[Senate Hearing 113-167]
[From the U.S. Government Publishing Office]
S. Hrg. 113-167
HOUSING FINANCE REFORM: ESSENTIAL ELEMENTS OF A GOVERNMENT GUARANTEE
FOR MORTGAGE-BACKED SECURITIES
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HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION
ON
EXAMINING HOUSING FINANCE REFORM, CONCENTRATING ON THE STRUCTURE OF A
GOVERNMENT GUARANTEE FOR MORTGAGE-BACKED SECURITIES
__________
OCTOBER 31, 2013
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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
Colin McGinnis, Policy Director
Glen Sears, Deputy Policy Director
Brian Filipowich, Professional Staff Member
Erin Barry Fuher, Professional Staff Member
Greg Dean, Republican Chief Counsel
Hope Jarkowski, Republican SEC Detailee
Mike Lee, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Kelly Wismer, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, OCTOBER 31, 2013
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Crapo................................................ 2
WITNESSES
Joseph Tracy, Executive Vice President and Senior Advisor to the
President, Federal Reserve Bank of New York.................... 4
Prepared statement........................................... 30
Phillip L. Swagel, Professor of International Economic Policy,
University of Maryland School of Public Policy................. 5
Prepared statement........................................... 88
Michael S. Canter, Senior Vice President and Director of
Securitized Assets, AllianceBernstein, on behalf of the
Securities Industry and Financial Markets Association.......... 7
Prepared statement........................................... 94
David H. Stevens, President and Chief Executive Officer, Mortgage
Bankers Association............................................ 9
Prepared statement........................................... 103
(iii)
HOUSING FINANCE REFORM: ESSENTIAL ELEMENTS OF A GOVERNMENT GUARANTEE
FOR MORTGAGE-BACKED SECURITIES
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THURSDAY, OCTOBER 31, 2013
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:05 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. I call this hearing to order.
I would like to thank our witnesses for joining us to
explore one of the fundamental questions of housing finance
reform, the structure of the Government guarantee for mortgage-
backed securities.
I would like to commend Senators Corker and Warner and the
cosponsors of S.1217 for recognizing in their bill that the
housing market as we know it cannot function without a Federal
backstop for mortgage lending. As we have heard in other
hearings this fall, the guarantee must be explicit,
appropriately priced, and stand behind private capital that is
not guaranteed.
However, the details of how a new guarantee should be
structured is paramount to a well-functioning national market.
The Government guarantee in the current system ensures that
qualifying mortgages are TBA eligible, which allows borrowers
to lock in their interest rates and connects loans and MBS with
investors from across the country and around the globe. If the
structure of the new guarantee is not compatible with TBA
execution, a wide range of stakeholders have expressed concerns
that access to credit will tighten for borrowers, making
mortgages more expensive, especially in rural and historically
underserved areas. This outcome is unacceptable.
Determining who is willing to step in to take the first-
loss position with private capital is also an important factor
when considering the interaction with the TBA market and the
stability of the future housing market. During the recent
crisis, private capital pulled back and was unwilling to take
credit risk except at an extremely high cost to borrowers. If a
new system allows a variety of private capital participants, we
must make certain that the new system is safeguarded against
future boom and bust cycles, like that which recently occurred
in the PLS market. It will be essential to create a system that
protects taxpayers, but also does not create so many
inefficient layers that the mortgage market becomes too
expensive for qualified borrowers.
In previous hearings, we explored how the PLS and
multifamily markets function, and earlier this week, we
examined solutions to improve the consumer's interaction with
the mortgage market. The witnesses at each of these hearings
recommended changes that would provide market efficiencies and
better protect taxpayers. I look forward to hearing from
today's witnesses about their visions for the future structure
of the Government guarantee for MBS and how different
structures would impact pricing and availability of credit.
This is a complex issue that has broad implications for
both the guaranteed mortgage market and the PLS market. As I
hope our aggressive hearing schedule demonstrates, Ranking
Member Crapo and I are taking this seriously and moving with
urgency. However, the housing market represents almost 20
percent of our economy. For the sake of families just getting
back on their feet after the housing and economic crisis, we
cannot afford to get the details wrong.
Senator Crapo, would you like to make an opening statement.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Yes, and thank you, Mr. Chairman. Today's
hearing is another opportunity, an important one, to discuss
the role of private capital in the context of housing finance
reform.
Today, Fannie Mae, Freddie Mac, and Ginnie Mae back nearly
100 percent of newly issued mortgage-backed securities.
Additionally, the Federal Reserve is supporting the housing
market by purchasing $40 billion a month of mortgage-backed
securities. Clearly, we need to move toward a more limited role
for the Federal Government and bring private capital back into
the housing market.
Several Members of this Committee have supported an
approach that provides for a limited, well defined Government
housing backstop. Senator Corker and Senator Warner are to be
commended for the extensive work that they have done.
During Tuesday's hearing, I noted that if we are to
consider housing reform options that include a Government
guarantee, we must ensure that the taxpayer is standing only
behind mortgages that meet strong underwriting standards. Also,
we must ensure that there is adequate private capital taking
the first loss at the security level if we are to avoid the
future taxpayer losses similar to the bailouts of Fannie Mae
and Freddie Mac, which required nearly $190 billion from the
taxpayers.
S.1217 allows for the development of various private sector
risk sharing mechanisms, including regulated bond guarantors,
senior subordinated deal structures, and credit-linked note
structures. Bond guarantors would maintain 10 percent of the
capital against their insured bonds and would become insolvent
before the proposed Federal Mortgage Insurance Corporation
insurance would step in to cover losses. This would mean that
the full resources of the guarantor would be available before
reaching the Mortgage Insurance Fund.
Capital markets transactions also would be an option to
facilitate private sources of capital to absorb first losses on
covered securities. In those transactions, the bill states that
the first-loss position must be at least 10 percent of the
principal or face value of what is defined as a covered
security for mortgage-backed securities transactions.
I am interested in the thoughts of today's witnesses on how
these structures would interact with the ``to be announced,''
or TBA, market. The TBA market allows investors the ability to
limit their mortgage lending exposure by relying on the
certainty of forward pricing on interest rates for home
mortgages. And the liquidity provided by those investors helps
to drive down the cost to homeowners. While not all available
financing products must be TBA compatible, we should keep an
eye on their interaction with the current TBA marketplace to
ensure that enough options will be available to allow for this
market to thrive.
The Federal Housing Finance Agency, FHFA, has already begun
work on developing options for transferring credit risk to the
private sector. The FHFA's 2013 Scorecard required that the
Government-Sponsored Enterprises demonstrate the viability of
multiple types of risk transfer transactions. The work of the
FHFA in this regard has been encouraging and shows the market's
appetite for owning the first-loss piece. The Freddie Mac STACR
Deal and Fannie Mae's NMI and C Deals are important examples of
how private capital can participate at a higher level in this
market.
In addition to the private capital that would be held to
take losses on covered securities, S.1217 would also create a
privately funded Mortgage Insurance Fund modeled after the
Federal Deposit Insurance Corporation's Deposit Insurance Fund.
I look forward to the witnesses' testimony on whether these
forms of private capital adequately protect the taxpayer. Are
we doing enough to protect taxpayers from losses? Are there
lessons we can learn from the FHFA on how to bring private
capital back into the market? What are the mileposts for
building capital during the transaction? And I look forward to
working with the Chairman, as he has indicated, and with the
other Members of this Committee as we address these critical
issues.
Thank you, Mr. Chairman.
Chairman Johnson. Thank you, Senator Crapo.
Are there any other Members who would like to give a brief
opening statement?
[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.
Our first witness is Mr. Joseph Tracy, Executive Vice
President of the Federal Reserve Bank of New York and Senior
Advisor to the President of the Federal Reserve Bank of New
York.
The Honorable Phillip L. Swagel is Professor of
International Economic Policy for the University of Maryland
School of Public Policy.
Mr. Michael S. Canter is Director of Securitized Assets at
AllianceBernstein, testifying on behalf of the Securities
Industry and Financial Markets Association.
The Honorable David H. Stevens is President and CEO of the
Mortgage Bankers Association.
We welcome all of you here today and thank you for your
time. Mr. Tracy, you may proceed.
STATEMENT OF JOSEPH TRACY, EXECUTIVE VICE PRESIDENT AND SENIOR
ADVISOR TO THE PRESIDENT, FEDERAL RESERVE BANK OF NEW YORK
Mr. Tracy. Chairman Johnson, Ranking Member Crapo, and
Members of the Committee, thank you for the opportunity to
appear before you today.
My name is Joe Tracy. I work at the Federal Reserve Bank in
New York. It is important for me to emphasize that my remarks
today and the conclusions of the research that I will share
with you represent my own views and are not official views of
the New York Fed or any other element of the Federal Reserve
System.
I commend the Committee for focusing on the elements
necessary to constitute a robust housing finance system in the
United States. By robust, I mean that such a system must
provide for the uninterrupted flow of credit to housing
markets, even in periods of market stress. In the wake of the
financial crisis, significant progress is underway to improve
the resiliency of financial markets. Nevertheless, we must plan
ahead for the risk of future market stresses.
My coauthors and I have started with the observation that
in the face of truly systemic housing shocks, Governments
always intervene. It is not hard to imagine why. Given the
importance of housing to Americans and to our economy, at some
level of housing market stress, the Government faces intense
pressures to take action. We cannot eliminate the risk that the
Government may have to intervene, so we need to acknowledge
that risk and establish a system to reduce and manage it or we
will reinstate an implicit guarantee that puts the taxpayer at
unacceptable risk. In my view, the private sector and the
borrower must absorb all losses up to an agreed point, with the
Government absorbing all further losses. The level at which the
Government steps in must be well known in advance and credible
to the market, meaning that there should be no speculation as
to when and how the Government would intervene.
In addition, the Government must determine its exposure net
of the loss absorption capacity provided by the private sector.
The required private capital should be of high quality and
should be determined relative to the total risk associated with
a given set of mortgage underwriting standards. Now, this may
sound complicated, but it is really not brain surgery. The
Government should bear only the cost of extraordinary systemic
risks and the private sector must bear losses associated with
the normal business cycle. If this can be arranged, then the
largest portion of the guarantee fee will be priced by the
market and not by the Government.
Our research has explored the notion that the Government
support would be triggered by the total losses across an entire
group or vintage of mortgage-backed securities. Vintage-based
support would likely only be triggered by a truly systemic
shock. A vintage approach would also provide a transparent and
finite maximum loss for the private sector to absorb,
supporting robustness at the onset, during, and through the
aftermath of a crisis. I believe that the costs of the recent
devastating economic downturn would have been far less to the
taxpayer, and the housing market would have rebounded far
quicker, had a vintage-based program containing adequate high-
quality private capital been in effect.
Attracting private capital to finance residential real
estate is another important consideration. Securitization
backed by a predictable level of Government support has a
useful function in facilitating the allocation of the different
risks associated with mortgage lending to different sets of
investors through the TBA market. I think the TBA market will
be a key to ensuring Americans' continued widespread access to
the 30-year fixed-rate mortgage.
The TBA market is also important to the role of small banks
and lending institutions in a competitive housing finance
system. Ensuring an easy, predictable path to securitization of
standardized mortgage products is essential to making mortgage
credit available throughout our country in traditionally
underserved and rural areas and urban areas, and to all sets of
current and potential homeowners, provided by financial
institutions of different sizes and in different locations. A
strong regulator whose primary focus is the housing finance
system can also help ensure fair access to smaller
institutions.
In summary, it is my personal belief that housing finance
reform must incorporate an explicit Government backstop
accompanied by significant sources of high-quality first-loss
private capital.
Thank you for the opportunity to appear before you today
and I look forward to the questions.
Chairman Johnson. Thank you.
Mr. Swagel, you may proceed.
STATEMENT OF PHILLIP L. SWAGEL, PROFESSOR OF INTERNATIONAL
ECONOMIC POLICY, UNIVERSITY OF MARYLAND SCHOOL OF PUBLIC POLICY
Mr. Swagel. Thank you, Chairman Johnson, Ranking Member
Crapo, and Members of the Committee. Thank you for the
opportunity to testify.
I also see Government intervention as inevitable in
housing, making an explicit guarantee preferable so that
taxpayers are compensated for taking on this risk. Still, it is
extraordinary for any private financial activity to have
taxpayers come to the rescue of those who make bad investment
decisions. The terms of the Government backstop should reflect
this, that a guarantee, any guarantee, is simply extraordinary.
My written testimony has a full discussion. I will briefly note
some of the key issues in designing the guarantee.
The most important decision, by far, is the amount of
private capital required to take losses before the guarantee
kicks in. The first-loss private capital will both protect
taxpayers and provide incentives for prudent behavior by
industry participants with their own capital at risk. The
capital should be at both the level of the individual loan,
with downpayments and private mortgage insurance, and at the
mortgage-backed security.
We learned in the crisis the importance of downpayments and
the importance of individual homeowners having equity, so
having considerable downpayments, I would say, is very
important to protect taxpayers.
The 10-percent capital requirement in S.1217 is appropriate
and essential. The existence of an explicit guarantee is a huge
step for people concerned about bailouts, but a 10-percent
requirement should provide considerable comfort regarding
taxpayer protection. By way of comparison, the losses of Fannie
and Freddie together were shy of 5 percent, though they would
have been larger had the Fed not intervened in its various
ways. So a 10-percent capital requirement, again, should give a
lot of comfort regarding taxpayer protection.
Now, requiring private capital will translate into higher
mortgage interest rates. The analyses I have seen say that this
will be around 40 or 50 basis points for the average borrower.
As we all know, the Fed can shift around interest rates by that
much with a single statement, or, as we saw this summer, a
single misstatement. And, of course, the Fed would use monetary
policy to help lessen any negative macroeconomic impact of
housing finance reform.
A simple way of thinking about the 10-percent capital
requirement is that if a 5-percent capital requirement is a
safe amount to protect taxpayers, then the incremental cost of
going from 5-percent capital to 10-percent capital will be
modest. After all, the capital position from the fifth
percentage point to the sixth, to the seventh, on up to the
tenth, is quite safe. So, if someone tells you that it is
expensive to go from 5- to 10-percent capital, then they are
really telling you that 5 percent is not enough private capital
to protect taxpayers. It is not possible to have it both ways.
It is not consistent to say that 5 percent is safe, but 10
percent is costly.
A suitably large capital requirement will also foster a
diversity of sources of funding for mortgages, including more
balance sheet lending and a revival of private label
securitization, in addition to mortgages that continue to be
packaged into guaranteed securities. I would say this change is
desirable when today most new mortgages are backed by the
Government, and yet too many potential homeowners find it
difficult to obtain financing. With reform, private investors
will take on the risks and rewards involved in housing finance.
Now, the nonguaranteed mortgage-backed securities played an
important role in the run-up to the financial crisis, but the
regulatory regime has changed, notably with the advent of the
Consumer Financial Protection Bureau, which has authority to
address bad behavior by nonbank originators.
So with this in mind, I would say a revival of private
label securitization is a desirable policy outcome, and
ultimately, it should be seen as a policy success to have some
mortgages that could receive a guarantee voluntarily choose not
to obtain one.
I would also have the secondary guarantee kick in only
after the entire private capital of the entities taking the
first-loss position at the level of the mortgage-backed
security. The Government would then cover the full principal
and interest of guaranteed MBS. Such an arrangement would
ensure that an event in which the Government pays out on the
guarantee is both rare and consequential, where the
shareholders of the failing firm will be zeroed out, investors
and risk transfer will take losses, and management will be
fired. This is the appropriate consequence of having the
Government make good on the guarantee. Anything less, having
the guarantee apply a vintage at a time or a mortgage-backed
security at a time, will mean that the full consequences of
failure do not operate.
A new housing finance system will both ensure that funding
is available and protect taxpayers and the overall economy. An
appropriately designed guarantee is an important element of
such a new system.
Thank you again for having me participate.
Chairman Johnson. Thank you.
Mr. Canter, you may proceed.
STATEMENT OF MICHAEL S. CANTER, SENIOR VICE PRESIDENT AND
DIRECTOR OF SECURITIZED ASSETS, ALLIANCEBERNSTEIN, ON BEHALF OF
THE SECURITIES INDUSTRY AND FINANCIAL MARKETS ASSOCIATION
Mr. Canter. Thank you. Chairman Johnson, Ranking Member
Crapo, and Members of the Committee, thank you for the
opportunity to testify before you today. My name is Michael
Canter and I am a Senior Vice President, Portfolio Manager, and
Director of Securitized Assets at AllianceBernstein, an asset
management firm with $450 billion of assets under management. I
am appearing here today on behalf of the Securities Industry
and Financial Markets Association, a trade association
representing hundreds of securities firms, banks, and asset
managers.
SIFMA and its members' primary focus in considering reform
of the GSEs is the preservation of the ability of secondary
markets to support the 30-year fixed-rate mortgage. The 30-year
fixed-rate mortgage is a stable and predictable way by which
most Americans have historically financed their home purchases.
Such 30-year mortgages, however, present significant risks to
lenders. To manage this risk, lenders need access to a liquid
forward market for mortgage loans.
Today, the to be announced, or TBA markets, serve this
function, allowing mortgage originators to sell conforming
loans before they are originated and enabling the originator to
provide interest rate locks to borrowers well in advance of
closing. Furthermore, the TBA market provides the necessary
liquidity that enables a national market, whereby regional
differences do not impact credit availability for borrowers in
particular locations. In addition to the loan origination
aspect, the TBA market provides an important benefit to
investors, such as pension funds, 401(k) plans, mutual funds,
State and local Governments, and global investors.
