
    into the trusts, and mitigate conflicts of interest for situations
    where the same entity serves as both servicer and trustee.
        In addition to incentivizing private capital to return because
    investors' rights would be better protected, creating a fiduciary duty
    would also reduce the incentives that currently exist to invest with
    the GSEs. Under the current model, the GSEs are often more attractive
    because they are partners to their own contracts. Investing with the
    GSEs ensures that an entity, the GSE, has proper recourse if there is a
    problem. By creating a fiduciary duty, private capital will be
    encouraged to continue investing in the PLS market, ultimately
    increasing the market share for the private market and reducing the
    Government footprint.
    Assignee Liability
        We believe that assignee liability once implemented and as
    currently defined in regulation will lead institutional investors to
    avoid the PLS market.
        The Dodd-Frank Act and the CFPB's subsequent regulations create a
    path for a defaulting borrower to sue the lender for irresponsible
    lending. We agree with this principle and believe that it is good to
    hold originators accountable for predatory lending. However, the
    statute and regulations also create assignee liability, which
    essentially means that if the originator sells the loan, the buyer of
    the loan can be sued even though they were not the lender that made the
    bad loan in the first place. In the case of the PLS market, the trustee
    for the transaction would be the lawsuit target, and any legal,
    settlement, and damage costs would come out of collateral cash flows.
        Such lawsuits are also not limited to the loan amount. Rather,
    potential damages awarded against the PLS trust, as the assignee, could
    equal to the sum of all finance charges and fees paid by the borrower
    (up to 3 years' worth from the origination of the loan), plus actual
    damages, court costs, and attorneys' fees. We expect that damage awards
    could amount to thousands of dollars per loan, and a typical RMBS bond
    includes thousands of loans. Thus, an investor could face millions of
    dollars in losses from this liability on each bond. Furthermore, as
    trusts often have the ability to pay more than small originators, we
    believe that assignee liability could actually have the unintended
    consequence of weakening the liability of the originator, because
    plaintiffs' attorneys will focus the lawsuits on the entity with the
    deepest pockets.
        Given this potential liability, assignee liability risk may already
    be affecting the PLS market, even in advance of the CFPB's ability-to-
    repay requirements going into effect in January 2014. Institutional
    investors in this market are not close enough to the origination
    process to determine for themselves if all loans are exactly as
    advertised at the time of purchase, and so institutional investors are
    not willing to take on the risk that they could be sued for others'
    actions. Further, although Dodd-Frank and the CFPB's regulations
    include a safe harbor for a certain subset of qualified mortgages
    (QMs), this does not assuage our concerns because even if the safe
    harbor qualifications are met, asset managers will be forced to expend
    resources to establish the applicability of the safe harbor in every
    case where the borrower asserts that the ability-to-repay requirements
    were violated, regardless of the merits of the claim. Unless
    legislative changes are made, we expect that the PLS market will
    deteriorate further once these rules go into effect in January.
        To address these concerns, we are supportive of any efforts to
    reduce the risk of assignee liability under Dodd-Frank and the CFPB
    regulations and to increase access to the ability-to-repay safe harbor.
    The best way to accomplish this goal would be by including language to
    eliminate assignee liability completely. Removing assignee liability
    would not reduce the protections afforded homeowners under the ability-
    to-repay provisions, but rather would ensure that only those that are
    responsible for generating the loans will be held accountable for the
    loans that they generate. Under such a system, incentives will be
    properly aligned and institutional investors would not be held
    responsible for the bad acts of other players. Alternatively, although
    less ideal, the legislation could include a provision that would ensure
    that the CFPB must expand its ability-to-repay regulations to allow
    more loans to meet the conclusive safe harbor standard.
    Eminent Domain
        It seems in every crisis, there are powerful and well-connected
    opportunists that prey again on the victims. Certain jurisdictions are
    considering implementing a program designed and aggressively marketed
    by a private fund whereby a city would rent out its local eminent
    domain power to seize performing high quality mortgage loans, held in
    interstate trusts, in order to restructure the mortgages at a profit
    for the city and the fund's investors. This unprecedented and misguided
    use of local eminent domain power could hurt the retirement savings of
    workers and retirees from across the United States, who currently
    invest in mortgages that would be seized, and significantly damage the
    overall PLS market.
        Under the fund's plan, cities would seize current performing
    mortgages that are in trusts held by pension plans, 401(k) plans and
    mutual funds across the United States and managed by our members. If
    mortgages are taken by eminent domain, we will take action to protect
    the assets of our clients.
        As fiduciaries, we have a duty to ensure that the investments we
    make on behalf of our clients are in their best interests. Therefore,
    after eminent domain is used, we will be forced to weigh the
    possibility that future mortgage contracts will not be upheld and our
    clients will lose value in their investments. Ultimately, we believe it
    will be difficult to continue investing in the mortgage markets if any
    local community uses eminent domain to seize assets out of interstate
    trusts.
        Given these concerns, the Association believes any GSE reform
    legislation should include language similar to the language in H.R.
    2733, the Defending American Taxpayers from Abusive Government Takings
    Act of 2013, which was included in the PATH Act (H.R. 2767). These
    provisions would prohibit the GSEs from purchasing, the Federal Housing
    Administration from insuring, and the Department of Veterans Affairs
    from guaranteeing, making, or insuring, a mortgage that is secured by a
    residence or residential structure located in a jurisdiction where
    eminent domain has been used to take a residential mortgage. We are
    also in favor of expanding the Home Affordable Refinance Program (HARP)
    to homeowners whose mortgages are held in PLS trusts, to provide these
    homeowners with relief.
    Conclusion
        As the Committee continues to consider housing finance reform, we
    hope our perspectives support your efforts. Each of our suggestions is
    intended to help promote a vibrant secondary mortgage market,
    accomplish your goal of reducing the Government footprint in the
    mortgage market, and avoid adverse consequences that will ultimately
    affect the millions of American investors who rely on the continued
    vitality of these markets in order to save for their families' needs.
    We thank the Committee for its continued work and for focusing on this
    difficult issue. As the Committee progresses in its work, we stand
    ready to provide information and assistance as a voice for the millions
    of Americans who rely on these markets.
        Thank you for the opportunity to participate in today's hearing.
                     PREPARED STATEMENT OF ADAM J. LEVITIN
               Professor of Law, Georgetown University Law Center
                                October 1, 2013

             RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK
                         FROM MARTIN S. HUGHES

    Q.1. FHFA has taken several steps while Fannie Mae and Freddie
    Mac have been in conservatorship to preserve the assets and
    protect the taxpayers. These steps include enhancing the
    underwriting, credit risk pricing, and reps and warrants
    contracts of counterparties with Fannie Mae and Freddie Mac.
    These actions ensure standards being used by the two
    Enterprises are more updated, comprehensive, transparent, and
    that they more accurately reflect the risks assumed by the two
    Enterprises. Had these reforms been implemented prefinancial
    crisis much of the fraud, poor risk-management, and losses to
    the taxpayers could have been avoided. Going forward, these
    actions are providing for a more attractive and transparent
    agency market for investors, which is essential to ensuring the
    U.S. housing market continues to be attractive for global
    investment.
        Can you tell me if the private label security (PLS) market
    is adopting the same stringent transparency and contractual
    standards as the agency market? If not, why not?

    A.1. Participants in the post crisis private label security
    (PLS) market have implemented increased transparency and
    contractual standards, but with variations among the PLS
    sponsors. For example, it is my understanding that most or all
    of the issuers have adopted the American Securitization Forum
    disclosure format, which contains approximately 150 fields of
    data per loan backing a PLS. This compares to approximately 35
    data fields disclosed by the Enterprises. Therefore, I would
    say that the PLS market provides far more data and transparency
    about the loans backing private securities than is currently
    being offered by the Enterprises. The contractual standards
    have also improved in the private market, but with variation
    among PLS sponsors. For example, some current securitization
    sponsors, mainly banks, have ``sunset'' clauses in their
    representation and warranties that they make to the
    securitization trusts, which we believe undermines confidence
    among the triple-A investors to purchase PLS. The PLS issued by
    Redwood do not have sunset provisions as we believe the PLS
    market needs to be held to a higher standard.

    Q.2. What is holding back standardization of the PLS market?
    What is happening to PLS pools in the market today?

    A.2. Simply stated, the lack of a self-governing organization
    or regulatory directed standardization is contributing to the
    holdback in standardization. As a result, PLS issuance
    represents a growing but still very small market. For example,
    in 2012, only $3.5 billion out of $200 billion of jumbo
    mortgage originations were securitized, representing less than
    2 percent of originations. For the first 6 months of 2013, $8.3
    billion of prime jumbo originations were securitized out of
    $113 billion of originations, representing 7 percent of the
    market. These percentages are much smaller than the period
    starting in 1995 through 2007 in which the percentage of jumbo
    loans securitized to total jumbo originations averaged 29
    percent.
        We believe that what is holding up the reemergence of prime
    PLS is a combination of structuring and monetary policy issues
    that currently incent large banks to retain mortgages on their
    balance sheets. The structuring issues that are holding up the
    reemergence of PLS include:

      1.  A need for standardized representations and warranties
            for all securitizations that protect investors from
            noncredit related losses. Any exceptions should have to
            be noted clearly on a schedule so that investors do not
            have to compare and contrast the rep's and warranties
            from one deal to another against a standardized format.

      2.  A need to have a standardized enforcement mechanism (such
            as binding arbitration) for rep and warranty breaches.

      3.  A need to empower the trustee to proactively monitor and
            take appropriate actions for the benefit of the
            security holders. We suggest the concept of the
            ``controlling holder'' as is used in our Sequoia
            securitizations.