Today's hearing asks this panel to consider the essential
elements of a guarantee. Homogeneity is what makes the TBA
market succeed. This homogeneity is driven by two main factors,
standardization of terms and the absence of credit risk. Terms
are currently standardized through the GSEs' lending,
servicing, documentation, and other guidelines. Credit risk is
addressed through the implied but near explicit Government
guarantee on the principal and interest payments of the
mortgage-backed securities.
Thus, to truly preserve the advantages of the TBA market,
it is essential that a Government guarantee provides timely
payment of all principal and interest associated with the
securities. Otherwise, the mortgage-backed securities would no
longer be an interest rate investment, but a credit investment,
as well. A credit investment requires an entirely different
investor base than the one that currently holds the $5 trillion
of mortgage-backed securities guaranteed by Fannie and Freddie,
and certainly, any change to this full guarantee would raise
mortgage borrowing costs.
We believe that taxpayers should only be exposed to
catastrophic or tail event losses in the newly envisioned
mortgage finance system. Thus, private capital will need to
take the first layer of risk of mortgage borrowers defaulting.
We support an approach where the size of this first-loss layer
fluctuates with the demand for mortgage credit risk. If
constructed otherwise, the regime will tend to be procyclical
and exacerbate booms and busts. But the most important factor
in considering how to structure this risk to be taken by
private capital is whether or not a particular approach will
disrupt the critically important liquidity of the TBA market.
We view the recent risk sharing transactions executed by
Freddie Mac and Fannie Mae, called STACR and CAS, as prime
examples of how the capital markets can provide first-loss
capital without disrupting the TBA structure. In essence,
through these transactions, Freddie and Fannie have bought
reinsurance, if you will, from the bond market and hedged their
credit risk to borrowers defaulting. While these two
transactions are just the start of the GSEs' risk sharing
program, we believe they are an important part of the solution
to the complex problem of how to bring private capital back
into the mortgage market.
There are some market participants who have concern that
there is not enough capital in the bond market to absorb the
credit risk necessary to buffer taxpayers from loss. At
AllianceBernstein, we are more sanguine about this possibility.
The way we look at it is that the private label residential
mortgage-backed securities market is approximately $850 billion
in size, the overwhelming majority of which is rated
noninvestment grade. Ten to 15 percent of this amount gets paid
back to investors each year, and investors are looking for a
way to reinvest. Thus, a whole market has now formed that holds
noninvestment grade mortgage credit risk that simply did not
exist pre-crisis.
Just as important, the marketplace has built up an enormous
amount of intellectual capital, systems, and models to analyze
mortgage credit risk. We believe that fixed-income investors
across the globe will want to participate in this market,
thereby spreading the risk across many market participants.
The benefit of this is not just the avoidance of
concentrating risk in a small number of financial institutions,
but also that fixed-income investors will price mortgage credit
risk relative to other risks in the marketplace. Financial
companies that can only take one type of risk do not have this
flexibility. The price transparency that these risk sharing
transactions will bring will help all market participants.
In conclusion, I want to thank you all for proceeding with
this critically important reform effort. SIFMA and its member
firms stand ready to assist you and your colleagues as you
develop a more sustainable housing finance system. Thank you.
Chairman Johnson. Thank you.
Mr. Stevens, you may proceed.
STATEMENT OF DAVID H. STEVENS, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, MORTGAGE BANKERS ASSOCIATION
Mr. Stevens. Thank you, Chairman Johnson, Ranking Member
Crapo, and Members of the Committee. Thank you for the
opportunity to testify today.
My name is David H. Stevens. I am the President and CEO of
the Mortgage Bankers Association. I appreciate the opportunity
to share MBA's views on how to ensure that the multiple
objectives of secondary market reform can best be balanced,
ensuring liquidity in the secondary market, providing mortgage
products that borrowers want at a price that is competitive and
protecting taxpayers from risk.
We are encouraged by recent legislative activity that has
revived this policy debate on the future of Fannie Mae and
Freddie Mac, including S.1217 offered by Senators Warner and
Corker, and commend the efforts of the Chairman and the Ranking
Member on thoughtfully working to create a comprehensive
framework for the future of housing finance.
MBA believes a successful secondary market needs to produce
a more stable and competitive system that benefits lenders and
borrowers. The transition to an improved system must retain and
redeploy key aspects of the GSEs' existing infrastructures,
including certain operational functions, systems, people, and
business processes. In order to prevent disruptions to day-to-
day business activities of lenders and to ensure fair,
competitive, and efficient mortgage markets for borrowers, any
new proposal must be carefully phased in to protect the housing
finance system from unnecessary disruptions.
With regard to the future structure of the secondary
mortgage market, MBA believes a stable and successful system
must include three key elements. First, an explicit Government
guarantee for mortgage securities backed by a well-defined
class of high-quality mortgages.
Second, protection for taxpayers through deep credit
enhancements that puts private capital in a first-loss position
with no institution too big to fail.
And, three, a fair and transparent guarantee fee structure
to create an FDIC-like Federal insurance fund in the event of
catastrophic losses.
The Government should provide quality regulation of
guarantors and systems along with clearly defined but limited
catastrophic credit backstops to the system. Without this
Government backstop, the mortgage market would be smaller and
mortgage credit would be much more expensive. This means that
qualified low- to moderate-income households would have less
access to affordable mortgage credit and be less able to
achieve sustainable home ownership. The multifamily rental
market, which predominately serves those with modest incomes,
would also be adversely affected.
How, then, do we define where private risk taking ends and
where Government support begins? In most proposals, private
entities or capital structures are assumed to take losses up
until the point that the entities fail or the structures are
tapped out. The key question then becomes how much capital the
entities need to set aside to absorb losses, or, alternatively,
how thick subordinate tranches within capital market structures
need to be.
The answer to the question of how much capital should be
set aside is not simple. First, there will always be
uncertainty regarding precisely how much risk resides within a
pool, vintage, or population of mortgages. Lenders, investors,
rating agencies, and regulators have developed considerable
information and analytics which can accurately gauge the
relative risk of default and loss from mortgages within
different characteristics. However, despite these accurate and
precise estimates of relative default risk, it is more
difficult to get a handle on the level of absolute risk, which
must be estimated across a range of home price, interest rate,
and economic scenarios.
So, what level of protection is enough? Private credit
enhancers should have sufficient capital so that it is
extremely rare that the insurance fund is called upon, and the
insurance fund and associated premiums should be large enough
that Government outlays would almost never be required.
However, there is a cost to being too conservative. Requiring
capital beyond the reasonable economic risk drives up cost,
which would limit access to credit for borrowers and will
distort market behaviors.
Congress should set broad parameters for the regulators to
establish capital requirements and credit enhancement levels
that are in line with regulatory capital standards for
mortgages held by other institutions. For example, legislation
should reference the most recent version of the Basel standards
when instructing the regulator on proper levels of capital. In
effect, Congress should establish a system where there is no
opportunity for regulatory capital arbitrage. Regardless of who
holds mortgage credit risk, regardless of capital type, the
capital requirements should be relatively the same.
In addition to regulations around capital requirements, the
regulation should also have rigorous criteria for approving
lenders, servicers, credit enhancers, and other participants in
the market. The regulator should also be an active supervisor
with access to timely information that allows them to be able
to make judgments about potential required actions to limit
risk to either the insurance fund or the taxpayer.
A successful secondary market needs to be more stable and
more competitive for all lenders, with greater protections for
borrowers and taxpayers. The system should utilize familiar and
operationally reliable business systems, processes, and
personnel from the existing GSE model. And it is essential that
any new system be accessible by lenders of all size and
business models as a robust and competitive marketplace
benefits everyone, including borrowers, taxpayers, and our
industry.
I look forward to your questions. Thank you.
Chairman Johnson. Thank you all for your testimony.
As we begin questions, I will ask the Clerk to put 5
minutes on the clock for each member.
Mr. Stevens, what is the impact on homebuyers if the first-
loss private-capital requirement for the guarantee is set too
high, and should the requirement be set by legislation or by
regulator?
Mr. Stevens. Thank you for that question, Mr. Chairman. The
impact that we are concerned about here is twofold, one, that
it be very clear that the guarantee be 100 percent on the
mortgage-backed security but that first-loss credit enhancement
be provided by a deep level of private capital.
Setting a flat line standard in a legislative initiative
concerns us only to the effect that it could create systemic
distortions, the likes of which we have seen actually in the
current model. With the GSEs holding only 45 basis points of
capital compared to what private capital standards are, we have
seen an unusual distortion where lenders sold off literally all
of their risk to a Government guaranteed structure. So we all
recognize that capital level has to go up.
The challenge to a flat line is that it does not take into
account the risk-based measures within that structure of
mortgages in a pool. Some mortgages, for example, at very high
loan-to-values, at lower FICO scores, might actually require
higher capital than would be proposed, say, in a 10-percent
level, while other mortgages at lower LTVs, lower loan-to-
values, with bigger downpayments and higher credit scores,
might require less than 10 percent.
And so from that standpoint, we strongly recommend that the
regulator be required in a very transparent way to set capital
levels using econometric measures that take into account
historical recessions and depressions and other variables when
they account for the capital standards required ultimately in
the mortgage securitization market and that it not necessarily
be set as an explicit number in a legislative format.
Chairman Johnson. Mr. Tracy, your research recommends
providing the Government guarantee to an entire group or
vintage of MBS instead of to an institution or a single MBS, as
proposed in legislation. What are the risks with the
institution or single MBS approaches?
Mr. Tracy. Thank you, Chairman. I think the key question
that we need to ask ourselves with any of these design
approaches is how is that approach going to function in those
rare events where the Government is acting upon that Government
guarantee, so the market has basically been subject to a
systemic shock? It is our view that the vintage-based approach
is going to be more robust under those conditions of severe
market stress and will be better capable of continuing to
provide access to mortgage financing.
Our concern with some of the other approaches is that,
again, by definition of a systemic shock, all insurers in other
models are going to be facing the same types of pressure, and
our concern is that you might run the risk of a collapse in the
provision of mortgage credit under those circumstances. If that
were to materialize, then it puts the Government back in a
situation of do we need to somehow intervene to remediate that
problem and, again, provide some alternative form of that
mortgage credit.
So, we think the vintage approach is a little more robust
in that very specific rare instance where the Government has to
step in on its guarantee.
Chairman Johnson. Mr. Canter, you suggest that the design
of the STACR and CAS deals is compatible with the TBA market.
How can S.1217 be improved to accommodate this from a risk
taken?
Mr. Canter. So, the advantage that STACR and CAS have is
that Fannie and Freddie are sitting in front of the
transaction. So they are sitting in front and they are simply
ceding out the risk, passing the risk off to the capital
markets. Within S.1217, it would be the financial guarantor
that would have the risk and then they would pass it off.
And so what is important is that all the standards be the
same across the financial guarantors, which they would as per
the FMIC, but, you know, and that the regulations'
infrastructure all is the same and so that when it is passed
off to the marketplace, it is, in essence, perceived the same
way as if Fannie or Freddie is being accepted into the
marketplace now.
Chairman Johnson. Senator Crapo.
Senator Crapo. Thank you, Mr. Chairman.
Dr. Swagel, in your testimony, you address the issue of
adverse selection. You state that there is a concern that
originators would seek to obtain the Government guarantee only
on their riskiest loans, which, of course, then would result in
the Government winding up insuring only lower-quality
securities. How should we address that problem?
Mr. Swagel. Thank you. Adverse selection is a problem
anytime there is a Government guarantee. Whether the capital
requirement is 10 percent or 5 percent, you have the same
problem with adverse selection. And the industry, of course,
will want to have its riskiest loans covered by a guarantee. So
it is critical to have a strong regulator, an independent
regulator who maintains high underwriting standards.
Ultimately, that is the basis for protecting taxpayers.
Senator Crapo. Are there ways to make sure that any
proposed Government backstop adequately takes that into
consideration? How would a regulator do that?
Mr. Swagel. You know, in my mind, it is important to have
these standards hard coded into the legislation. I think we all
understand the pressures on the regulator will be in the
direction of less capital and lower standards. And that is why
I would have the capital requirement specified directly in the
legislation, to avoid those sorts of pressures.
Senator Crapo. All right. And, Mr. Canter, one of the ways
that we can encourage private capital in the future housing
finance system is to provide markets with certainty about how
any proposed risk sharing will work in practice. The FHFA
recently carried out a number of transactions designed to give
a better sense of how the market might price risk in the
future. What can we learn from the private market's response to
these transfer transactions?
Mr. Canter. I think we can learn that the market is very
capable of measuring and taking mortgage credit risk. We
estimated at AllianceBernstein that the expected loss on the
STACR and CAS transactions ranged between 10- to 15-basis
points cumulatively over a 10-year period. So, when you are
thinking about a first-loss buffer of 10 percent, that is many,
many multiples of that expected loss.
And so what is important is how that 10 percent is
structured, because, in essence, what we learned is that
everything above an attachment point of, say, 1.5 or 2 percent,
everything above that point is going to be considered
investment grade. That is a big deal in the fixed-income
markets, even still. Even after the crisis and everything that
the rating agencies went through, it is still a big deal for
the way we manage money. And so if everything above 2 percent
is investment grade, it just opens up many, many more investors
able to invest in the transactions.
And so you want to take advantage of that, and in order to
do that, you have to make it so that bond investors around the
world can invest, and that is the huge advantage of doing that
as opposed to an insurance company model where the return on
capital might be excessive because they want an equity return
on capital as opposed to a bond return on capital.
Senator Crapo. All right. And I think you already answered
this, but moving forward, what are the mileposts we should be
looking for to assure that markets are comfortable with the
system?
Mr. Canter. Well, certainly, the acceptance of the deals
and how they are trading in the marketplace, you know, as we
look to transition to a new system and how that system is
actually constructed and what that transition looks like is
going to be key. But, the continuation of these deals is
important, how they are priced. Are Fannie and Freddie able to
open up new markets? So, for instance, are they going to be
able to actually transfer risk away from the bond market even
and actually into the property and casualty insurance market,
right, or reinsurance market as another outlet for this risk.
So, the more places you are able to place this risk, the better
and more resilient the private market capital system will be.
Senator Crapo. All right. And, just quickly, the S.1217
framework has approved bond guarantors as well as capital
market executions, such as senior subordinate structures and
credit notes. Why is it important that we encourage these
various sources of private capital?
Mr. Canter. I think it is important because we do not
actually know what the most efficient structure is going to be,
and like Mr. Stevens mentioned, there are different FICO
scores, different LTVs that are out there and we want to leave
lots of room for those types of borrowers, as well. So, the
more options as we go into a new system, the more options we
have, the more chances we have of success and flexibility. I
think the most important thing that is really in S.1217 is the
flexibility that it offers for all of these different avenues.
Senator Crapo. Thank you.
Chairman Johnson. Senator Warner.
Senator Warner. Thank you, Mr. Chairman, and thank you for
this hearing.
I appreciate particularly the final comments of Mr. Canter
about the flexibility in S.1217. I guess I want to make one
comment before I get to questions. Mr. Stevens and I have had,
we have had lots of conversations about S.1217. We understand
your concerns on the capital number.
I guess I would point out, for those of us who want to make
sure we maintain access for borrowers across the spectrum, that
your notion that if you had a series of lower FICO scores with
less quality loans, that you might require even more capital
than 10 percent for those kind of pools. I actually think that
would mean that that would decrease the availability of those
loans to get funded. You would, in effect, be segregating them
into some kind of worse pool and could dramatically cut back
access.
So, I do think Mr. Swagel's comments that if the 10 percent
mark has been a bit overshot, that this kind of top-line
standardization, that the sophistication of your industry, Mr.
Canter, and others would be able to price that and tranche that
appropriately, so if the number should be at four, five, six,
or whatever, that that remaining capital would be priced at a
lower level and we could then avoid the notion of kind of all
the bad loans being lumped off and, consequently, not have
access to the market that they have, I think, under our
proposal or under the current system.
I guess I want to ask first--again, there are two questions
I want to get at. One is, S.1217, we acknowledge that there are
ways of trying to make sure we guarantee particularly smaller
lenders, we try to get geographic diversity, we try to make
sure that the Federal backstop is only in a catastrophic event,
and again, I might mention that with the G fees, there is also
a reinsurance fund that backs up even before we hit the
taxpayer. But I guess--and I would hope you would all be able
to say just yes or no on this--does the panel believe that the
bond guarantors who, whatever amount of capital they put up,
should all go out of business or be fully liquidated before you
would ever tap into the insurance?
Mr. Stevens. Absolutely.
Mr. Swagel. Yes.
Senator Warner. Mr. Tracy.
Mr. Tracy. In that model, yes, but we prefer a different
model. Yes.
Senator Warner. Mr. Swagel.
Mr. Swagel. Yes.
Senator Warner. Mr. Canter.
Mr. Canter. My personal view is yes. There are
disagreements among members of SIFMA on that.
Senator Warner. Right, because they might be some of the
institutions that might go out of business.
Mr. Stevens.
Mr. Stevens. Absolutely. That is why competition in the
model is extremely important. You would have multiple entities.
Senator Warner. We tried to build that in.
I guess one of the things, going back to Mr. Tracy's
comment, and we tried to stay--leave some flexibility on this,
is we have got Mr. Tracy's notion of a vintage model, I think,
that Senator Crapo--which kind of helps on the TBA market,
which perhaps gets us more in terms of geographic diversity.
Mr. Swagel, I think, wants to make sure we keep it at the
guarantor level so there is more responsibility. Could you
each, in my remaining minute and a half, pros and cons of
vintage versus security level in terms of where the guarantee
is.
Mr. Swagel. Sure. I will just say, the problem with the
vintage approach is that failure is not consequential, right,
or with a cooperative with vintages, there is a failure in a
year, the executives stay there, the shareholders are fine. I
mean, there is not the sort of--there should be fire and
brimstone when there is failure. When the Government has to
write a check, really severe consequences should follow, and
you cannot have that with a co-op that is a single co-op that
is too big to fail. I think there are other ways to address
this sort of a systemic risk. There has to be securitization,
and in some senses, Dodd-Frank does that.
Senator Warner. I am not sure, though, that--and I do not
want to put words in Mr. Tracy's mouth--that it has to be a
single co-op, but one of you speak to it. Mr. Tracy.
Mr. Tracy. No. We have never stipulated that it has to be
one, although we would imagine that you would not have many.
And, yes, while it is important to impose market discipline,
our concern is in periods of a systemic shock and the sort of
market stresses, whether or not all of these bond guarantors
are going to be facing similar pressures. And the market
discipline effect collectively might manifest itself as a
restriction in the ability to supply mortgage credit. So, what
we like about the vintage approach is that it is designed to
help restart the system and make sure that these entities can
continue to lend even after a systemic shock.
Senator Warner. I have run out of time, but I would love to
get--perhaps later, Mr. Canter or Mr. Stevens could give me
their views on that.
Chairman Johnson. Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman, and thank you to
the panel for being here.
Let me, if I might, take a bit of a step back here. As you
know, the House is working on a piece of legislation. The
Senate has S.1217. I think the House concept envisions no
backstop. Let me just go down the panel and ask, first of all,
do you envision any possibility that you would have a workable
system here if there were no backstop whatsoever? And I will
just start with Mr. Tracy, and if you could keep your answers
fairly quick, or fairly short. Mr. Tracy.
Mr. Tracy. I think the problem I alluded to in my statement
was the credibility of that no backstop, and my suspicion is it
would not be credible, so we would be back to an implicit
guarantee. Also, it creates, then, credit risks that the
investors have to manage, and I think that is an advantage of a
backstop guarantee, is that you can basically sell securities
to people who are only interested in managing the interest rate
risk, not the credit risk.
Senator Johanns. Theoretically, at least, and I think
practically, if you have a system where you have got the
appropriate backstop, the whole idea is that you do not use it,
but it is there and it is reassuring to the marketplace.
Mr. Tracy. That is correct.
Senator Johanns. Yes.
Mr. Swagel. So, I would agree with everything that Joe
said, and I would just say, in the House bill, they still have
the FHA as a guarantor, so they do have a Government backstop.
It is more limited than in the Senate version.
Senator Johanns. Right.
Mr. Canter. We do not think it would be workable without a
Government guarantee. Under the presumption that it is
important for the housing market to have 30-year mortgages and
that mortgage availability is vital to the housing market, we
do not think it is workable without a Government guarantee.
Senator Johanns. Yes. Great.
Mr. Stevens. I would agree. And, Senator, to your point, if
you keep the first-loss protection deep enough with private
capital up front, to your point, it would be, obviously, the
desired outcome would be a rare or never instance that the
Government ever gets tapped to back that up. But the
international global markets have confidence to buy those
mortgage-backed securities because they know at least in a
worst-case scenario, they have a counterparty they can depend
on.
Senator Johanns. OK. Let me take that and jump right to
some of your testimony, Mr. Stevens. You were talking about the
whole idea of flexibility, and you are looking at a former
mayor and Governor. I always said to Congress, give me
flexibility. I do not like one-size-fits-all. So, I understand
where you are coming from.
But having said that, here is what I worry about, and try
to convince me why my worry is not justified. You could
literally have a system that I think Senator Warner was
alluding to, where you have a group of mortgages and poor
credit scores and maybe in the part of the country that is not
performing very well and a whole host of factors entering into
that, and what worries me is that that category would almost be
junk bond status.
Mr. Stevens. Mm-hmm.
Senator Johanns. You could go to another area and you would
have, you know, a good economy or wealthy people, big houses,
great credit scores, everything is going right for them, and
they get the triple-A treatment, if you will.
Mr. Stevens. Right.
Senator Johanns. Am I missing something here?
Mr. Stevens. No. This is, obviously, a complex problem that
is difficult to answer in a hearing, but just to lay out some
basic groundwork. So, FHA today is a flat-price model. The risk
is priced the same whether you are the best credits or the
worst credits, and we have seen what happened in that
portfolio.
The other thing we are seeing today, Senator, is in the
risk-based model, which is the way the GSEs are currently
operating, they are actually doing very little high-risk
mortgages. Seventy-five percent of all African American
purchase borrowers got their mortgages through a Ginnie Mae
mortgage in the last 2012 year, not through Freddie Mac or
Fannie Mae. First-time homebuyers are getting their mortgages
through a Ginnie Mae program. So, we are already seeing the
impact in the current purchase market with a very deeply
steeped curve of risk-based cost in the GSE model where the
best credits and the lowest risk are easily being insured or
guaranteed by Freddie and Fannie and everything else is being
traded away.
The adverse selection occurs on the other side, as well,
however. If you look at the private label market, those are the
best credits----
Senator Johanns. Right.
Mr. Stevens. ----the high credit score, lowest LTVs,
highest net worth borrowers are also trading away. So, getting
this balance right so that you do not create market
distortions, I think that is the difficult work that needs to
be discussed as you move forward in your legislative process.
Senator Johanns. I have run out of time. Thank you, Mr.
Chairman.
Chairman Johnson. Senator Merkley.
Senator Merkley. Thank you, Mr. Chair, and thank you, all
of you.
I think the question I was pondering in my mind is a
follow-up to, really, what Senator Johanns was raising, but
maybe presenting a little bit different piece of it. If you
have this variable capital standard based on downpayments and
credit scores, I assume also under that formulation would be
the amount of private market insurance you have incorporated,
and I see a nodding head on that.
In that context, we have--Mr. Swagel has noted that he
would like to see things hard-wired up front because of concern
about pressures on regulators undermining the system. Is it
possible to have the flexibility you are talking about and the
hard wiring that Mr. Swagel is talking about? Are those two
things really driving in different directions?
Mr. Stevens. I will take a stab at this, Senator. The way
we dealt with this in the past with the GSEs is to ensure that
they had a duty to serve the system through affordable housing
goals, and that was one way to encourage that activity.
However, obviously, that is going to be a discussion that will
ensue in this debate.
I do believe that if I look at the worst adverse selection
that took place through interventions, it was at the FHA, where
seller-funded downpayment assistance programs, for example, was
a form of intervention that caused extraordinary harm to that
portfolio, and had it not been there, the portfolio would have
never gone negative. So I think we have reflection points in
terms of the impact of too much interventions, as it were, into
this form or structure, and so framing in the roles.
One of the advantages of the existing GSE structure, for
example, and there are advantages and disadvantages, but one of
the advantages is they are private companies. And so there was
no, other than the goals, it was much more difficult to
legislatively direct them.
So, getting this balance right, both in the flexible
pricing model so that the Government and taxpayer does not get
adversely selected with the worst credits, but also making sure
that there is a structure that interventions are protected to a
point where you do not create systemic risk in the market,
these are the nuances that really have to be teased out, in my
view, in this legislative process, because this is where
getting it right or wrong is going to shift the markets, and we
have seen it today in terms of what is happening. Again, when
the GSEs' capital is only 45 basis points, it created a harmful
outcome, and that is the part that I would love to follow up on
and we would love to follow up on with the Members of this
Committee.
Senator Merkley. Thank you very much.
Mr. Swagel.
Mr. Swagel. I have two quick thoughts. One is on the
flexibility, and I think you got it exactly right, that the
flexibility can be there, and one natural way to do it is to
have an escape hatch in a crisis. During a crisis, private
capital will be scarcer, or less willing to fund housing, so
that is a macro policy decision, have the Fed Chair and the
Treasury Secretary together say that the FMIC can adjust the
amount of private capital and have the Government insurance, in
some sense, expand, as it did in this last crisis.
The second point, on the flexibility, is about this adverse
selection, and I think it is important to keep in mind that the
loans inside the Government guarantee will still be under the
QM standard, so that is pretty safe. Or, at least the industry
has said that is safe. So it is kind of strange to have the
industry say, well, 5-percent capital will give us no adverse
selection, but 10 percent will, when there will still be QM
loans. So I just--I think the adverse selection issue can be
overstated with regards to the 10-percent capital limit.
Senator Merkley. Well, I think that point is pretty
interesting in that, essentially, a piece we often do not talk
about is a form of insurance, is that we have eliminated the
liar loans, if you will--undocumented loans, a more formal term
for it--and proceeded to really eliminate the teaser rate
strategy and the steering payments that incentivize folks to
steer people into high-risk loans. And all of that certainly
provides a significant factor in the broader discussion here.
I was--your point made sense to me, Mr. Swagel, about the
fact that if 5 percent is safe, then the cost of going to 10
percent should be very low. That certainly sounds like a very
logical argument, but I had not heard it presented in that way.
Does anyone disagree with that point or want to throw something
else in there?
Mr. Stevens. Yes. I would just reiterate that in the
transactions we have seen from Fannie or Freddie, which are
very much down the middle credit transactions, very good FICO,
60 to 80 loan-to-values, that it has been shown that, really,
everything above a 2-percent type of level is investment grade.
So that means maybe excess of 5 percent would be rated triple-
A, and again, that opens up a lot of potential buyers.
Senator Merkley. Mm-hmm. Well, is that point, though,
possibly consistent with the point Mr. Swagel made that,
mathematically, the cost of that additional amount should be
low, even if it is not necessary?
Mr. Stevens. Could I just----
Senator Merkley. Yes, yes, please.
Mr. Stevens. --quickly add that, keep in mind that the
FMIC's guarantor program will not be the only outlet. Lenders,
with their consumers, will choose best execution. And so under
a Basel standard, Senator, just as an example, using an 8-
percent capital requirement to hold whole loans at a 50-percent
risk weighting, that is 4-percent capital for those mortgages.
They will remain all of their best credit mortgages. My concern
is not the 10 percent or the 5 percent per se. It is the
relative adverse selection that will occur----
Senator Merkley. Yes.
Mr. Stevens. ----as a result of having one out, two out of
context with the other and having the FMIC ultimately inherit
only the higher-risk mortgages because people have----
Senator Merkley. Yes.
Mr. Stevens. ----the institutions have options.
Senator Merkley. Yes. The difference between different
institutions.
Mr. Stevens. Right.
Mr. Canter. Could I just note that----
Senator Merkley. Yes, I will accept--let me just note, it
is up to the Chair, because I am now over my time, so I will
leave it up to the Chair as to whether we need to----
Chairman Johnson. One more response.
Mr. Canter. Thank you. I just wanted to say, however, if
the extra 5 percent, from 5 to 10 percent, if that capital was
going to try to be raised from the debt market for
corporations, meaning you have an insurance company that is
looking to raise capital by issuing debt, that is a very, very
different story. That would be inordinately expensive. It would
not get nearly the same treatment as a risk sharing
transaction.
Senator Merkley. Thank you.
Chairman Johnson. Senator Vitter.
Senator Vitter. Thank you, Mr. Chairman, and thanks to all
our witnesses.
This discussion is certainly very important, so I thank the
Chairman and Ranking Member for promoting it. I, quite frankly,
think it should have happened a while ago. We are 5 years out
from the crisis and all this was absolutely at the center of
the crisis. So I think we should have attacked this head-on a
while ago, but better late than never and I am eager to move
from this discussion to a markup as soon as possible.
And in conjunction with that, I want to thank and applaud
the work of many Committee Members, including Senators Corker
and Warner and folks who have been working on their bill. I
think that is a very, very strong and positive starting point.
If we were at a markup today, I would support that starting
point. But I really hope it is not eroded in any way,
particularly with regard to key provisions like shielding the
taxpayer from first losses between now and a markup. So, let me
go to some of those issues in my questions.
Professor Swagel, in that bill, Section 204(e) prohibits
entities taking the first-loss position from receiving
Government assistance. Is that prohibition too broad or not,
and if flexibility is added, is it not difficult to impossible
to still be assured that you are really preventing the taxpayer
from being in a first-loss position?
Mr. Swagel. Right. The consequence of failure should be
severe, and that means no bailout, no assistance. The investors
who make bad decisions should suffer losses, and only then
should the Government write checks. So I would avoid that sort
of flexibility, again recognizing that the Dodd-Frank bill has
the kind of protections against systemic risk in Title II.
Senator Vitter. Right. So, again, you would support the
language in 204(e) as it is, not put in that flexibility that
some are pushing for?
Mr. Swagel. That is correct.
Senator Vitter. OK. Well, as you could tell from my earlier
comments, I agree with you, and that is exactly the sort of
retrenchment that I certainly hope does not happen between now
and the markup.
We have touched on this, but again, some are suggesting
that capital requirements in S.1217 are too high, and I have
heard the arguments about adverse selection. Is anybody saying
it is too high just in terms of being able to raise that
capital, because I just point out that when the FDIC released a
new leverage ratio that was due in a short amount of time, $100
billion, bank stocks went up the following few days. So I do
not think the market was shaking in its boots over that. This
is over a 10-year period.
Mr. Stevens. I agree. I think the capital could be raised.
I do not think that is the issue.
Mr. Canter. I think it really depends on how the capital is
raised. I think that if you were just going to strip out the
financial guarantors and they were just financial guarantors
and they kept all the risk, I think that the return on capital
that the equity investors would want to make on that investment
in those companies would be very high. You are talking double-
digit types of returns on 10 percent. That is way too much
capital to raise, OK.
But when you start using the securitization market and risk
sharing transactions, that is when it becomes doable. You know,
we are very bullish on the risk sharing transactions and their
ability to fill that gap, but it is an unknown at this point.
Senator Vitter. OK. Anyone else on that point?
[No response.]
Senator Vitter. All right. If we open up the system to
being capitalized by a greater variety of sources, in general,
can we not bring in capital more quickly if we do that right--
or more cheaply, rather, if we do that right?
Mr. Stevens. Absolutely, Senator. I think that is exactly
right. In exploring more forms of risk share options, whether
it is structured front end, back end, pool, all of those will
bring in opportunities for competition.
Senator Vitter. Anybody else on that point?
Mr. Swagel. I would just say that the initial risk sharing
transactions are very small and they are costly, but as Fannie
and Freddie scale up, there will be greater liquidity and the
costs will go down.
Senator Vitter. OK. Thank you very much.
Chairman Johnson. I apologize for interrupting this
hearing, but we have just reached a quorum and have two
nominees that we need to quickly address. So, this hearing is
in recess and I move the Committee into Executive Session.
[Whereupon, the Committee proceeded to other business and
reconvened at 11:10 a.m.]
Chairman Johnson. Senator Warren.
Senator Warren. Is it all right if I stay here, Mr.
Chairman?
Chairman Johnson. Yes.
Senator Warren. Thank you. Well, it is good to be here. As
the Senator from Massachusetts, home of the World Champion Red
Sox----
[Laughter.]
Senator Warren. ----I have a few questions. I hope I worked
that in subtly.
[Laughter.]
Senator Warren. But, we have been talking about the 10
percent up-front first-loss money ahead of the guarantee and
whether or not that part is right. But, the question I want to
focus on is the back end, that is, when is the guarantee
triggered, because I think that is also very important.
And we have two financing models that we have talked about
in S.1217. One is the bond approach or mutual approach that you
were talking about, Mr. Tracy, but the other is the structured
transaction. And so what I want to focus on is the difference
in trigger between those.
So, as I understand it, one would think in a structured
transaction what we may be doing is every time any particular
transaction runs beyond the 10-percent first-loss money, then
the Government is in the position of writing a check, which
would mean, if that is so, that the Government is in the
position of writing checks long before there is any systemic
risk, but really just backing up a bad deal.
The flip side of that is in a big bond approach or mutual
approach, it is a long time before you see 10 percent of the
first-loss money disappear, and that may mean that the
Government is coming in only long after the market has begun to
crater and we have serious systemic problems. So, I think of
this kind of like a Goldilocks problem, too hot or too cold in
terms of the Government intervention.
So, the first question I want to ask is about how we get
the dial between those two, is there a way to do it, and then
go to the implications of that.
Mr. Stevens, you were nodding. Would you like to comment on
that?
Mr. Stevens. Well, I think you are raising an important
point, and at the highest level, we agree with your premise,
and that is why having various types of options in place for
the credit enhancement component, you know, to keep in mind
before the Government, the taxpayer, gets affected by this, you
have the borrower's equity, you have the first-loss credit
enhancement, and then you have the guarantor who is there, and
then, finally, you have the Federal fund at the regulator
level. So, all of those have to be pushed through in order to
ultimately get to a loss to the taxpayer.
Senator Warren. Right, which is just a way of saying, we
hope we are never going to be there.
Mr. Stevens. That is right.
Senator Warren. But when you sit on this side, you have got
to write the law in the fear that we are going to be there
someday.
Mr. Stevens. That is right.
Senator Warren. That is the point here. So, the question
is, what is the right trigger? Should we be backing up every
deal?
Mr. Stevens. I think, ultimately, the backstop on--we have
to separate the backstop on the MBS itself versus how we
structure the credit enhancement within the transactions
themselves, and I think keeping that dialog separate is
important, right. So the 100-percent guarantee on the mortgage-
backed security for whatever framework of loans are allowed for
within this new guarantor model, that will frame in the size
and scope that the Government's role plays in this new entity.
But once you get past that, we think there needs to be a
variety of competitive structures on the credit enhancement
model itself. So, it cannot do just solely senior
substructures, for example, in this new model. We think there
needs to be multiple entities, as well, because a single entity
can create this too big to fail approach in the cooperative
model.
Senator Warren. So--and I am still trying to work through
that, because I certainly understand--that is why I said it is
a too hot, too cold problem. I understand that part of the
problem. But here is my concern. I do not know how these things
can exist in the same universe in the sense that if I were an
investor and I knew that investing in structured transactions
would get a quicker trigger in terms of when the Government has
to pay, then those will be priced differentially, right?