      4.  A need for investors to have confidence that their
            collateral will not be unfairly taken from them through
            Government actions (such as through eminent domain) or
            by third-party mortgage servicers that do not have an
            economic stake in the securitizations they service by
            modifying loans to further their own interests.

      5.  A need to protect investors from having their mortgage
            collateral diminished in value by allowing borrowers an
            unlimited ability to withdraw equity from their houses.
            We suggest that any lender who proposes to provide a
            subordinate financing on a property that would increase
            the combined loan-to-value ratio above 80 percent
            obtain the consent of the first mortgage holder, and if
            the consent is not granted, the new lender can provide
            a new first mortgage for the entire amount desired.

        We also believe that investors take comfort from issuers
    that have meaningful ``skin in the game.'' At Redwood, for
    securitizations we have sponsored post crisis, we hold 100
    percent of the noninvestment grade securities that are first in
    line to incur losses, which we believe provides a high
    alignment of interest with the investors in the senior
    securities. We realize that this issue is far more complicated
    than just risk retention, but it is unfortunate that it appears
    most residential securitizations will not require sponsors to
    retain risk. We expect to continue to hold all of the
    noninvestment grade credit risk tranches on our
    securitizations.
                                    ------

            RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN
                         FROM MARTIN S. HUGHES

    Q.1. One component of the housing finance system that has much
    received significant discussion over the last year is the role
    of recourse available to the lender. Recourse is available to
    lenders on a State-by-State level. States where recourse is
    available to lenders have a significantly lower risk of default
    as comp, especially among those who may strategically default.
    One Federal Reserve analyst found that for a sample of loans
    originated between August 1997 and December 2008, ``the
    probability of default is 32 percent higher in nonrecourse
    States than in recourse States.'' Borrowers who had a property
    value of $500,000-$750,000 at origination were over 100 percent
    more likely to default in nonrecourse States than in recourse
    States. In your view, would expanded availability of recourse
    strengthen our housing finance system? What is the impact of
    recourse availability on investors' decision making in real
    estate and private-label mortgage-backed securities?

    A.1. On the subject of recourse lending, we are generally in
    favor of the concept and we understand that it has worked well
    in Canada and Australia. As a practical matter, when a lender
    has an option of using a nonjudicial foreclosure process that
    does not allow for a deficiency judgment, or a using a judicial
    foreclosure that provides the lender with a deficiency
    judgment, lenders overwhelming use the lower-cost nonjudicial
    foreclosure alternative. Borrowers that ``strategically
    default,'' despite having ample resources, inflict damage to
    the integrity of the mortgage market and ultimately force all
    borrowers to pay a higher price for a loan, since investors
    suffer additional losses.
        RMBS investors factor into their pricing models loss
    severities by loan, which is a function of where the property
    is located and the rules around the foreclosure processes in
    each State, which would take into account the ability to obtain
    a deficiency judgment.

    Q.2. In your written testimony you said we should ``remove the
    uncertainty caused by unfinished regulations,'' referring
    specifically to the Dodd-Frank Act. You said the incompleteness
    ``has constrained the development and growth of the private MBS
    market.'' As you know, some proposals for the future housing
    finance system would place a new Federal regulator in the
    system in the form of the Federal Mortgage Insurance
    Corporation. The Federal Reserve, Department of Housing and
    Urban Development, Securities and Exchange Commission, Office
    of the Comptroller of the Currency, and Consumer Financial
    Protection Bureau all already manage these regulations. In your
    view, what are the most significant outstanding regulations
    impeding the industry currently? Additionally, how do you
    believe the future complexity of navigating regulations by
    these different agencies will adversely impact innovation and
    flexibility in the marketplace?

    A.2. As of October 1, 2013, only 40 percent of the 398 rules
    required by Dodd-Frank have been finalized. Various unfinished
    rules have a greater impact on some parts of the market than
    others. For the mortgage securitization market, one of the key
    unfinished rules is the risk retention, or QRM, rule. My point
    is not to single out any one rule as most important, rather the
    weight of all the unfinished rules is stifling growth and
    innovation. Markets cannot grow if businesses cannot understand
    the rules under which they will be required to operate. Perhaps
    some of the rulemaking delay is the result of having such a
    fragmented financial regulatory system. The addition of yet
    another regulator should be reason enough to step back and
    assess the need to streamline the current regulatory
    infrastructure.
                                    ------

                   RESPONSES TO WRITTEN QUESTIONS OF
                   CHAIRMAN JOHNSON FROM JOHN GIDMAN

    Q.1. Can Government guaranteed MBS with private capital first
    loss exposure (as described in S.1217) be structured to allow
    trading in the TBA market? If so, how?

    A.1. The Association believes that Government guaranteed MBS
    with private capital first loss exposure can be structured to
    allow trading in the TBA market. However, in order to do so,
    there must be increased transparency, a fiduciary duty for
    servicers and trustees, and loan level disclosures.
        This year, Freddie Mac successfully marketed a new product,
    the Freddie Mac Structured Agency Credit Risk (STACR)
    securities, which shows that there is an appetite and it is
    possible to sell first-loss pieces of certain Government
    guaranteed MBS into the private market. However, deals like
    STACR 2013-DN1 did not include any new originations, and
    investors were able to review the history to appropriately
    price the risk.
        Unlike STACR 2013-DN1, under S.1217 investors are assuming
    the first loss position without the ability to review
    historical data related to the underlying collateral. In this
    type of scenario, increased disclosures and a fiduciary duty
    are necessary to attract institutional investment advisers to
    consider investing in the deals. Assuming increased
    transparency and a fiduciary duty provides institutional
    investors with more comfort in the quality of these
    investments, the Association expects these deals would be as
    reasonably attractive as any other subordination investment.
        Also, the STACR deal had Freddie Mac taking first 0.3
    percent of risk below investors, and ``catastrophic'' risk
    above the credit risk sold to investors. This created an
    alignment of interest between Freddie Mac and investors, with
    Freddie Mac having a strong economic interest to minimize
    losses--we think this is a very important credit consideration
    for investors. In a situation where all of the credit risk is
    sold to investors, this alignment of interests would not exist,
    and investors would likely demand a higher return for the
    increase in risk.
                                    ------

             RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK
                            FROM JOHN GIDMAN

    Q.1. FHFA has taken several steps while Fannie Mae and Freddie
    Mac have been in conservatorship to preserve the assets and
    protect the taxpayers. These steps include enhancing the
    underwriting, credit risk pricing, and reps and warrants
    contracts of counterparties with Fannie Mae and Freddie Mac.
    These actions ensure standards being used by the two
    Enterprises are more updated, comprehensive, transparent, and
    that they more accurately reflect the risks assumed by the two
    Enterprises. Had these reforms been implemented prefinancial
    crisis much of the fraud, poor risk-management, and losses to
    the taxpayers could have been avoided. Going forward, these
    actions are providing for a more attractive and transparent
    agency market for investors, which is essential to ensuring the
    U.S. housing market continues to be attractive for global
    investment.

        Can you tell me if the private label security (PLS)
            market is adopting the same stringent transparency and
            contractual standards as the agency market? If not, why
            not?

        What is holding back standardization of the PLS
            market? What is happening to PLS pools in the market
            today?

        I would love to see the conforming loan limits for agency
    mortgage backed securities to be lowered, as it is one of the
    more obvious ways to increase and incentivize the private
    market back into this market space. I am concerned however that
    if the standards in the PLS market are not the same as the
    agency market--including to provide for clear and updated reps
    and warranties agreements and greater transparency--that
    investors will be hesitant to move to the PLS space.

        If the standards for risk-based pricing, reps and
            warranties and standardization of agency securities are
            improved for any ``agency-like'' security that is
            developed post-housing finance reform, will investors
            begin demanding these enhanced standards for PLS
            investment? What more could be done to incentivize the
            private market to adopt such standards?

        Do you think that the PLS market can truly be
            optimized if loan limits are lowered before greater
            transparency, contractual, and fiduciary changes/
            updates are adopted in the PLS market?