Mr. Stevens. I do not think so----
Mr. Canter. There is no----
Senator Warren. Everyone will bleed in one--you do not
think they will go that way?
Mr. Canter. There is no reason for the Government to pay
anything on a structured transaction until the capital of the
financial guarantor is wiped out.
Senator Warren. Well, I get that, but that is the question
we are asking.
Mr. Canter. So, on a deal-by-deal basis, let us say on one
deal, a financial guarantee company sells off 10 percent of the
risk, the bottom 10 percent, OK.
Senator Warren. Right.
Mr. Canter. Well, investors take that risk.
Senator Warren. I get that.
Mr. Canter. Well, let us say the risks get to be 20
percent. Well, the financial guarantee company is going to have
to pay the 10 percent in excess of the first 10 percent, not
the Government, OK. The Government would only kick in if all of
the capital for the financial guarantee company were wiped out.
Senator Warren. No, I understand that, but the question is,
you have got differential points at which the Government kicks
in if the trigger is by transaction or by structured deal
versus if it is a mutual pool, and this is what Mr. Tracy was
going to----
Mr. Tracy. Yes.
Senator Warren. ----when he was talking about the vintage
question. But the point is, they trigger differently, which
means--I will put it this way. If they are priced the same,
then the market will show us which one is giving a better deal
for investors.
Mr. Tracy, did you want to comment, and I am now out of
time, so I----
Mr. Tracy. So, the key to the investor is they know that
they are facing no credit risk.
Senator Warren. Yes.
Mr. Tracy. And so that is important. The virtue of the
vintage effect is that there is no uncertainty as to the amount
of losses that the utility is going to take before the
insurance kicks in, and then, importantly, those losses cannot
spill into prior vintages, and so the capital that is being
freed up from those vintages as they pay down is available for
new lending, nor can those losses spill forward so that the
guarantee fees on the new loans also will not need to be used
to pay back any of those losses. So, this helps to support, I
think, lending going on even after a vintage may trigger.
Now, what the threshold is depends on, again, how
frequently do we think, or what circumstances do we want to
call a systemic event? But I do believe that the optics are
important. It is really helpful if the Government is only
paying out in a systemic event, not if a particular security
went bad, not if a particular issuer went bad.
Senator Warren. So, I understand the point, and I will just
stop by saying I get this. The question is whether or not these
can all exist simultaneously or the market will drive away
from, in effect, the mutual pool. All of this, it seems to me,
affects the pricing of the insurance and, ultimately, the
regulatory oversight, which would be very different in a pool
than it would be, for example, in structured transactions.
So, thank you, Mr. Chairman. Thank you for your indulgence.
Chairman Johnson. Senator Corker.
Senator Corker. Mr. Chairman, thank you, and thanks for
having this series of hearings. This is a complex topic and I
think, obviously, it gives everybody an opportunity to ask
complex questions. If mine are redundant, I apologize. I have
been in another hearing.
But I would like to ask Mr. Swagel and Mr. Stevens to talk
a little bit about the fact that one of the ways we are looking
at reforming GSEs is through a bill, S.1217, that a lot of
members up here have been a part of, and I think each of you
have opined about. But one of the things that has been such a
problem is that Fannie and Freddie not only add credit to the
deals, but they also compose all of the plumbing that takes
place, which really makes them, if you will, essential to the
marketplace and, no doubt--I hate using this word, I am so
tired of it--but certainly too big to fail, because without
them, you do not have the plumbing.
One of the things that S.1217 seeks to do, and many others
have looked at in different ways, is to separate that credit
enhancement from the plumbing itself, creating a much more
dynamic situation, and I wonder if the two of you might comment
on that.
Mr. Swagel. Maybe I will start. I think it is really
important in terms of this. This is one of the most desirable
features of S.1217, is the entry and competition. We see today
the negative effects of insufficient competition in mortgages,
right. Too many people do not have access and interest rates
are too high for many people. And this sort of entry and
competition, let others come in, will both help homeowners and
address this too big to fail problem.
You know, one key element to that is having the common
securitization platform so that a new entrant can compete on
equal grounds with, whether it is Fannie or Freddie or large
institutions. So that is a key element in having the
competition.
Mr. Stevens. And, Senator, I completely agree with your
point and what Phil said, is we believe a common utility for
securitization clearly eliminates the dependency on any single
guarantor institution for that process, and I think another
variable benefit for regulators and for policymakers is you get
far greater transparency, both to the regulatory community and
to the markets. We already see the challenges today between
data from Freddie Mac and Fannie Mae and how it is released and
the lack of cohesiveness between the two ways they release
data. Having a single utility that could be accessible by all
institutions, large and small, bank and nonbank, eliminates
that dependency and it creates greater transparency in the
marketplace.
Senator Corker. Thank you both.
Mr. Swagel, there has been some debate about when, under
S.1217--and again, I just keep referring to that because I know
there have been a lot of discussions about it--but the way
S.1217 is now constructed, a bond guarantor would have to go
insolvent prior to any kind of FMIC guarantee kicking in. I
know there have been some folks who have said that is not
workable. I just wonder what your comment might be in that
regard.
Mr. Swagel. I would say it is both workable and appropriate
that the Government should not be writing checks, that the
guarantee should activate only in an extreme situation, and in
between, as markets deteriorate, well, of course, the Fed will
be taking action. Congress can take action, as well. But the
guarantee should be there only for the extreme situation.
Senator Corker. And, I guess, just to sort of tease that
out, there have been people who have said, what we really ought
to do is each grouping, if you will, of securities, if one of
those fails, it should kick in. But-- and I do not know if
anybody else wants to comment on this-- to me, to have it only
kick in when an entity that is guaranteed becomes insolvent
means that the strength of these guarantees has to be really
there, whereas with the other, certainly, you could have much
weaker bond guarantors participating in it. Would that be true
or false?
Mr. Swagel. No, I agree with that, and I think the capital
is there. I mean, there is a search for yield and this is good
origination and people should be willing to take on this
housing credit risk.
Mr. Canter. I would just add that the financial guarantees,
by their very nature, are going to be extremely highly
correlated, and so when one is failing, it is going to be
highly likely that the others are going to be under the stress,
as well, and that complicates the problem of what is the
housing market going to look like then.
Senator Corker. Any other comments on that?
Mr. Stevens. I agree with the premise, Senator, and, as a
matter of fact, there should be early warning signs so that you
know when an institution is close to failure so you can be
prepared to transition any risk to one of the other entities in
order to keep the markets functioning.
Senator Corker. Thank you very much.
I am going to ask Mr. Swagel this question and not Mr.
Stevens, based on what I heard he might have said earlier today
in testimony. But, you know, some people are trying to
correlate the 10-percent capital issue that we are talking
about right now relative to S.1217 and FMIC, or the bond
guarantors, or, candidly, credit-linked notes or AMBPs or
whatever it is, with bank capital, and I would like for you to,
if you would--people are saying, well, bank capital is
different and, therefore, loans are going to flow in a
particular direction. Would you like to editorialize on that,
if you did not in your opening comments?
Mr. Swagel. Sure, and I did not say this in my opening
comments. Banks have a 4-percent capital standard, but they
also have a much more burdensome regulatory regime. There are
capital surcharges for large banks, liquidity requirements,
FDIC deposit premiums, and so on. So, 4 percent in
securitization would not be the same as the bank standard.
The other thing I would editorialize on is to say I think
it is good to have an incentive for lending not to be done
through the guarantee. We want a diversity. We want more
balance sheet lending. So a high capital requirement for
securitized guaranteed lending would lead more lending back
onto balance sheets. I think that is a fine thing.
Senator Corker. Right. Mr. Chairman, I know my time is up.
I do want to thank these witnesses, and, Mr. Chairman, I had a
pretty energized discussion with one of the witnesses earlier
this morning. Look, the housing industry is a big part of our
Nation and I know that we need to get this right. At the same
time, people make a lot of money off this and make a lot of
money off the fact that the Government, candidly, takes a lot
of risk for them. I do look forward to working with you and all
of the witnesses that are here today to try to come up with the
right balance. I hope we can do that soon. But, again, thank
you for having this hearing and I thank each of you for
testifying.
Chairman Johnson. Senator Manchin.
Senator Manchin. Thank you all for being here, and thank
you, Mr. Chairman, for holding this.
I have a problem with the guarantees. I always have had a
problem with the guarantees. When I was Governor, I used to sit
there and watch the taxpayers of West Virginia take all the
risk and someone else get the uptick. It never made any sense
to me. We do not do that in the real world, and the business
world does not work that way, but yet when the Government steps
up to the plate and underwrites everything, you see a lot of
things floating back and forth that normally would not float in
a normal market.
I guess what I would ask any of you, and, Mr. Swagel, maybe
we will start with you again because you have been pretty
outspoken about this, and I appreciate it, but the bottom line
is, you think it will disrupt the markets. Do you think, are we
going to harm or hinder the markets? Everything I am hearing
you say is you think it is going to be more diversified. There
will be more people that are going to benefit than will be
harmed.
And for the naysayers that say, oh, wait a minute, we
cannot operate without Fannie and Freddie, well, if you have
been raking in the unbelievable profits that have been out
there for some people with the Federal Government and the
taxpayers of this country underwriting all the risk, I
understand why you would be upset. We have disrupted your
model, if you will. Give me if I am missing something here.
Mr. Swagel. I agree. The old model was broken and had the--
--
Senator Manchin. Well, we are still in conservatorship,
right?
Mr. Swagel. And we are still in it. We are still----
Senator Manchin. So, no matter how well they might tell you
they are doing----
Mr. Swagel. Yes. There still is----
Senator Manchin. --we are still in trouble.
Mr. Swagel. --capital.
Senator Manchin. OK.
Mr. Swagel. I think that the new system will work and will
benefit people. There has to be a transition. We do not want to
go from zero capital to 10-percent capital instantly, but we
will do that over time and we will buildup to it. There will be
an impact on interest rates, but it will be very modest, in my
view, and the new system will open up capital to many people
who are outside of it now.
Senator Manchin. Right. I mean, if I was taking the risk, I
would go right to Fannie and Freddie.
Mr. Swagel. Yes.
Senator Manchin. And that is where they have been going. So
that makes it very logical. But now, I might have a chance for
someone to say, you have got a pretty good model there. I might
go with you.
Mr. Swagel. I would want private investors to take a risk
on----
Senator Manchin. Well, let me ask you about S.1217. Any of
you all can answer this, if you will. But I know that most of
the Committee has signed onto the bill and everyone is looking
at some way to make it a little bit better. What can you do to
give us some direction of what we could do to modify it? If you
see something in S.1217 that would help it, to enhance it, and
we will start, Mr. Stevens, with you.
Mr. Stevens. Thank you, Senator. And I want to be very
clear. I and the MBA strongly advocates the winding down of
Fannie Mae and Freddie Mac. There are absolutely unacceptable
distortions in the current business model. They are
undercapitalized at 45 basis points. That should clearly be
higher. We have advocated something ten times that amount, or
greater, depending on how the discussion goes.
And I applaud--we applaud the work done on S.1217, without
question. We have provided a lot of feedback to the authors as
well as staff on an ongoing basis and we think there is--it is
clearly, whether it is acknowledged or not, it has become the
baseline text, as is acknowledged by the discussion here today.
Very much looking forward to what the leadership introduces in
the final bill.
I think, at this point, we are talking about complexities
such as issuer guarantor models versus securitization models,
construct of the form of the credit enhancements, and these are
things that we would provide ongoing feedback on. I am not sure
it would be as helpful to go through those here today, but
there is a lot of good in that structure that can be clearly
used in a--and it is hopefully something that gets implemented
in the Committee, or introduced in the Committee.
Mr. Tracy. So, Senator, I might just mention, I think it is
important, given the complexities that we have been talking
about, to keep a degree of humility in terms of our ability to
design, in some sense, an ideal system. And this really
suggests that we take an incremental approach, an approach that
is conservative at the outset, and then as we gain experience,
you can try to sort of expand the approach itself. And so in
particular on things like the underwriting standards and the
credit box, I would start, again, with a more conservative
approach and then expand it as we get more information. But I
do think we need to be humble about our ability to anticipate
every aspect that we may--any of these designs may be faced
with. So we want to be able to build in some learning as this
process is rolled out.
Mr. Canter. I think it is important to leave a lot of
flexibility for the regulator to react to how that transition
is taking place.
Senator Manchin. Sure.
Mr. Canter. The other thing I would mention is that the
bill in the House has an aspect that we like, which is that it
has a prohibition on eminent domain. Eminent domain is where a
municipality could use that power to take a mortgage, and I
think that that would be extremely harmful to any type of
outlet of private label securities. And so a mention of that, I
think, would be----
Senator Manchin. Just very quick, if I may, Mr. Chairman,
do any of you--and you can give a very quick yes or no--believe
that the 10-percent deductible should be modified? Too high?
Too low? Just real quick, and just start right down.
Mr. Stevens. We think there is room for discussion on that
subject.
Senator Manchin. OK.
Mr. Canter. I think it depends a lot on how that 10 percent
is funded.
Senator Manchin. I have got you.
Mr. Swagel. I think it is appropriate, but I agree with
Michael that it has to be done right. But it is appropriate.
Mr. Tracy. And, as I have stated, it depends on the credit
box and all the other dimensions.
Senator Manchin. I have got you. Thank you, Mr. Chairman.
Chairman Johnson. Senator Reed.
Senator Reed. Well, thank you very much, Mr. Chairman, and
gentlemen, thank you for your testimony, and not only your
testimony but the work you have done over many years to help us
understand the issues and come up with some concrete proposals.
Senator Warner and Senator Corker have done, I think, a superb
job in trying to get this process moving forward. Now the
Chairman and Ranking Member are taking it and I commend them
for their activities.
But, Mr. Stevens, we have been going back and forth, the 10
percent, 5 percent, 10 percent. I think everyone can see that
raising the capital is--it is certainly feasible. But you have
suggested there are some unintended consequences of operating
at the 10-percent level. Could you--and I know you mentioned
them before, but could you sort of list them as specifically as
possible.
Mr. Stevens. Senator, I wish I could draw it on a chart,
but I----
Senator Reed. That would help us.
Mr. Stevens. Well, and I will provide that as a follow-up,
some feedback.
I want to be very clear that we clearly acknowledge that
the capital levels of the GSE structure are ridiculously low
and it has created adverse outcomes to the markets. We know
that. The question is, how do you get it right in such a way
that the future system ultimately does not create another set
of distortions.
Credit is spread across geographies, across downpayment,
FICO credit scores, borrower profiles, products, et cetera, and
so when you set a flat capital standard, the true cost of
capital in any loan, depending on where it crosses in the
spectrum, to have a flat line, hard line capital standard when
credit is nuanced across a spectrum could ultimately create
some adverse selection.
I have heard other comments to the fact here in the panel,
but I know for a fact that institutions have options. They do
what is called best execution. We call it Best X. We talk about
it all the time. You have options to hold, sell, securitize, or
other investors in the marketplace. The goal here is to create
a system that is absolutely safe and sound, that puts the
Government only in the absolute worst case catastrophic
position and the capital standard has to go up. If it goes up
too far, the distortion will shift the other way, where
institutions will retain or sell away to other sources the
absolute best product and this FMIC will then be perhaps
undercapitalized because they framed in the box too narrowly as
a result.
And I think that is an opportunity, to the degree that we
can be helpful, we would love to talk about other ways to get
there that hopefully could satisfy the broad set of
stakeholders.
Senator Reed. Let me just follow up with a question, and
that is that at times, we have to restrain the market. We saw
that in 2006, 2007, et cetera----
Mr. Stevens. Right.
Senator Reed. And we didn't because the capital for Fannie
was statutorily 1 percent, because we could implore them, but
they could say, no, we do not have to do anything like this, et
cetera. And then there are other times when, frankly, it is in
our best interest economically to try to encourage the housing
market.
Can I conclude from your comments that this flat sort of
level, if we pick a flat level, will not give us policy tools
to either restrain or support, or am I missing the point?
Mr. Stevens. No, I think that is generally right. The one
thing that S.1217 does have in it is a provision to change the
capital standard in a recession. So I think that was a smart
addition.
But I would say this, Senator, is legislating these numbers
may be locking in to a position where a regulator could do a
better job if they were required to be transparent, use
econometric modeling, use the data elements of the loans that
are being distributed, and make certain that the catastrophic
position of the Government is never breached. And so the
question is, do you legislate the capital standard or do you
set framework in place that the regulator must be obligated to
follow in order to protect the U.S. taxpayer.
Senator Reed. Just my reaction is that there was a
statutory capital limit, I believe, of 1 percent for Fannie and
Freddie, as I recall.
Mr. Stevens. Right, which is too low, though.
Senator Reed. Much too low, but also, it allowed the
entities to always argue with the regulator that they were
doing them a favor by raising more capital because the law only
required 1 percent.
So I think your point is well taken about whether this
should be flexible with regulation, good regulation, or
statutory. It is harder for us to change things around here.
You might have noticed.
[Laughter.]
Senator Reed. My time is rapidly expiring, and Mr. Canter,
I am tempted to jump into the TBA market, which you talk about
arcane issues, but I do not have to tell you. This is what you
do. It is the futures market that allows, basically, mortgages
to be sold before they are technically originated and it locks
in prices. It is the way we operate today. And I think your
testimony suggests that there might be some problems with the
current proposals with respect to the TBA market. Could you
very quickly, because my time is expiring, give us a glimpse?
Mr. Canter. Well, I think what is important is that if we
are going to have financial guarantors that are also going to
be, in essence, guaranteeing the security, that if they were to
miss a payment but yet they are still solvent, the Government
will need to make that payment, and it needs to be clear to the
market that the Government will make that payment.
So, if you are targeting the same investor base as we have
today, that own Fannie-Freddie wrapped securities, it needs to
be clear that we do not have to worry about the ability or the
willingness of a financial guarantor company to make an
interest or principal payment.
Senator Reed. And that--is that implicit in the legislation
that we are talking about today, or is that something we would
have to make clearer?
Mr. Canter. I think it should be clearer.
Senator Reed. Clearer. And that raises kind of the issue,
sort of a big macro issue, of it looks like we are sort of
making--the Government is making up for the miscues of the
private sector on a regular basis, which is not a very popular
position anywhere.
Mr. Canter. Well, I think, given the enormous power that
FMIC would have over that financial guarantor, I think it is
highly unlikely. But, nonetheless, it would be important to
state it.
Senator Reed. Thank you. Thank you, gentlemen. Thank you,
Mr. Chairman.
Chairman Johnson. Thank you all, our witnesses, for being
here with us today. I want to thank Senator Crapo and all of my
colleagues for their continued dedication to housing finance
reform.
This hearing is adjourned.
[Whereupon, at 11:37 a.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF JOSEPH TRACY
Executive Vice President and Senior Advisor to the President, Federal
Reserve Bank
October 31, 2013
Chairman Johnson, Ranking Member Crapo, and Members of the
Committee, thank you for the opportunity to appear before you today. My
name is Joe Tracy. I work at the Federal Reserve Bank of New York.
Today I will be discussing research \1\ in the area of Government
support for housing finance that colleagues and I at the New York Fed
have conducted. It is important for me to emphasize that my remarks
today, and the conclusions of the research that I will share with you,
represent my own views and are not official views of the New York Fed
or any other element of the Federal Reserve System.
---------------------------------------------------------------------------
\1\ http://www.newyorkfed.org/research/staff_reports/sr644.html
---------------------------------------------------------------------------
I commend the Committee for focusing on the elements necessary to
constitute a robust housing finance system in the United States. By
``robust'' I mean that such a system must provide for the uninterrupted
flow of credit to housing markets even in periods of market stress. In
the wake of the financial crisis, significant progress is underway to
improve the resiliency of financial markets. Nevertheless, we must plan
ahead for the risk of future market stresses.
My coauthors and I have started with the observation that in the
face of truly systemic housing shocks, Governments always intervene. It
is not hard to imagine why: given the importance of housing to
Americans and our economy, at some level of housing market stress, the
Government faces intense pressure to take action. We cannot eliminate
the risk that the Government may have to intervene. So we need to
acknowledge that risk and establish a system to reduce and manage it,
or we will re-create an implicit guarantee that puts the taxpayer at
unacceptable risk.
In my view, the private sector (and the borrower) must absorb all
losses up to an agreed point, with the Government absorbing all further
losses. The level at which the Government steps in must be well known
in advance and credible to the market, meaning that there should be no
speculation as to when and how the Government would intervene.
When should the Government intervene? If markets believe that the
Government will intervene sooner than it claims, then this will
generate uncertainty, and financial markets will speculate on the
timing and nature of the intervention. This uncertainty could have a
destabilizing effect, leading to higher losses that the Government
would ultimately have to absorb. A Government guarantee that is unclear
or not credible, even if it is explicit and priced, will result in
greater costs to the Government and, ultimately, the taxpayer.
What should parties pay the Government for its willingness to
intervene? In my view, the Government must determine its exposure net
of the loss absorption capacity provided by the private sector. This
includes evaluating the counterparty credit risks generated by any
risk-sharing transactions. Risk-sharing must require a payment of cash
from the private sector and oversight of the capital and overall risk
profile of any participants in risk sharing. Of course, the required
private capital should be of high quality and should be determined
relative to the total risk associated with a given set of mortgage
underwriting standards. This may sound complicated, but it is not brain
surgery. The Government should bear only the cost of extraordinary
systemic risks and the private sector must bear losses associated with
the normal business cycle. If this can be arranged, then the largest
portion of the overall guarantee fee will be priced by the market and
not by the Government.
An important design decision for a housing finance system is
whether the Government backstop will apply directly to mortgage-backed
securities, their issuers, or some other legal entity. An institution-
based program could erode private sector discipline, while a security-
based backstop would pick up the idiosyncratic and cyclical risks that
are better left to the private sector. Seeking to balance these
concerns, I have explored the notion that Government support would be
triggered by the total losses across an entire group or ``vintage'' of
mortgage-backed securities.
Vintage-based support would likely only be triggered by a true
systemic shock. A vintage approach would also provide a transparent and
finite maximum loss for the private sector to absorb, supporting
robustness at the onset, during, and through the aftermath of a crisis.
I believe that the costs of the recent devastating economic downturn
would have been far less to the taxpayer, and the housing market would
have rebounded far quicker, had a vintage-based program containing
adequate high-quality private capital been in effect.
Attracting private capital to finance residential real estate is
another important consideration. It is difficult for institutions that
depend on short-term funding to take long-term interest-rate risk for
example, the long-term interest-rate risk posed by 30-year fixed-rate
mortgages. It is also difficult for investors who do not do the
underwriting themselves to take long-term idiosyncratic credit risk.
Securitization backed by a predictable level of Government support has
a useful function in facilitating the allocation of these different
risks to different sets of investors through the To-Be-Announced or
``TBA'' market. I think the TBA market will be key to ensuring
Americans' continued widespread access to the 30-year fixed-rate
mortgage.
The TBA market is also important to the role of small banks and
lending institutions in a competitive housing finance system. Ensuring
an easy, predictable path to securitization of standardized mortgage
products is essential to making mortgage credit available throughout
our country--in traditionally underserved rural areas and urban areas,
and to all sorts of current and potential homeowners, provided by
financial institutions of different sizes in different locations. A
strong regulator whose primary focus is the housing finance system can
also help ensure fair access to smaller institutions.
In summary, it is my personal belief that housing finance reform
must incorporate an explicit Government backstop accompanied by
significant sources of high-quality first-loss private capital. Thank
you for the opportunity to appear before you today. I look forward to
your questions.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF PHILLIP L. SWAGEL
Professor of International Economic Policy, University of Maryland
School of Public Policy
October 31, 2013
Chairman Johnson, Ranking Member Crapo, and Members of the
Committee, thank you for the opportunity to testify on housing finance
reform. I am a professor at the University of Maryland's School of
Public Policy and a faculty affiliate of the Center for Financial
Policy at the Robert H. Smith School of Business at the University of
Maryland. I am also a senior fellow with the Milken Institute's Center
for Financial Markets and a visiting scholar at the American Enterprise
Institute. I was previously Assistant Secretary for Economic Policy at
the Treasury Department from December 2006 to January 2009.
It is extraordinary for any private financial activity, asset, or
firm to have a Government guarantee. Any such guarantee should be
strictly limited and with the terms and conditions that reflect the
fact that it should be rare to have arrangements in which American
taxpayers come to the rescue of those who made bad investments.
I see housing finance as an instance in which having an explicit
Government guarantee is a better policy than the alternative of not
having one. Policy makers would feel obligated to intervene if mortgage
loans were not available to Americans during a future financial crisis.
This intervention would take place for social reasons because of the
appropriately special place of housing in our society, and for economic
reasons that reflect the importance of the housing sector for
investment and consumption. Government officials would feel obligated
to intervene if the market for mortgage securities locked up because
these represent a vital part of U.S. financial markets and because
problems in secondary markets would impair the flow of new mortgage
origination.
This means that intervention by the Government is latent. It would
be better to formalize the Government guarantee and have it priced so
that taxpayers are compensated for providing a backstop in housing
finance rather than allowing the Government guarantee to remain
implicit and unpriced. Unfortunately, it is not a simple matter to do
away with the implicit guarantee in housing finance--it is not enough
to simply say that there is no guarantee. A housing finance reform in
which the Government ostensibly does not guarantee housing would
inadvertently re-create the implicit guarantee that was one of the
worst aspects of the previous failed system. The implicit guarantee
made it possible for private shareholders and management to receive the
upside when Fannie Mae and Freddie Mac did well, but left taxpayers
with the bailout when the firms faced collapse in 2008.
Any Government guarantee creates moral hazard. This is not a
problem to solve but a fact of life. The proper policy focus is on how
to minimize the moral hazard, recognizing that the attendant incentives
exist.
The question then is how to best structure the Government
involvement in housing finance to meet the goals of ensuring that
mortgage financing is available across market conditions while
protecting taxpayers from another costly bailout and guarding the U.S.
financial system and overall economy from the systemic risks that arose
in the past failed system. In doing so, it is important to ensure that
the new housing finance system is durable. A future financial crisis is
inevitable despite the best efforts of regulators and supervisors.
Housing finance reform should take this into account.
In looking at the decisions involved with having the Government
provide a guarantee on MBS that is secondary to considerable private
capital, an overarching point is that it is vital to spell out what
happens when the Government must make good on its guarantee. To be
sure, the guarantee should be designed so that the taxpayer liability
is far behind private capital. But eventually there will be another
crisis severe enough to activate the guarantee; otherwise, there is no
point in having one. With this in mind, I see the following key
decisions in designing the guarantee.
Switch the Guarantee to MBS Rather Than Entities
The U.S. Government now effectively stands behind Fannie Mae and
Freddie Mac's insured mortgage-backed securities by guaranteeing those
two firms as ongoing entities. It would be preferable to have the
guarantee formalized--made explicit--and switched instead to attach to
particular MBS rather than firms. This has several advantages. The
first is that this change would allow for entry and competition into
securitization and guaranty. In the past, the implicit Government
guarantee allowed Fannie and Freddie to fund themselves at an advantage
of around 100 basis points compared to other financial firms. But the
market power of the two firms meant that only around half of this
implicit subsidy passed through to mortgage holders in the form of
lower interest rates, with the balance going instead to shareholders
and management of the two GSEs. Recent research provides further
evidence that a lack of competition in the mortgage industry leads to
higher interest rates for homebuyers. \1\ Entry and competition will
help prevent this situation, with competitive pressure pushing to
homeowners any implicit subsidy from underpriced Government insurance.
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\1\ David Scharfstein and Adi Sunderam, 2013. ``Concentration in
Mortgage Lending, Refinancing Activity, and Mortgage Rates'', April.
Available on ttp://www.people.hbs.edu/dscharfstein/Mortgage_Market_04-
2013.pdf.
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Entry and competition will further help address the problem of Too
Big to Fail institutions. In the fall of 2008, policy makers felt
obligated to avert the collapse of Fannie and Freddie to avoid a
situation in which American families could not obtain mortgage lending
and the banking system needed to be recapitalized en masse to offset
losses on GSE securities. Allowing additional firms to participate in
the activity of securitization and guaranty for mortgages that qualify
for Government backing will ensure that these firms can fail without
the need for a bailout.
At the same time, it is possible that a future financial crisis
will lead to the failure of many or even all firms that perform
securitization and guaranty. In this case, it is likely that the
Government would feel obligated to intervene to keep one or more in
operation. This could be done using the authorities in the Title II
Orderly Resolution Authority of Dodd-Frank. Under Title II, the
Government could put money into a failing securitization and guaranty
firm to ensure that at least one such entity remained operational to
allow the continued flow of mortgage financing. A natural course of
action would be for the assistance to be withdrawn as other private
sector firms are constituted to enter the market. The Government
eventually would be repaid for any losses suffered as a result of this
assistance, in this case by a tax on the rest of the financial system.
There is thus the ability to maintain the flow of mortgage financing
even in the face of industry-wide losses that swamp all participants in
mortgage guaranty. A system of multiple firms each of which is allowed
to fail is fully consistent with the idea that securitization activity
must continue throughout a crisis.
The alternative to allowing competition and entry is to have a few
firms--just one or two would be natural given the scale economies
involved--that are guaranteed as entities. Such an arrangement would
ensure the continuity of mortgage securitization, but give up the
benefits of competition and innovation. A securitization cooperative in
which the Government backstop applies one vintage at a time likewise
would miss out on benefits of competition for consumers and limit the
extent to which mortgage industry participants suffer appropriate
consequences in the event of failure. Continuity of the industry is
important, but this can be assured without giving up other benefits of
housing finance reform.
Ensure Considerable High-Quality Private Capital Ahead of the
Government Guarantee
Having substantial private capital in the first-loss position will
both protect taxpayers and provide market participants with an
incentive for prudent behavior in mortgage origination. It would be
useful to have private capital in a variety of forms and through
multiple mechanisms. In particular, private capital should be present
at both the level of the individual loan through homeowner downpayments
and private mortgage insurance, and at the level of mortgage-backed
security. For individual loans, the salient role of underwater
borrowers since the collapse of the housing bubble has made clear the
importance of homeowner equity. The collapse of Fannie and Freddie
likewise made clear the importance of capital at the level of the
securitization. MBS-level capital can be put in place in through both
common equity of the firm that performs the securitization and
purchases the Government guarantee, and through various forms of risk
transfer. This could include subordinated MBS tranches or other capital
market structures such as credit-linked notes, or through capital
provided by MBS insurers, provided that this insurance capital is
strictly overseen to ensure that it represents risk-bearing capacity.
The key in all cases is to ensure that the private capital can bear
losses when they come, recognizing that this could be in the midst of a
difficult financial market environment. In the recent financial crisis,
insurance capital was problematic in some instances, as highly rated
insurers such as AIG did not have the financial wherewithal to make
good on their commitments when needed. This suggests a preference for
equity capital and for capital market structures such as subordinated
securities in which it is clear in advance that the financial resources
exist to bear losses. It is possible for investors to use leverage in
capital markets transactions--the purchasers of a credit-linked note,
for example, could borrow the funds with which to take on that risk.
But such concerns are omnipresent--the risk will exist somewhere, and
ultimately the regulators of other industry participants must be relied
on to ensure the soundness of the banking system (if this is the
provider of leverage in housing). The key for housing finance reform is
for the housing credit risk taken on by private investors ahead of the
Government to be clearly identified and funded.
Ten-Percent Capital Requirement
The Housing Finance Reform and Taxpayer Protection Act (S.1217)
includes a 10-percent capital requirement at the MBS level, in addition
to the norm of a 20-percent capital requirement at the level of the
individual mortgage from homeowner equity and private mortgage
insurance. This 10-percent MBS capital requirement is both appropriate
and essential. By way of comparison, the total losses of Fannie Mae and
Freddie Mac were shy of 5 percent of their assets, so a 10-percent
requirement represents a considerable amount of capital. Indeed, there
is a sense in which a 10-percent capital requirement at the MBS level
is closer to 100 percent than the current capital requirement of zero,
since 10 percent would have been enough for the two firms to have made
it through the crisis. I recognize that the existence of an explicit
guarantee is a huge step for people concerned about bailouts and the
adverse effects of Government intervention in housing finance. A 10-
percent capital requirement should provide considerable comfort that
taxpayers are protected from future bailouts.
At the same time, it should be kept in mind that the losses at
Fannie and Freddie in all likelihood would have been considerably
higher had the Government not intervened to support the housing market,
not just through the injection of capital into the two firms but also
through the actions of the Federal Reserve in purchasing over a
trillion dollars of the two firms' securities. Such quantitative easing
by the Fed effectively reduced the losses at the GSEs. This suggests
caution in looking at a 5-percent capital requirement as sufficient. A
future system with 10-percent capital would not have to rely on such
unprecedented central bank or taxpayer intervention to withstand a
repeat of the recent crisis.
Members of the Committee should look skeptically at assertions that
a 10-percent capital requirement will have a serious adverse impact on
the housing recovery--and even more skeptically at suggestions that
this amount of capital is simply not available to finance housing. To
be sure, a steeper capital requirement will translate into higher
interest rates, but the impact should not be overstated. Recent
analysis by Mark Zandi quantifies the impact of recapitalizing the
housing finance system under a structure such as that envisioned in
S.1217, and puts the interest rate impact at just above 50 basis points
for the average borrower. In a normal economic environment, the Federal
Reserve can shift interest rates by 50 basis points or more over the
course of a 2 day FOMC meeting. And of course the Fed would be watching
the impact of any increase in rates on the housing market and the
overall economy and presumably would use monetary policy to help lessen
the macroeconomic impact. Moreover, Mr. Zandi's analysis so far has
assumed that the 10-percent first-loss private capital has a uniform
structure--that it is entirely common equity. Allowing for this private
capital to be tranched, as envisioned in S.1217, would result in lower
estimates of the impact on mortgage interest rates.
To be sure, the mortgage interest rate impact is not zero, and will
come on top of eventual interest rate increases when the Federal
Reserve finally normalizes monetary policy. But affordability remains
strong and the housing recovery will continue even with higher rates--
indeed, moving forward with housing finance reform that spurs a return
of private capital will lessen the barriers now faced by too many
borrowers in obtaining access to mortgage financing.
In evaluating the incremental impact of the 10-percent capital
requirement over a smaller one such as 5 percent, it is important to
keep in mind that the private capital ahead of the Government can be
split into tranches. Investors will receive a higher return to take on
the first-loss position at the bottom of the capital stack, reflecting
the fact that the risk of the first 5 percentage points of housing
credit risk is greater than that of supplying the fifth to tenth
percentage points of private capital.
The incremental cost of capital and the degree to which taxpayers
are protected by the capital go together. If 5-percent capital is a
safe amount to protect taxpayers, then this means that the incremental
cost of going from 5-percent capital to 10 percent will be modest--
after all, the capital position from the fifth percentage point to the
tenth point is quite safe. Putting it more starkly, an assertion that
the incremental cost of going from 5-percent to 10-percent capital is
not modest should be taken as a signal that 5 percent is not an
adequate capital requirement to protect taxpayers. It is not possible
to have it both ways--to say that 5 percent is safe but that 10 percent
is costly.
This is of course the usual implication of the renowned Modigliani-
Miller theorem, but this is not an academic or theoretical statement.