    A.1. Summary--The PLS market has not adopted the same stringent
    transparency and contractual standards as the agency market
    because institutional investors and their investment advisers
    are not parties to the agreements, unlike the Government-
    sponsored enterprises (GSEs). Without being parties to the
    agreements, investors have little leverage to ``demand'' these
    enhanced standards for PLS investment. Further, the parties to
    the agreements have no incentive to enhance the underwriting,
    credit risk pricing, and representations and warranties.
        We believe Congress should consider the agency market and
    the PLS market as part of one interconnected mortgage finance
    system. We believe that any regulation or legislation that
    reforms one market needs to consider the impact on the other
    market.
        S.1217 considers the establishment and operation of a
    Federal Mortgage Insurance Corporation (FMIC) as playing an
    important role in structural reforms designed to align
    interests appropriately for the various parties engaged in the
    housing finance markets. It may be helpful to explore ways to
    support expansion of this concept to the PLS market though
    implementation of an agency-like entity, perhaps titled the
    Private Mortgage Assurance Corporation, which could provide
    many of the structural elements we have highlighted as
    important components of housing reform in support of the PLS
    markets.
        This type of private mortgage agency entity, while not
    providing a Federal backstop, could promote a variety of
    services including standards for documentation covering PSAs,
    representations and warrantees, enforcement mechanisms, due
    diligence, and identification of baselines for risk managers
    and servicers. Such an entity could be party to the contracts,
    similar to the way the GSEs are party to their contracts, and
    would have the authority to enforce these contracts on behalf
    of investors. We think this approach is better than the complex
    documentation and multiple levels of re-underwriting that is
    becoming prevalent in the PLS market, which increase costs
    without providing an enforcement mechanism.
        The Association's members support further standardization
    of documentation in the PLS market, as well as efforts to
    increase transparency and enhance representations and
    warranties. These changes will ultimately help create a more
    level playing field. However, we do not believe standardization
    should be the ultimate goal. Even without standardization, if
    servicers and trustees had a fiduciary duty to act in the best
    interest of investors, the Association believes that
    communication and trust would increase among the parties and
    the market would be strengthened.
        The PLS market already had loan-level data transparency,
    risk-based pricing, and many of the contractual protections
    that have come into the agency market in the past several
    years. However, the crisis exposed the fact that trustees are
    not required to enforce the documentation, and servicers (often
    the same banks that originated the faulty loans) are unwilling
    to hand over borrower credit files to be examined for Reps and
    Warrants breaches. In the end, investors have had very little
    actual success in enforcing their rights.
        Rather than looking to incentivize the private market to
    adopt such standards, the Association believes it would be
    better to focus on ensuring that servicers and trustees act in
    the best interests of the investors. Trustees would act more
    rapidly and decisively to protect a trust's assets if subjected
    to a fiduciary duty, and they would also better oversee the
    activities of servicers. Further, servicers would have the
    proper incentives to act transparently in their servicing
    duties. The Association believes the PLS market cannot be
    optimized if loan limits are lowered before a fiduciary duty is
    extended to these entities.
        Expanded Response--The fundamental issue across the PLS
    market is alignment of interests between the originator of the
    loans, the servicer, and the PLS investor. The simplest way to
    align interests (the way it is done in almost every other
    securitized market in the U.S., and also in most foreign
    mortgage markets) is for the originator to hold the subordinate
    position. Risk retention places the first-loss risk with the
    party that has the best information to evaluate that risk--the
    originator. It aligns the interests of the originator and PLS
    investor in the most straight-forward way. If risk retention is
    impossible, first-loss piece shifts to investors, who do not
    have the best information or control of the servicer. As a
    result, we think PLS investors need protections, such as very
    strict contractual protections and enforcement mechanisms.
        There is little homogeneity in ``to-be-announced'' (TBA)
    pools. The agency market is liquid because of the GSEs'
    guarantee, not because the market or the pools have become more
    standardized. Therefore, the Association believes that
    standardization may not be the major obstacle for investors to
    return to the PLS market. The Association agrees that there is
    a marginal benefit to standardization, as it avoids
    fragmentation. However, despite this marginal benefit,
    investors would prefer that Congress focus on creating
    transparency and ensuring that investors' interests are being
    protected, rather than focusing on standardizing documentation.
    As long as the market is transparent and investor rights are
    enforced, institutional investment advisers can appropriately
    price the risk and buy the assets.
        Transparency would be best created in a market where market
    participants are able to trust one another, rather than be
    concerned that each participant is only focused on their own
    best interests. To create such trust, it would also be helpful
    to have access to the actual loan files. Particularly when our
    clients are taking the first loss risk, the operational and
    borrower risk is documented in those loan files. Further, the
    Association recommends creating a fiduciary duty for trustees
    and servicers, which would better align interests among market
    participants. Such a change would best be achieved through
    amending the Trust Indenture Act, and specific language
    regarding such changes is detailed in the Association's White
    Paper submitted to the Committee on October 11, 2013.
        The Association agrees with Senator Kirk that FHFA has been
    far more successful in enforcing representations and warranties
    than the private market. However, this is largely due to the
    ways in which the GSEs are able to identify, find, and enforce
    the repurchase of defects, rather than the difference in the
    underlying contracts. If PLS issuers were obligated to operate
    in the same fashion, investors would benefit, but it is
    unlikely PLS issuers will ever do so. The GSEs are able to
    operate as they do simply because of their market power, not
    because of increased standardization or better reps and
    warranties. If, for example, a major bank says they will not
    buy back loans, the GSEs could in theory shut them out of the
    market. Institutional investment advisers and their clients do
    not have this type of negotiating power.
        If the standards for risk-based pricing, representations
    and warranties and standardization of agency securities are
    improved for any ``agency-like'' security that is developed
    post-housing finance reform, investors would ask for these
    enhanced standards to also apply to PLS investments. However,
    just as these requests are going unheeded in today's market,
    leading to a lack of new PLS pools, there would likely be no
    incentive for this to be created in the post-housing finance
    reform PLS market, unless a fiduciary duty is created for
    entities like trustees and servicers.
        As we mentioned above, we also believe it is worth
    exploring creating an organization that would standardize
    contracts and oversee that these contracts are enforced. The
    Association believes this concept could be built into the FMIC
    common securitization platform provisions of the Corker-Warner
    bill, if this is the base text of the Senate Banking
    Committee's mortgage reform proposal. We view this proposal as
    additional and complementary to assigning fiduciary designation
    to the trustees. Such an organization could be a party to the
    contracts, similarly to the way the GSEs are party to their
    contracts, and would have the authority to enforce these
    contracts in the best interests of the trust.
        Over the course of the Financial Crisis, because of
    thousands of PLS trusts (each with its own documentation) and
    hundreds of PLS investors, investors have found it challenging
    to coordinate their efforts in order to enforce their
    contractual rights. Often it is difficult to even determine who
    other investors in each trust may be, in order to reach minimum
    voting thresholds that would compel trustees to act. Existing
    trustees are typically themselves large banks, and have a
    multitude of relationships with the banks they are supposed to
    sue, causing conflicts of interest. Creating a central utility
    with standardized representations and warrants of underwriting
    quality and stringent enforcement mechanism would give all
    investors greater confidence to buy and give the originators
    the right incentives to securitize high-quality loans. This
    organization would also have the ability to set servicing
    standards and hold servicers accountable for acting legally and
    in the best interests of investors, something the GSEs do today
    but which is impossible in today's PLS market.
        Originators and Wall Street firms would still originate
    loans, create the liability structure and control pricing
    execution--assets and liabilities would remain priced by the
    market. We think this approach is better than the complex
    documentation and multiple levels of re-underwriting that has
    become prevalent in the PLS market in the past 2 years, which
    increase costs without providing an enforcement mechanism. A
    standardized platform may also reduce pressure for banking
    consolidation, by making it easier for midsize investors to
    perform due diligence on PLS, and making it cheaper for smaller
    banks to sell loans into PLS trusts. If investors found such a
    framework attractive, they would chose to buy securities issued
    under these contracts, offering lower cost of funds than is
    available through the current structure of the PLS market.
                                    ------

            RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN
                            FROM JOHN GIDMAN

    Q.1. One component of the housing finance system that has
    received significant discussion over the last year is the role
    of recourse available to the lender. Recourse is available to
    lenders on a State-by-State level. States where recourse is
    available to lenders have a significantly lower risk of default
    as comp, especially among those who may strategically default.
    One Federal Reserve analyst found that for a sample of loans
    originated between August 1997 and December 2008, ``the
    probability of default is 32 percent higher in nonrecourse
    States than in recourse States.'' Borrowers who had a property
    value of $500,000-$750,000 at origination were over 100 percent
    more likely to default in nonrecourse States than in recourse
    States. In your view, would expanded availability of recourse
    strengthen our housing finance system? What is the impact of
    recourse availability on investors' decision making in real
    estate and private-label mortgage-backed securities?

    A.1. Summary--The Association believes that to the extent that
    expanded availability of recourse lowers delinquencies and
    foreclosures, it would likely be helpful. However, in today's
    market, recourse is not enforced in any State, including those
    States where recourse is available. The Association believes
    that transitioning the U.S. to a full-recourse system would be
    very difficult, and instead efforts should be focused on
    ensuring that servicers and trustees use legal tools available
    to them today to act in the best interests of the trusts.
        History of Recourse Provisions--To fully understand why the
    Association believes it would be nearly impossible to implement
    a Federal recourse \1\ standard, it is helpful to consider some
    of the changes to the market that have been implemented since
    2008, when the Federal Reserve's study cited in the question
    concluded. The Association agrees that prior to the crisis, the
    probability of default was higher in nonrecourse States.
    However, since the financial crisis, the public policy trend
    has clearly been toward weakening recourse in all States.
    ---------------------------------------------------------------------------
         \1\ In this discussion, the Association is defining ``recourse''
    as laws that: (1) permit the lender to seize any assets that were used
    as collateral to secure the loan, and (2) if money is still owned after
    the collateral is seized and sold, then take the borrower's other
    assets or sue to have his or her wages garnished.
    ---------------------------------------------------------------------------
        Much of this stems from Congress' implementation of the
    Home Affordable Modification Program (HAMP), which was designed
    to assist struggling homeowners. In order to entice servicers
    to work under the program, it included a servicer safe harbor,
    which ensured that investors and others could not sue the
    servicer. The HAMP program subsequently emboldened State
    legislatures to implement and enforce investor-unfriendly
    regulations. Today, not only is recourse no longer practically
    (and politically) enforceable, but lenders are effectively
    required to both allow the borrower to keep their house and
    forgive debt.
        Given this history, any Federal deficiency regulation would
    have to supersede State regulations, and Federal regulators
    would have to ensure that each State was enforcing the
    requirements. Until the housing market fully recovers, we
    believe that this would be very difficult, and recourse
    provisions would likely not be enforced.
        Potential Unintended Consequences of Expanded Recourse
    Provisions--Additionally, it is important to also consider the
    potential macro impacts of expanded recourse that may be less
    helpful to the market. Other systems, such as the housing
    market in Japan, have full recourse available, and it has
    actually harmed the system because it places too great of a
    burden on consumers. In practice, creating a system where there
    is no ability to forgive debt has led to situations where
    bursting asset class bubbles cause consumers to find themselves
    with so much debt that consumer attitudes shift against any
    future investment in that asset class--in this case, housing.
        Impact of Recourse Availability on Investors' Decision
    Making--Currently, since recourse provisions are almost never
    enforced, institutional investment advisers assign no value to
    the availability of recourse. Therefore, they currently have no
    impact on investors' decision making.
        Alternative Solutions--The Association believes there are
    better ways to protect investor interests than expanding the
    availability of recourse provisions, including creating a
    fiduciary duty for trustees and servicers. For example, if a
    fiduciary duty were imposed upon trustees and servicers in a
    similar manner as mutual fund or ERISA pension plan trustees,
    investors would have more reason to have confidence that their
    assets are protected because the servicer and trustee would be
    required to act in the investors' best interest. Additional
    information regarding how the Association would implement such
    a fiduciary duty is included in the Association's testimony, as
    well as the Association's White Paper submitted to the Senate
    Banking Committee on October 11, 2013.
                                    ------