For sure there is a cost from higher capital, since the Modigliani-
Miller conditions do not hold in practice--in particular, the tax code
with its double-tax on the return from capital provides an incentive
for the use of debt finance over equity. But members of Congress should
look skeptically at those who deny that incremental capital will have a
modest cost impact, especially if such claims are accompanied by
noxious assertions about the supposed difference between ``academia''
and the ``real world.'' There are costs of additional capital, but
these are too readily exaggerated.
A related issue is the claim that there is simply not enough
capital available to fund housing with a 10-percent capital
requirement. This is equivalent to saying that the yield required to
attract 10-percent capital is unimaginably high--that capital will not
take on housing credit risk regardless of the rewards. This assertion
is hard to take seriously in an era in which monetary policy has driven
down long-term interest rates and spurred a search for yield.
At the same time, the capital requirement should not instantly
change from the current situation of zero up to 10 percent--there
should be a transition period during which private investors become
comfortable with the mechanisms by which they take on housing risk and
the attendant markets for housing credit risk become more liquid.
The amount of capital involved in a 10-percent capital requirement
should be viewed in context. In round numbers, total U.S. financial
market assets are on the order of $50 trillion, split roughly equally
between equity and fixed-income securities. Housing finance is about
$10 trillion of this (with the value of the housing stock roughly twice
as large). If eventually housing finance reform results in a system in
which half of mortgages are guaranteed and half are not, this means
that a 10-percent capital requirement needs about $250 billion more in
capital than one with a 5-percent capital requirement. This additional
$250 billion is a one percentage point shift from fixed-income
securities into equity. By further way of comparison, banks and the
GSEs together raised around $400 billion in capital in 2007 and 2008 in
the face of mounting mortgage losses. We have all learned over the past
5 years that a safer financial system requires more capital--if
anything, the higher mortgage interest rates reflect the fact that the
financial system was previously undercapitalized. Higher rates
correspond to increased protection for taxpayers.
Diverse Sources of Funding From a 10-Percent Capital Requirement
A 10-percent capital requirement will both protect taxpayers and
provide appropriate incentives for diverse sources of funding for
mortgages (in addition to the incentive for prudent behavior by those
with capital at risk). Starting from the situation of today in which 90
percent of mortgages have Government backing, it would be desirable to
have more lending done without a Government guarantee so that private
investors can finance those who fall outside the Government-backed
programs. This would include both balance sheet lending and
nonguaranteed private label securitization.
While nonguaranteed MBS played an important role in the run-up to
the financial crisis, the regulatory regime has changed, including
through the advent of the Consumer Financial Protection Bureau (CFPB)
to address behavior by nonbank originators. With this in mind, a
revival of private label securitization is a desirable policy outcome,
to end up with a mortgage market with many sources of capital and a
greater share of housing market risk borne by private investors rather
than taxpayers. Ultimately it should be seen as a policy success to
have some mortgages that could receive a guarantee choose not to obtain
one. I recognize the concerns that poor lending practices will reemerge
with the private label market but see the regulatory apparatus,
including the CFPB, as the right way to address this issue. The
alternative would be to have the vast majority of mortgage loans
receive a Government guarantee as is the case today, with the attendant
current downside of the restricted access to financing for too many
potential borrowers. It is better to allow private providers of capital
rather than the Government to fund incremental borrowers, including by
having private providers of capital figure out which risks to take on,
and reap both the rewards from these investments and the consequences
when loans go bad.
A related concern over a revival of private label securitization is
that Government policy makers will feel obligated to carry out an ex-
post bailout in the next crisis. I believe the experience of the
financial crisis shows that this is not correct in that the policy
focus in the crisis was on ensuring the flow of new financing--that was
a paramount reason why Fannie and Freddie were bailed out. Similarly,
the TALF program was set up by the Treasury and Federal Reserve to
ensure the flow of new securitization to support lending and economy
activity and did not provide an ex-post bailout to legacy assets. These
considerations likewise argue against an expansion of Government
guarantees more broadly than housing to other securitized assets such
as by setting up a permanent TALF. I see an implicit guarantee as
inevitable in housing and thus prefer to make it explicit and priced.
But this is the not the case for other securitized lending.
A Government guarantee gives rise to adverse selection, as
originators seek to obtain a guarantee on risky loans. This is a
concern for any plan with a guarantee, regardless of the capital
requirement--this applies just as well to a system with a 5-percent
capital requirement as it does to one with a 10-percent requirement. If
anything, the concern over adverse selection highlights the importance
of the housing finance regulator, whether FHFA or FMIC, ensuring that
origination standards remain high for loans to be eligible for a
guarantee and that the private capital standing in front of the
Government is able to absorb losses when needed.
Still, it is the case that setting the capital requirement at 10
percent when banks have a 4-percent capital requirement for mortgages
held in portfolio provides an incentive to have some loans stay on
balance sheet and others go into guaranteed securitization. But again,
this same concern applies even if the MBS capital requirement is the
same 4 percent as for depository institutions under the Basel
standards--once a guarantee is available, originators will have an
incentive to obtain a guarantee on their riskiest loans.
Moreover, while banks have a capital requirement of 4 percent for
mortgage assets under the Basel framework, they face a broad suite of
regulation that does not apply to securitization outside of insured
depository institutions, including the threat of prompt corrective
action when things go bad, deposit insurance premiums, and a capital
surcharge and enhanced liquidity requirements for large banks.
Adjusting for these factors means that equivalent capital requirement
to compare balance sheet lending to securitization is probably more
like 5 or 6 percent rather than the simple 4-percent Basel capital
charge. The disparity between the 10-percent capital requirement for
guaranteed MBS is thus smaller than it seems. And again, it should be
extraordinary for any financial sector activity to receive an explicit
Government guarantee. An elevated capital requirement is appropriate in
this circumstance. An incentive for balance sheet lending and
nonguaranteed securitization is welcome, not problematic.
I further suggest that housing finance reform legislation include a
mandated minimum capital requirement--again with 10 percent as an
appropriate figure--rather than allowing regulators to determine this
crucial figure. Experience and expectation suggest that political
pressures will push regulators in the direction of less capital. This
should be avoided. The housing finance regulator is still left with the
vital task of ensuring that the capital is high-quality and able to
absorb losses. But with the capital requirement representing the
bedrock foundation on which protection for taxpayers rests, it would be
desirable to have this specified in the legislation.
Activation of the Guarantee
As in the Housing Finance Reform and Taxpayer Protection Act
(S.1217), I would have the secondary Government guarantee kick in only
after the entire private capital of the entities taking the first-loss
position at the MBS level. The Government would then cover the full
principal and interest of the guaranteed MBS. Such an arrangement would
ensure that an event in which the Government pays out on the guarantee
is both rare and consequential.
Private capital at the MBS level could include the equity of the
private firm that undertakes the securitization as well as capital that
shares the risk such as through credit-linked notes and other
structures. The 10-percent capital requirement in this setup would
require the securitizer to gather private capital equal to 10 percent
of all of the guaranteed MBS it creates. The entire capital required
for all guaranteed MBS from a firm would be on the line before the
Government pays on any MBS. This ensures that the guarantee will rarely
activate and that the Government will not have to write checks on
individual MBS or even multiple MBS that go bad within a particular
vintage of origination.
Activation of the guarantee would then be associated with the
failure of the private guarantor that has arranged the first-loss
capital. This is appropriate to ensure that the investors and
management involved with the private guarantor suffer the full
consequences of failure: shareholders go to zero, management is
replaced, and the full losses are imposed on other investors who have
taken on housing credit risk. These consequences are attenuated in
alternative approaches in which the Government guarantee applies to
only a vintage of origination at a time. In such a setup, less capital
is in front of any one vintage meaning that the guarantee will activate
more frequently. With a cooperative structure that persists over time,
the management and shareholder/participants of the cooperative likewise
do not suffer the full consequences of failure--the cooperative
continues and shareholders and management remain.
Adjusting the Capital Requirement
Provisions to adjust the amount of first-loss private capital would
be useful to adapt to temporary circumstances in which the willingness
of private investors to supply capital for housing recedes in the face
of market uncertainties. Such a mechanism should have safeguards,
however, so that it is used infrequently. Policy makers should not seek
to ensure that homeowners can obtain low interest rate loans at all
times, and should not look to make frequent adjustments to the settings
of the housing finance system for the purposes of macroeconomic
stabilization. Instead, the Federal Reserve should have the primary
responsibility for macro stabilization policy, with changes to housing
finance used only when the Fed is not able to achieve its dual
objectives.
To ensure this separation between housing finance and macroeconomic
stabilization, the director of the housing finance regulator should not
have the authority to adjust the required amount of capital. This
should be left instead to a joint decision of the Fed Chair and
Treasury Secretary, along the lines of the revised Fed authorities
under exigent circumstances. As in S.1217, it is appropriate to ensure
that any reduction in the capital requirement be explicitly temporary
and subject to a limited number of renewals by another decision of
those two officials. Such a limited timeframe for renewal of a reduced
capital requirement is useful to ensure that the minimum capital
requirement is not subverted. A crisis lasting longer than 12 or 18
months--one or two renewals of the initial 6-month authorization for a
reduced capital standard--is appropriately addressed by legislation
rather than regulatory initiatives.
Market Structure for Guaranteed Securitization
The approach taken in S.1217 would arrive at a housing finance
system in which multiple firms compete in the business of
securitization and guarantee, gathering the required private capital
and purchasing the secondary Government guarantee. As noted above, such
a system would involve competitive pressures that pass on the benefits
of any inadvertent Government subsidy from underpricing of the
secondary insurance to homeowners through lower interest rates.
Multiple firms would likewise help address the too big to fail problem
by ensuring that one or more could fail without impairing the flow of
mortgage financing.
A key requirement for such a system is that sufficient firms are
willing to enter into the business of securitization, gathering the
private capital and purchasing the secondary Government guarantee.
S.1217 appropriately looks to jump-start the process of entry and
competition by making all of the infrastructure of the existing GSE's
licensable to approved issuers of guaranteed MBS (this infrastructure
is the property of Fannie and Freddie, which remain private firms, and
thus would be obtained for compensation). Among the new entrants would
be a mutually owned firm to ensure that smaller banks have access to
the secondary Government guarantee without having to go through one of
the large banks that today dominate mortgage origination (a single
securitization cooperative inevitably would be dominated by large
banks). This step of licensing infrastructure would considerably reduce
the startup costs for new entrants. Similarly, the requirement that all
guaranteed MBS trade on a common securitization platform would ensure
that new entrants have the benefits of the full market liquidity. This
would avoid a situation in which the securities of a new entrant trade
with a considerable liquidity penalty over those of incumbents. The
housing finance regulator would likewise be tasked with looking out for
anti-competitive practices, including such as the past use of volume
discounts that tended to lock originators into particular channels for
securitization.
The system in S.1217 would require entry by enough firms to ensure
competition. It is hard to say how many are required, but at least
three and preferably five seems reasonable as a balance between having
enough competition and avoiding TBTF concerns, while not dissipating
the natural scale economies involved in housing finance. A variety of
firms might be expected to enter into the business of securitization
and guaranty, starting with entities that now take on housing credit
risks--both investors such as asset managers and private equity funds,
and originators such as banks. As noted above, an essential part of
housing finance reform is to ensure that smaller institutions have
access to any secondary Government guarantee without the need to rely
on the existing large banks.
Looking ahead, the Government eventually could ensure the return of
nonguaranteed lending by auctioning off a limited amount of insurance
capacity for the Government guaranty. The balance of mortgages would
then go into the various forms of nonguaranteed lending. Such a system
would further help ensure that the risk taken on by taxpayers through
providing the secondary Government guarantee is appropriately priced in
an auction setting.
Conclusion
A housing finance reform that creates an explicit guarantee is
appropriate with considerable protection for taxpayers in the form of
first-loss private capital, but should be seen as an extraordinary
ongoing intervention of the Government in the market. In allowing for a
guarantee, it is vital to avoid having housing finance reform re-create
other aspects of the previous system that failed so badly and imposed
immense costs on taxpayers. This would include ensuring that the
retained investment portfolios are not allowed for firms with access to
the guarantee, and avoiding re-creating the previous housing goals that
distorted behavior (though the goals were not a primary driving factor
behind the collapse of the two GSEs). Any subsidies for affordable
housing activities should be done through explicit expenditures and not
through housing goals or by imposing duties to serve various
populations on firms participating in the housing finance system.
A new housing finance system will be beneficial for individual
homeowners by providing new channels through which borrowers can obtain
mortgage funding, while providing benefits of greater protection for
taxpayers and increased stability for the overall economy. An
appropriately designed Government guarantee can be an element of such a
new system.
______
PREPARED STATEMENT OF MICHAEL S. CANTER
Senior Vice President and Director of Securitized Assets,
AllianceBernstein, on behalf of the Securities Industry and Financial
Markets Association
October 31, 2013
Chairman Johnson, Ranking Member Crapo, and Members of the
Committee, thank you for the opportunity to testify before you today.
My name is Michael Canter and I am Senior Vice President and Director
of Securitized Assets at AllianceBernstein, testifying today on behalf
of the Securities Industry and Financial Markets Association (SIFMA).
\1\ SIFMA and its members look forward to working collaboratively with
you all in analyzing how policy choices made will affect the ability of
secondary mortgage markets to provide liquidity to lenders, and thus
the availability and cost of credit to support housing finance.
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\1\ SIFMA brings together the shared interests of hundreds of
securities firms, banks, and asset managers. SIFMA's mission is to
support a strong financial industry, investor opportunity, capital
formation, job creation, and economic growth, while building trust and
confidence in the financial markets. SIFMA, with offices in New York
and Washington, DC, is the U.S. regional member of the Global Financial
Markets Association (GFMA). For more information, visit www.sifma.org.
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Among other priorities which I will discuss, SIFMA and its members
believe that the preservation of the ability of secondary markets to
support the 30-year, fixed-rate mortgage should be a key priority. The
30-year fixed-rate mortgage is a stable and predictable way by which
most Americans have historically financed their home purchases. While
adjustable rate and shorter-term mortgages have benefits of their own,
the 30-year mortgage provides for an affordable and predictable payment
for many borrowers. Such 30-year mortgages, however, present
significant risks to lenders and investors in that the stream of
interest income is locked in over a long period, regardless of where
funding costs move. To manage this risk, lenders need access to a
liquid, forward market for mortgage loans. Without such a market to
manage interest rate risk, lenders would be less willing to originate
30-year fixed-rate loans and many would likely not originate them at
all.
Indeed, SIFMA's primary focus in considering reform of the housing
Government-Sponsored Enterprises (GSEs) is the preservation of a
liquid, forward market for the trading of mortgage-backed securities
(MBS). Today, the ``to-be-announced'' (TBA) markets serve this
function. The TBA market serves a critical function in our current
system, allowing mortgage originators to sell conforming loans before
they are originated, enabling them to provide interest rate locks to
borrowers well in advance of closing while hedging their risk. This
allows the borrower the ability to lock in a rate well in advance of
settlement. Furthermore, the TBA market provides the necessary
liquidity that enables a national market whereby regional differences
do not impact credit availability for borrowers in particular
locations, as MBS traded in the TBA market tend to be geographically
diverse. In addition to the loan origination aspect, the TBA market
provides an important benefit to investors such as pension plans,
401(k) plans, mutual funds, State and local Governments, and global
investors. Indeed, with over $250 billion of securities traded on an
average day, the TBA market is the largest and most liquid secondary
market for mortgages, and second only to the U.S. Treasury securities
market in terms of bond market activity.
Today's hearing asks this panel to consider the essential elements
of a guarantee but to flip that a bit, an essential element of the TBA
market is the guarantee itself. Homogeneity is what makes the TBA
market succeed. In this market, buyers and sellers agree on certain
terms of a trade, but importantly buyers do not know all of the
specific characteristics of the security they have purchased until 2
days before the trade settles. This is what allows liquid forward
trading, and allows originators to hedge production pipelines.
The homogeneity is driven by two main factors: standardization of
terms, and the absence of credit risk. Terms are currently standardized
through the GSE's lending, servicing, documentation, and other
guidelines. Credit risk is addressed though the implied but near-
explicit Government guarantee on the principal and interest payments of
the MBS. A structure whereby private capital would take a first
position loss with a limited Government guarantee supporting losses
beyond the first position loss would serve to diminish any credit risk
concerns. This allows for what is essentially a one-factor analysis of
the market--that of prepayment risk or the risk that borrowers will
refinance or otherwise repay principal before it is due in response to
changes in interest rates. It is a so-called ``rates market'', as
opposed to a ``credit market''. The guarantee serves another beneficial
function by attracting investors who would otherwise not invest in MBS.
Possibly the most important benefit of the guarantee is the support
that it provides to the market in times of crisis--it allows investors
to fund mortgage credit creation even at times when other markets
become less liquid. This was tested in 2008, when private-label MBS
markets completely shut down, bank portfolios significantly contracted
lending standards, and the GSE and FHA markets took on the vast
majority of credit provision. Without the guarantee, credit would have
dried up as it did for corporations and other significant borrowers.
And what mortgages could be sold would have been far, far more
expensive. No one disagrees that the role of the Government must
shrink, but it must also be recognized the critical countercyclical
role the guarantee plays.
Sharing Risk With the Private Sector
When thinking about the private capital that should stand in front
of the guarantee, we believe that the risk that taxpayers are exposed
to losses should be very remote and that risk should stand behind a
number of levels of private capital acting as a shield or buffer. In
arranging such a system, the various sources of private capital
protecting the Government should be recognized:
Borrower equity;
Equity capital in loan- or pool-level mortgage/bond
insurance providers and/or providers of corporate guarantees
\2\ and capital markets-based risk transfer transactions; and
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\2\ We note that such entities should be required to be adequately
capitalized and regulated to withstand events such as the recent market
downturn and avoid the recent experience of rescissions and denied
claims.