                   RESPONSES TO WRITTEN QUESTIONS OF
                 CHAIRMAN JOHNSON FROM ADAM J. LEVITIN

    Q.1. Please detail the potential size of the market for private
    label MBS based on historical levels. In addition, please
    provide a comparison to the size of other fixed income markets.

    A.1. At the peak of the PLS market in 2007, there were $2.2
    trillion in PLS outstanding. Over 90 percent of those PLS were
    investment grade (usually AAA-rated), indicating that there has
    never been more than $220 billion of true credit risk
    investment in the PLS market. Annual PLS issuance peaked at
    less than $1.2 trillion in 2005. Based on this, I cannot
    imagine a PLS market supporting more than $500 billion in
    annual flows--slightly more than the annual issuance of PLS in
    2002, before the housing bubble and PLS crazy took off.
    Correlations between flows and outstandings vary significantly,
    but a reasonable rule of thumb based on historical correlations
    is that outstandings are unlikely to be more than three times
    flows. Therefore, based on a peak possible flow of $500
    billion, a PLS market could probably support no more than $1.5
    trillion in housing finance needs. The current U.S. housing
    market has $11 trillion in financing needs.
        Relative to U.S. fixed income markets, the PLS market has
    always been relatively small. There were approximately $38.1
    trillion in U.S. fixed income securities outstanding as of the
    end of 2012. Of this $38 trillion, approximately $36.6 trillion
    (96 percent) of these securities--involve zero or quite limited
    perceived credit risk: Treasury securities; the debt of Federal
    agencies and GSEs; GSE MBS; money market instruments;
    investment grade corporate debt; investment grade municipal
    debt; investment grade structured financial products. Investors
    in these classes of fixed-income securities are not credit risk
    investors.
        This means that there is only perhaps $1.5 trillion in
    deliberate credit risk investment in U.S. fixed-income markets:
    high-yield bonds plus junior tranches in structured financial
    products. There is another $1 trillion in speculative grade
    leveraged-loans. This indicates that the total pool of
    investors willing to assume real credit risk on any fixed-
    income security or the like in U.S. markets is around $2.5
    trillion.
        The limited pool of investment for real credit risk in
    fixed-income securities suggests that PLS cannot support
    anything close to the $11 trillion U.S. housing finance market,
    even with tranched credit risk. Assuming--perhaps generously--
    that PLS could be tranched so that there was no real credit
    risk for 90 percent of investors, the market would still
    require $1.1 trillion in credit risk investment. It is hard to
    see that emerging given that most of the $2.5 trillion in
    credit risk investment is already committed to the high-yield
    loan and bond markets, with only a small part invested in PLS
    (around $100 billion outstanding now in junior tranches) and
    other asset-backed securities.

    Q.2. How can variable or flexible LTV ratios (or other methods)
    improve countercyclicality in the PLS market? What can be drawn
    from methods used in other countries, e.g., Spain or Canada?

    A.2. In theory, authorizing a macroprudential regulator, such
    as the Federal Reserve Board or the Federal Open Markets
    Committee to impose maximum LTV ratios would provide a tool for
    countercyclical regulation that is focused solely on the
    housing market, as opposed to macroeconomic tools such as
    interest rates that affect more than the housing market. Such a
    tool would, of course, only be as useful as a regulator's
    willingness to use it.

    Q.3. What are the risks of the different types of capital that
    could support bond guarantors, in particular, if capital was
    not limited to common equity? What is the most realistic mix of
    capital for guarantor entities taking first loss risk, or who
    should determine this and how should it be enforced?