Well-capitalized insurance reserve funded by fees paid for
---------------------------------------------------------------------------
Government backstop.
Introducing market-based risk taking into the system will confer an
important benefit on the system. Global capital markets are often more
able to accurately price mortgage credit risk than a Government agency
or regulator. Capital market participants also price risk on a relative
basis, in comparison to other investment options, and this should help
temper risks of a race-to-the-bottom. To the extent that mortgage risk
becomes underpriced, participants should gravitate toward alternatives
that provide more attractive returns, tempering the level of
underpricing. Of course, this pricing of risk will not be perfect, and
it will not necessarily in and of itself service whatever goals policy
makers may set forth. It will, however, provide critical signaling to
the world as to exactly what level of risk taxpayers are taking on as
they provide the ultimate guarantee for the new conforming MBS, and
should promote a more safe and sound system.
A consideration here is that a mandatory, fixed level of risk
sharing could contribute procyclically to fluctuations in mortgage
markets and credit availability. We could support an approach where
mandatory levels of risk sharing fluctuate in relation to the demand
for mortgage credit risk. If constructed otherwise, the regime will
tend to exacerbate booms and busts. If there were housing market
distress, risk would be more expensive to sell, and that would increase
the cost of credit. Increases in the cost of credit could exacerbate
housing market distress. This is not to say that it is inappropriate
for mortgage rates to fluctuate due to economic or other factors, but
rather that it is appropriate for policy makers to have levers to ease
extreme periods of dislocation before they become systemic problems.
Importantly, significant changes in the pricing of this risk will
signal to regulators and policy makers that something is happening in
mortgage markets that may warrant further study. One of the most
important factors in considering how first-loss capital should be
introduced into the markets for the new conforming MBS is whether or
not a particular approach will disrupt the critically important
liquidity of the TBA market.
Securities-based structures to take first-loss risk have important
advantages and disadvantages. Some securities-based proposals involve a
requirement that risk be shared with capital markets investors
concurrently, or near concurrently, in order to obtaining a Government
guarantee. We note above that the TBA market provides important price
information to lenders that allows them to hedge risk and provide rate
locks to borrowers. To the extent that obtaining a Government guarantee
is conditioned upon the prior sale of a set amount of risk into private
markets, advance price information may not be available to the lender
because there is no liquid, forward market for mortgage credit risk.
This will make it harder or impossible for lenders to provide rate
locks to borrowers because the cost of the risk sharing is a factor in
the pricing of the loan. This would likely cause significant problems
for the liquidity of the TBA market, and could potentially render it
inoperable. This implies that risk sharing requirements are better
structured to not be a strict concurrent mandate with the issuance of a
new conforming MBS--risk needs to be warehoused somewhere for a period
of time.
The liquidity of the current GSE MBS markets must flow seamlessly
into the new market; this $4 trillion market cannot be orphaned in the
transition to the new system. Abandoning outstanding securities would
immediately diminish liquidity and value in the market for existing GSE
MBS, and would likely damage the confidence of current global investors
as regards to the merits of investing in the new securities. It would
also mean that the market for the new form of conforming MBS would
start with zero liquidity--it would be very volatile, and would not
offer attractive pricing to lenders or borrowers. Therefore, the form
of the conforming MBS in the future needs to be generally compatible
with the form of conforming MBS today, or at least not so different
that the current GSE MBS could not be converted into the new form or
otherwise made fungible.
To the extent that capital-markets risk sharing mechanisms involve
security structuring, such as in a senior/subordinate arrangement,
there is a risk that homogeneity will be lost among different
structures and this will cause difficulties in promoting a liquid TBA
market. It would also be more challenging to ensure these securities
would be fungible with existing MBS in a common TBA market. That does
not mean this structure should be discarded but it is an important
factor to keep in mind.
Capital markets transactions similar to Freddie Mac's STACR or
Fannie Mae's CAS series are viewed as the most viable currently used
form of risk sharing with capital markets. Since these types of
transactions do not impact security structure, they do not have an
impact on the functioning of the TBA market. They are also flexible and
should be able to accommodate various investor needs and strategies for
sharing risk with them. \3\ However, their performance through a cycle
and ease of execution in less favorable market environments has not yet
been observed. Other arrangements that do not alter security structure,
such as the pool-level mortgage insurance transaction recently executed
by Fannie Mae, also appear to be compatible with TBA.
---------------------------------------------------------------------------
\3\ There is a related, specific inefficiency that should be
remedied in housing finance reform legislation. The CFTC's commodity
pool regulations would cover risk-sharing transactions executed with
credit-linked notes or other derivatives. Characterization of the
transaction as a commodity pool, and its sponsors as commodity pool
operators, would require the sponsors of the transaction to comply with
burdensome and not particularly relevant reporting, registration,
disclosure, and other requirements which were intended for operators of
true commodity pools (i.e., those which invest in true commodity
interests such as cotton or grain). The original design of the GSE's
recent transactions was in the form of credit-linked notes. Because of
these still unresolved issues, the transactions were significantly
delayed, and were changed to a less efficient securities-based
structure. Legislation should ensure that these types of risk-sharing
transactions are exempted from characterization as commodity pools, and
that their sponsors are not deemed to be commodity pool operators.
---------------------------------------------------------------------------
There are similar considerations for models that involve private
guarantors, especially regarding how many there should be. The range is
from zero (i.e., FMIC is the guarantor in the system) to one, two, or a
multitude of privately owned entities. Advantages to a greater number
of first-loss credit providers include the ability to optimize
execution among competing pricing and eligibility criteria, insulation
from operational failure of any single first-loss credit provider,
greater variety and more innovation in product offerings and more equal
bargaining strength between the first-loss credit provider and mortgage
originator.
On the other hand, fewer first-loss credit providers would offer
increased product standardization, enhanced liquidity for both loans
and securities, and lower total cost of infrastructure. Due to the
extreme correlation of their business models, the benefits of risk
diversification stemming from larger numbers of first-loss credit
providers are likely smaller than they may appear.
Finally, competition among first-loss credit providers creates a
risk of ``race to the bottom'' pricing and guideline offerings. A
similar issue also arises in Co-Op structures where members may attempt
to gain market share or increase margins by making riskier loans and
``free riding'' by delivering them into the Co-Op's pricing, which is
based on aggregate collateral performance. This argues for a focused
effort to ensure that competition is promoted among guarantors and
other parties. Barriers to entry should be limited to the level that is
necessary to ensure a stable environment; regulatory standards should
be high enough to ensure that incentives to ``race to the bottom'' are
mitigated.
Transition Issues
As many have noted, the transition to whatever new system policy
makers create is just as important as the new system itself. Put
simply, the Government should reform, repeal, or avoid policies that
repel private capital or generate uncertainty. Private market
participants demand transparency and certainty in their investments and
capital allocations. Many factors and events during and stemming from
the recent financial crisis have caused private capital to retreat from
funding mortgage credit. In particular, the potential for seizures of
loans through a municipality's use of eminent domain run the risk of
causing private capital to once again flee the mortgage markets. Such
actions, if they are allowed by policy makers to proceed, would damage
investor confidence in mortgage markets and drive the cost of mortgage
credit higher, and availability therefore lower. Policy makers must
recognize the national importance of this and ensure that individual
municipalities or other governmental entities are not able to cause
damage and act in opposition to the national interest. Above all,
Federal Government programs and entities such as the Federal Housing
Administration should not be party to such activities.
The time line for transition must be long enough to facilitate
continual liquidity and flexible to accommodate unforeseen challenges.
The transition will consist of changes to the legal and operational
framework of the core of mortgage finance. The transition begins
immediately with the implementation of the legislation, and continues
with the development of guarantors and other capital market risk
sharing and operational standards. Additionally, the expectations of
current bondholders must be supported through clarification of
guarantee for existing securities: Not making explicit the implicit
guarantee on existing MBS and corporate debt will disrupt the markets
for these securities, harm the confidence of investors who are needed
to participate in the new market, and make impossible a seamless
continuation of the liquidity from the current markets to the future
markets.
In conclusion, as this Committee continues down this critical path
toward establishing a more sustainable housing finance system, SIFMA
and its member firms stand ready to assist you and your colleagues in
answering the tough questions that lay ahead.
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PREPARED STATEMENT OF DAVID H. STEVENS
President and Chief Executive Officer, Mortgage Bankers Association
October 31, 2013
Chairman Johnson, Ranking Member Crapo, and Members of the Senate
Banking Committee, thank you for the opportunity to testify on behalf
of the Mortgage Bankers Association. My name is David H. Stevens and I
am the President and CEO of MBA. From 2009 to 2011, I served as
Assistant Secretary for Housing and FHA Commissioner at the U.S.
Department of Housing and Urban Development (HUD). I have over 30 years
experience in real estate finance.
I appreciate the opportunity to share with this Committee MBA's
views on how to ensure that the multiple objectives of secondary market
reform can be best balanced: ensuring liquidity in the secondary
market, providing mortgage products that borrowers want at a price that
is competitive, and protecting taxpayers from risk. My testimony today
describes how these objectives can be achieved, focusing on the
interplay between private capital and a necessary Government backstop.
MBA recognizes that a successful secondary market needs to be more
stable and competitive for all lenders with greater protections for
borrowers and taxpayers. This system would utilize familiar and
operationally reliable business systems, processes, and personnel from
the current GSE model. It is also essential that any new system be
accessible by lenders of all sizes and business models--as a robust and
competitive marketplace benefits everyone, including borrowers,
taxpayers, and our industry.
We are encouraged by recent legislative activity that has revived
the policy debate on the future of Fannie Mae and Freddie Mac,
including S.1217 offered by Senator Mark Warner and Senator Bob Corker.
We commend the efforts of the Chairman and Ranking Member for working
in a thoughtful and transparent manner as you seek to reach consensus
on legislation to reform the secondary mortgage market and create a
potential new end state for the housing GSEs.
Objectives of Secondary Market Reform
Five years after being placed in conservatorship, Fannie Mae and
Freddie Mac continue to play a central role in the U.S. mortgage
market. MBA believes a successful secondary market needs to produce a
more stable and competitive system for all lenders. Any transition to
an improved system must retain and redeploy key aspects of the GSEs'
existing infrastructures, including certain operational functions,
systems, people, and business processes.
In order to prevent disruptions to day-to-day business activities
of lenders and to ensure a fair, competitive, and efficient mortgage
market, any new proposal must be carefully phased-in to protect the
housing finance system from unnecessary disruptions.
MBA believes that the secondary market should:
Ensure equitable, transparent, and direct access to
secondary market programs for lenders of all sizes and business
models;
Preserve key GSE assets--technology, systems, data, and
people--by transferring them to any new entities created by GSE
reform, or placing them into a public utility;
Promote liquidity and stability by connecting global
capital to the U.S. mortgage market;
Provide an efficient means of hedging interest rate risk
through a robust TBA market;
Provide for a consistent offering of core products
including the 30-year fixed-rate prepayable mortgage;
Provide certainty in mortgage transactions for qualified
borrowers;
Rely on a single, highly liquid, Government-guaranteed
security that is delivered through a common securitization
platform;
Achieving these objectives will require:
An explicit Government guarantee for mortgage securities
backed by a well-defined class of high quality home mortgages;
Protection for taxpayers through deep credit enhancement
that puts private capital in a first-loss position, with no
institution too big to fail; and
Fair and transparent guarantee fees to create an FDIC-like
Federal insurance fund in the event of catastrophic losses.
The Government's role is to provide quality regulation of
guarantors and systems and to provide a clearly defined, but limited,
catastrophic credit backstop to the system. Without this Government
backstop, the mortgage market would be smaller and mortgage credit
would be more expensive, meaning that qualified lower and middle class
households would have less access to affordable mortgage credit and be
less able to qualify to achieve sustainable home ownership and the
multifamily rental market, which predominantly serves those of modest
incomes, would be adversely impacted.
The Need for a Government Backstop
The American mortgage market has long been dominated by 30-year
fixed-rate fully amortizing loans, with no penalty for refinancing the
loan. The advantage for borrowers is that it protects them against
increases in interest rates while providing a long period over which to
amortize the loan principal, thus providing more affordable monthly
payments than would be available under a shorter amortization schedule.
The advantages for borrowers, however, are offset by the risks
posed to depository institutions trying to hold 30-year fixed-rate
mortgages in portfolio, given the short duration of most bank deposits
and other liabilities. When interest rates rise, banks may end up
earning negative spreads on the mortgages they hold. This funding
mismatch can be dangerous for financial institutions.
For example, the thrift industry debacle of the 1980s largely grew
out of the removal of interest rate ceilings on bank and thrift
deposits for many years. The resulting spike in the interest rates on
the deposits funding long-term fixed-rate mortgages essentially wiped
out the capital at many thrifts. Similarly, funding mortgages with
long-dated fixed-rate deposits can be a problem if rates fall and
borrowers exercise their options to refinance their mortgages at lower
rates. The bank then faces low or negative interest rate spreads when
it reinvests the funds from the paid-off mortgages at lower rates.
Thus, relying on bank portfolios to fund 30-year fixed-rate mortgages
places tremendous risk on the existing Government support of the
mortgage market through the FDIC.
Securitization developed as a means of removing this interest rate
risk from depository balance sheets, while providing a long-term fixed-
rate asset for investors that had a better capacity to manage such cash
flows. However, securitization relies on a steady presence of private
investors willing to take on the risks of mortgage-backed securities.
We have seen repeatedly over the last 20 years that while investors are
generally willing to buy guaranteed MBS, even during a market
disruption, they are unwilling to take on uncertain credit risk during
these times.
When depositors or security holders become concerned over the
health of the assets supporting their investments, they want to
liquidate their positions and hold on to their cash until the situation
settles. In the case of banks, this is a run on deposits. For
securitization, it is a panic sale of the securities with a large drop
in price. It is as if bank depositors were forced to sell their
deposits to another investor at a deep discount rather than attempting
to redeem them at par at the bank. Because those who sell first suffer
the smallest losses, there is an advantage to sell quickly before a
panic, thus helping fuel a panic. Even if they do not sell, mark-to-
market accounting rules do not distinguish between normal price drops
and those caused by panic selling, causing large losses for investors.
The question is not whether a Government guarantee will limit the
potential damage of periodic panics in the securities. The benefit is
clear. The real question is how to go about limiting the risk to the
taxpayers that comes with any sort of Government support. Adequate
private capital in a first-loss position, the establishment of an
insurance fund, and a limited, clearly defined credit box (such as has
been accomplished with the QM rule) all would be strong steps in this
direction.
In summary, the U.S. mortgage market is unique in the degree to
which 30-year fixed-rate mortgages play such a large role in financing
home purchases. To date, however, that market has been supported by
securitization and the implicit and explicit support the taxpayers have
given to that market. MBA believes that such a guarantee can be put in
place in order to reduce the volatility that would exist in a purely
private market, but that would be implemented in such a way as to limit
the exposure of the taxpayers.
Investors Should Be Able To Rely Solely on the Full Faith and Credit
Guaranty Behind the Security
Investors should be ensured that they will receive timely payment
of principal and interest, and that this backstop reflects the full
faith and credit of the U.S. Government. As noted above, the purpose of
the backstop on the security is to ensure liquidity even during
financial market disruptions. Limiting the coverage to less than 100
percent would cause investors to question whether the securities would
remain liquid in a downturn.
The Government guaranty should be paid for through premiums that
build up a Mortgage Insurance Fund (MIF) over time. The MIF only pays
in the event that a private credit enhancer goes out of business.
Attachment Points, Capital Requirements, and Risk
A central question in reordering the secondary market is to define
where private risk taking ends and where Government support begins. In
most proposals, private entities (or capital market structures) are
assumed to take losses up until the point that the entities fail (or
the structures are tapped out). The key question then becomes how much
capital the entities need to set aside to absorb losses, or
alternatively, how thick subordinate tranches within capital market
structures need to be.
There are several challenges in answering these questions. First,
there is uncertainty regarding precisely how much risk resides within a
pool, vintage, or population of mortgages. Mortgage losses are a
function of borrower, loan, and property characteristics that are
measurable at origination. Lenders, investors, rating agencies, and
regulators have developed considerable information and analytics which
can accurately gauge the relative risk of default and loss from
mortgages with different characteristics. For example, Standard & Poors
in their 2009 ratings criteria estimate that holding all other factors
equal, loans with a 50 LTV are at less than half the risk of default of
loans with a 75 LTV, while loans with a 90 LTV are 2.5 times more
likely to default. Loans to borrowers with a credit score of 680 are at
twice the risk of default of a borrower with a 725. ARM loans have a
baseline default rate that is 1.2 times higher. No-doc loans are at six
times the risk of full documentation loans.
However, despite these accurate and precise estimates of relative
default risk, it is more difficult to get a handle on the level of
absolute risk. In a recession, when unemployment increases sharply,
default rates across all types of loans increase. A sudden, sharp
increase in interest rates can lead borrowers with adjustable-rate
mortgages to fall behind on their payments. And as we have clearly
witnessed in the Great Recession, borrowers who cannot sell their homes
because they are underwater, i.e., their property value is less than
the balance on their mortgage, are more likely to default and go to
foreclosure. Home price movements are thus a critical factor. Faster
rates of home price appreciation such as we saw during the boom can
dampen default and loss rates across all types of loans, while steep
declines in home prices may lead to higher loss rates across the board.
Lenders, investors, and others attempt to address these economic
risks by estimating loan performance across a range of different
economic environments, testing the impact of alternative home price,
interest rate, and economic scenarios. These experiments result in
estimates of performance across a range of outcomes, and can provide a
credible picture of the potential distribution of losses one might
expect from a given set of loans.