    A.3. If capital in bond guarantors was not limited to common
    equity, there is a risk that bond guarantors could have an
    asset-liability duration mismatch: their funding might be of
    shorter duration than the bonds they guarantee, resulting in
    the bond guarantors facing a risk of frozen capital markets or
    runs. To put this in the most extreme example, a bond guarantor
    that finances its operations through overnight repo could find
    itself without funding the next day, making its guarantees
    worthless.
        I do not have an opinion on what is the most realistic mix
    of capital for guarantors entities taking first loss risk, but
    it is important that the capital requirements for bond
    guarantors not result in an arbitrage situation in which bond
    guarantors can hold less capital than competing methods of
    financing mortgages, such as depositories on balance-sheet
    operations. In general, any reform of the housing finance
    market should take care that there are similar capital
    requirements for all financing channels; if there is not,
    financing will flow to the channel with the lowest
    capitalization requirements, resulting in a less stable housing
    finance system.
                                    ------

             RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK
                          FROM ADAM J. LEVITIN

    Q.1. FHFA has taken several steps while Fannie Mae and Freddie
    Mac have been in conservatorship to preserve the assets and
    protect the taxpayers. These steps include enhancing the
    underwriting, credit risk pricing, and reps and warrants
    contracts of counterparties with Fannie Mae and Freddie Mac.
    These actions ensure standards being used by the two
    Enterprises are more updated, comprehensive, transparent, and
    that they more accurately reflect the risks assumed by the two
    Enterprises. Had these reforms been implemented prefinancial
    crisis much of the fraud, poor risk-management, and losses to
    the taxpayers could have been avoided. Going forward, these
    actions are providing for a more attractive and transparent
    agency market for investors, which is essential to ensuring the
    U.S. housing market continues to be attractive for global
    investment.
        Can you tell me if the private label security (PLS) market
    is adopting the same stringent transparency and contractual
    standards as the agency market? If not, why not?

    A.1. The PLS market is not adopting the same stringent
    transparency and contractual standards as the agency market. As
    an initial matter, the PLS market has been moribund since 2008,
    with less than 40 PLS securitizations done since then. This
    makes it hard to meaningfully talk about the PLS market
    adopting any particular standards. The post-2008 PLS deals have
    had pristine, ultra-prime credit quality, but representations
    and warranties and structures for their enforcement vary
    considerably among post-2008 PLS deals. The PLS market appears
    to be experimenting with deal structures as it attempts to
    figure out what structures will strike the right balance
    between investor protection and seller/sponsor comfort.

    Q.2. What is holding back standardization of the PLS market?
    What is happening to PLS pools in the market today?

    A.2. There are no formal legal barriers to standardization of
    the PLS market. Instead, PLS continue to be nonstandardized
    because deal sponsors see no immediate benefit from
    standardizing. While standardizing PLS would help create a more
    robust and liquid market overall, currently there are only a
    small number of deals and the market is still trying to
    determine the optimal post-2008 deal structure.

    Q.3. I would love to see the conforming loan limits for agency
    mortgage backed securities to be lowered, as it is one of the
    more obvious ways to increase and incentivize the private
    market back into this market space. I am concerned however that
    if the standards in the PLS market are not the same as the
    agency market--including to provide for clear and updated reps
    and warranties agreements and greater transparency--that
    investors will be hesitant to move to the PLS space.
        If the standards for risk-based pricing, reps and
    warranties and standardization of agency securities are
    improved for any ``agency-like'' security that is developed
    post-housing finance reform, will investors begin demanding
    these enhanced standards for PLS investment? What more could be
    done to incentivize the private market to adopt such standards?

    A.3. It is possible that reforms of the ``agency-like'' market
    will begin to set standards for PLS as well; this is something
    that can be observed elsewhere in fixed-income securities as
    many securities that are not subject to the Trust Indenture
    Act, such as sovereign bonds, nonetheless include deal terms
    required by the Trust Indenture Act. The PLS market could be
    incentivized to adopt such standards through the provision of
    regulatory safe harbors. I would nonetheless urge Congress to
    consider certain nonwaiveable minimum standards for PLS, akin
    to those required by the Trust Indenture Act of 1939 provides
    for covered debt securities.

    Q.4. Do you think that the PLS market can truly be optimized if
    loan limits are lowered before greater transparency,
    contractual, and fiduciary changes/updates are adopted in the
    PLS market?

    A.4. If conforming loan limits are lowered at this point, it is
    unlikely that the PLS market will expand rapidly to provide
    financing for homeowners with mortgage loans larger than the
    conforming loan limit. Instead, credit availability will likely
    significantly contract for these homeowners. Until and unless
    investors feel comfortable with PLS deal structures and have
    confidence that representations and warranties about the
    securitized loans will be enforced, I do not see the PLS market
    providing any meaningful level of financing for the U.S.
    housing market. Thus, I do not see lowering the conforming loan
    limits as precluding reforms in the PLS market so much as
    producing a decline in housing prices.