It is worth noting that the range of scenarios imagined may
necessarily be limited by historical experience. In more than 70 years,
the U.S. had not experienced an economic and housing market downturn
that severe since the Great Depression. It is extremely difficult to
accurately gauge the likelihood of such a tail event recurring. Are the
odds 1 in 70? 1 in 200? 1 in 30? The data do not reveal enough
information to accurately make that judgment. It is fundamentally an
assumption, and similar to an engineer constructing a bridge, it is
reasonable to err on the side of conservatism, but there are costs to
being too conservative.
Typical practice in industry would be to target a rating (e.g.,
``AAA'') which is associated with surviving a certain level of losses
while remaining solvent. An alternative approach is to define a
stressful economic path, and then show that the entity would survive
such a stress. The OFHEO risk-based capital test utilized a stress path
(roughly a 15-percent decline in national home prices) from the oil-
patch recession in the mid-1980s, and then applied that level of losses
on a national basis. The Corker-Warner bill requires that entities be
able to survive a 35-percent decline in national home prices. (Note
that different home price measures and other factors can lead to very
different levels of stress, so a larger number may not necessarily be
consistent with a more severe stress if a more volatile home price
index is used.)
What level of protection is enough? Private credit enhancers should
have sufficient capital so that it is extremely rare that the insurance
fund is called upon. And the insurance fund and associated premiums
should be large enough such that Government outlays would almost never
be required.
However, as noted, there is a cost to being too conservative.
Requiring capital beyond the actual economic risk drives up costs and
would limit access to credit. A balance must be achieved.
Private capital should stand in front of the Government backstop in
order to protect taxpayers, but should be at a level to keep credit
affordable and accessible to middle class homeowners.
At the loan or at the pool level, substantial private capital
should stand in front of the Government backstop in order to limit
taxpayer exposure. Most discussions suggest that private capital should
take on the ``predominant'' credit risk.
Congress should set broad parameters for the regulator to establish
capital requirements/credit enhancement levels that are in line with
regulatory capital standards for mortgages held by other institutions.
In effect, Congress should establish a system where there is no
opportunity for regulatory capital arbitrage.
Regardless of who holds mortgage credit risk, regardless of charter
type, the capital requirement should be the same. For example,
legislation should reference the most recent version of the Basel
standards when instructing the regulator with respect to proper levels
of capital.
In the old regime, the GSEs were only required to hold 45 bps of
capital against ``off balance sheet'' exposure to mortgage credit risk.
Banks and other depositories holding whole mortgage loans had to hold
4-percent capital (50-percent risk weight against 8-percent total
capital requirement).
Moreover, the banks had a 20-percent risk weight on GSE MBS, so
they could hold 1.6-percent capital on MBS. Taken together, the system
went from 4-percent capital for whole loans on bank books to 2.05-
percent capital for loans guaranteed by the GSEs but held by banks as
MBS. Tragically this was too little to buffer against the losses
experienced through the downturn.
Not surprisingly, the GSEs rapidly gained market share under this
artificial competitive advantage with respect to required capital.
Under S.1217, the securitization channel for conforming loans would
have a 10-percent capital requirement. Banks under Basel III are still
at 4 percent (5-6 percent for the very largest banks under the new
leverage requirement). With this requirement, mortgages would be
expected to flow to the banking system. Another worse possibility is
that only the highest risk mortgages, which warrant higher capital
standards, would be securitized and receive the Government backstop,
leading the Government-backed segment of the market to be small, high
risk, and high cost.
Lenders originate to best execution. Operationally this means that
when they are taking an application and pricing a loan, their systems
determine which possible investors/programs might be eligible, sort by
best all-in price, then assume that the loan will be sold through the
highest price channel (execution).
For example, suppose a customer would like a 30-year loan. The bank
he is working with could sell the loan to the GSEs, securitize through
a private-label issuer, or hold the loan on their balance sheet. At the
time of application, the lender knows the prices associated with each,
and assumes that the loan will be sold to the best opportunity, and
typically would use that quote to provide a rate to the consumer.
Between application and origination and sale, circumstances may change,
and the loan may wind up being sold to an alternate execution.
The relevance here is that relatively small changes in the price of
one channel can quickly lead to large changes in best execution. A most
recent example concerns the jumbo market. Before the run up in rates,
private-label jumbo securitizations were beginning to pick up. After
that run up, securitization cannot compete with a portfolio execution,
so you are seeing jumbo securitizations being canceled or postponed.
A longer-term trend with respect to jumbos is this: typically, the
jumbo-conforming spread on 30-year fixed-rate loans had been roughly
25-50 bps. Though not seemingly dramatic, this spread was enough to
drive consumer and lender behavior. The ARM share of conforming loans
was roughly 20 percent. For jumbo loans it was roughly 60 percent. The
relatively small difference in rates on jumbo vs. conforming loans was
sufficient to cause jumbo borrowers to choose ARMs.
If the FMIC channel is relatively expensive compared to other
executions, one of two outcomes will occur. Either no loans will go
through this channel, or only the higher risk loans will go through.
This adverse selection would increase risk to the taxpayer, as the
insurance fund and the Government would be left reinsuring a much
riskier pool of loans.
How do we know that a capital level similar to what the banks are
held to would be sufficient to protect taxpayers? There are multiple,
sophisticated approaches one could take to answering this question, but
the simplest, most direct approach is to simply require that credit
enhancers hold sufficient capital so that they could have survived the
downturn we just experienced.
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As shown in the chart above, the default rate on the 2007 book of
business from Fannie Mae is approaching 12 percent. This book contained
substantial amounts of Alt-A and other high-risk business that would be
explicitly excluded by a QM requirement. Loss severity, i.e., losses as
a proportion of the unpaid principal balance, are running at about one-
third. This means that a 12-percent default rate translates to a loss
rate of roughly 4 percent on this 2007 book. To the extent that tighter
underwriting results in lower default rates, loss rates even in future
extremely adverse scenarios should remain below this recent experience.
Charging a modest reinsurance premium (on the order of 10-15 bps)
should be more than sufficient to cover any residual risk over time,
particularly if the mortgage credit risk is limited by mandating that
only QM loans may be securitized.
Beyond this simple analysis, researchers (e.g., Moody's Analytics,
Urban Institute, et al.) have conducted substantial econometric
analysis that shows that capital in the range of 4-5 percent would
cover losses in all but the most extreme scenarios.
Proper Regulation and Oversight To Minimize Systemic Risk
While setting proper capital requirement levels is critical, other
aspects of regulation and supervision must receive attention as well.
MBA strongly recommends that the system be set up so that there is
robust competition for business in the secondary market, and so there
is a credible threat of additional competitors entering the market if
existing companies are making outsized profits. Congress and the
regulator should work to eliminate barriers to entry. Fannie Mae and
Freddie Mac had a legislatively granted duopoly.
In addition to promulgating regulations around capital
requirements, the regulator should also have rigorous criteria for
approving lenders, servicers, credit enhancers, and other participants
in the market. The regulator should also be an active supervisor, with
sufficient timely information to be able to make judgments about
potential required actions to limit risk to the MIF and to the
taxpayer.
The regulator should monitor concentration risks within the system.
If the new regime relies upon a small number of entities with highly
correlated business models, there is a risk that they could all fail at
the same time. Plans for the new system should carefully calibrate
capital requirements to mitigate this potential, and contemplate how
the new regulator could continue lending until new entities could be
formed following a crisis. The ability for the regulator to temporarily
lower capital requirements for reinsurance eligibility during a
systemic event is a wise and necessary provision.
If the new regime relies heavily upon capital markets to lay off
credit risk, the systemic risk potential is that concentrations of risk
exposures and leverage could build up in hidden ways throughout the
system. Unlike with entities that have clear and transparent capital
requirements, capital market leverage can be hidden and can result in
multiple, opaque layers of leverage even if transactions appear to be
in ``cash.''
The New System Should Promote Direct Access to the Secondary Market for
Lenders of All Sizes and Support a Broad Variety of Business
Models
MBA believes that any improved secondary mortgage system should
utilize familiar and operationally reliable business systems and
processes from the current GSE model. It should also include components
to ensure access for lenders of all sizes. Some examples of what the
new model should deliver include the following functions:
Cash Window/Whole Loan Execution
Multi-Lender Security Execution
Single Loan Securitization
Servicing Retained Sales
Servicing Released Sales
Single-family lenders should be able to utilize familiar credit
enhancement options, such as mortgage insurance, to facilitate
secondary market transactions in a timely and orderly way. Key
functions present in today's secondary market system should be
preserved, while allowing new forms of private credit enhancement to
develop over time.
It may well take a combination of approaches to ensure that the
system works for both smaller and larger lenders. It is imperative that
the new system provide access on a competitive basis to qualified
institutions, as this vibrant competition will ultimately benefit
borrowers.
Under the current GSE model, Fannie Mae and Freddie Mac are the
issuers. They purchase loans from lenders and provide a guarantee
(backed by an implicit Government guarantee).
Under the Ginnie Mae model, lenders are the issuers. Lenders obtain
loan-level insurance from a Government program (FHA, VA, USDA) and then
issue the securities, obtaining a security-level guarantee from Ginnie
Mae.
The GSE model provides for many, typically smaller, lenders to sell
whole loans to Fannie Mae and Freddie Mac for cash. This provides quick
funding, which is a valuable benefit for many smaller lenders.
The Ginnie Mae approach puts greater responsibility and control
with the lender. However, the operational complexities may prevent some
smaller lenders from becoming issuers. As a reference, there are
roughly 400 Ginnie Mae issuers, and over 1,000 direct sellers to Fannie
and Freddie.
The Corker-Warner bill provides both paths, with an ability for
lenders to obtain private credit enhancement and be the issuer, and a
Mutual Securitization Company which can fill the aggregation role for
those lenders who do not have the operational capability or desire to
be an issuer. Additionally, the bill would allow the Federal Home Loan
Banks to act as aggregators for smaller lenders.
MBA believes serious consideration should be given to expanding
Federal Home Loan Bank membership eligibility to include access for
nondepository mortgage lenders. In fact, historical evidence shows that
such a move is consistent with the original intent of the system (see,
Snowden, 2013). These lenders are often smaller, community-based
independent mortgage bankers focused on providing mainstream mortgage
products to consumers. In exchange for membership in the FHLB system,
these institutions could be required to hold a limited class of stock
with appropriate restrictions. Expanding FHLB access to these
institutions would enhance market liquidity and ensure a broader range
of mortgage options for consumers.
Getting More Private Capital Back Into the Market Today While the
Legislative Process Continues To Refine the Proper End State
Fannie Mae and Freddie Mac have recently reported substantial
profits, leading some to ask whether the business models of Fannie Mae
and Freddie Mac have regained credibility that was lost during the
financial crisis. Record GSE profits do not tell the whole story. In
their current form, GSE profits are dependent in large part on three
factors:
Guarantee fees, which have more than doubled in recent
years.
Remarkably low-risk business, a sign of tight credit.
Their ability to shift legacy costs back to lenders.
This current status is not sustainable over the longer term, and
MBA believes that we should begin moving toward a more sustainable
environment. While the legislative process will continue to refine the
desired end state, MBA has proposed a set of transition steps designed
to move in the direction of the developing consensus regarding the
shape of the future secondary market. The steps we propose, none of
which require legislation, create an even greater competitive landscape
for all originators beyond where we are today, and provide better value
to borrowers. Further, they are consistent with the vast majority of
end-state proposals.
FHFA and the GSEs should move to a common, fungible MBS to
improve liquidity in the market. The discount on Freddie Mac's
security represents a loss to the taxpayer, as it is being
implicitly subsidized by lower guarantee fees resulting in
lower dividends to the Treasury. We should act now to remove
this distortion by moving to a common, fungible security.
FHFA should mandate that the GSEs accept deeper credit
enhancement on pools from lenders in exchange for reduced
guarantee fees in order to lower costs and increase access to
credit for consumers. The PATH Act includes language to this
effect, which we would support as a means of bringing
additional private capital into the market. Importantly, we
believe that lenders should have ``front-end'' credit
enhancement options in addition to the ``back-end'' options, as
we believe the former have the potential to produce greater
cost savings for consumers.
Regardless of which end state Congress decides upon, we
need to ensure that lenders of all sizes have securitization
options to directly access the secondary market in order to
level the playing field.
FHFA should impose a well-regulated and fully transparent
credit framework with clear representation and warranty
protections to increase transparency in the system and enable
lenders to responsibly expand access to credit.
FHFA should continue to seek stakeholder input regarding
the Common Securitization Platform to lay the groundwork for a
more efficient market in the future. The PATH Act also contains
plans for a new market utility that would perform many of the
roles and functions envisioned for the platform, with the
exception that the bill would not permit the utility to
securitize Government-backed loans. While we appreciate the
agreement that such a central, operationally focused utility is
needed, we do believe that some level of Government backstop is
needed for the conventional conforming market.
Below is an illustrative example of how MBA's proposal for up-front
credit enhancement would work. In today's market, private capital can
be competitive with the GSEs in certain segments. If guarantee fees
were to increase further, borrowers could realize real savings through
this approach at the same time that taxpayer exposure to the mortgage
market is reduced.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Up-front Gfee reflects loan-level price adjustments
(LLPAs).
MI premium is standard 25-percent coverage. Pricing is by
credit tier.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Proposed deeper coverage (45 percent on 90 LTV) accounts
for vast majority of the risk.
10 bps covers catastrophic risk assuming MI is sufficiently
capitalized.
10 bps for payroll tax.
Specific Gfee is most sensitive to level of MI
capitalization and required returns for GSEs.
Savings to borrowers are significant. Would extend to
borrowers at lower credit tiers as well.
Process
Each approved MI would file a standard pool policy with
FHFA/Fannie and Freddie and the insurance regulators so that
everyone was clear on the structure--the simpler, the better.
Any approved lender could deliver deep CE pools to the GSEs
for a Gfee discount.
Menu approach--lenders would have the option to deliver
loans and pay the full Gfee, or arrange for deeper CE through
an MI or by retaining recourse, and pay a much reduced Gfee.
MIs would compete for the business on total price, but also
on mix of business, e.g., LTV and credit score. Allows for
differences in views on credit.
Multifamily Finance Key Principles for Multifamily Housing Finance
Reform
Our views on the multifamily housing finance market run parallel
and are consistent with our views on the single-family residential
market.
More than one in three American households rent their home, and
more than 16 million \1\ of those households live in multifamily rental
housing, a development with five or more units. Renters include workers
who want to live near their jobs, young professionals, empty-nesters,
retirees on a fixed income, families with children, students, and
households who value the convenience and mobility that renting offers.
Notably, the vast majority of multifamily rental housing provides homes
for households earning modest incomes, with 93 percent of multifamily
rental apartments having rents affordable to households earning at or
below the area median income. \2\
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\1\ 2011 American Housing Survey.
\2\ Joint Center for Housing Studies Tabulations of 2009 American
Housing Survey, U.S. Census Bureau.
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Recognizing the unique attributes of the multifamily market as a
key component of the broader housing finance system, we believe that
policy makers should pursue the following principles in shaping the
Government's role in the multifamily housing finance system.
First, our Nation's housing policies should reflect the importance
of multifamily rental housing, the range of capital sources that
support this market, and the need for liquidity and stability in all
market cycles. The number of renter households in multifamily housing
is expected to grow from the current estimate that exceeds 16 million.
A broad range of capital sources support the multifamily finance
market, including private capital sources. The roles of the GSEs and
FHA in financing multifamily mortgages have been substantial, but other
market participants--including life insurance companies, banks, and
other lenders--have maintained a strong presence as well. With respect
to the GSEs' multifamily activities, credit performance has been strong
during the recent market downturn and, with Government support, the
GSEs have served a countercyclical role that provided liquidity when
private capital sources largely exited the market.
Second, private capital should be the primary source of financing
for multifamily housing with a limited, Government-backed insurance
program ensuring that the market has access to liquidity in all cycles.
The risk insurance program would provide support at the mortgage-backed
security, rather than at the entity, level. The role of private capital
is vital in several respects: (1) the deployment of private capital
through market participants that have historically supported
multifamily finance, such as portfolio lenders and CMBS investors; (2)
the private capital that is already embedded within existing market
executions (e.g., DUS, K-Deals) through risk-sharing structures; and
(3) the investment of private capital in entities that would be
permitted to issue Government-backed securities. We believe that a
focused role for the Federal Government through a Government-backed
risk insurance fund, with a Federal catastrophic backstop, would ensure
continuous liquidity and stability in all market cycles. Eligible
mortgage-backed securities would have a Government wrap. The insurance
fund, paid for through risk-based premiums, could be modeled after FDIC
programs and would support such mortgage-backed securities, not at the
level of the issuer, as is the case today.
Third, entities eligible to issue Government-backed securities
should be funded by private capital, be focused on securitization,
serve the workforce rental market, and be regulated in a manner that
protects taxpayers and ensures robust competition among capital
sources. A strong Government regulator with market expertise would
provide oversight regarding the issuing entities, including their
safety and soundness, risk-based capital requirements, and products
offered. The entities, which would not be limited to potential
successor entities to the GSEs, also would assume a significant risk
position by providing an entity-level buffer, placing private capital
at risk ahead of any Government backstop. Risk-based premiums would be
deposited into a Federal insurance fund, to be drawn upon only if and
when the entity becomes insolvent. The pricing of the premiums would be
structured in a manner that allows robust competition. Importantly, the
issuing entities would need to attract private capital and maintain
financial viability. We believe, however, that they should be mono-line
institutions limited to secondary mortgage market activities and the
housing finance sector, with a focus on workforce and affordable rental
housing.
Fourth, stewardship of existing GSE assets and resources on behalf
of taxpayers should be a core consideration for any action--during the
current period of conservatorship, any transition period, and in the
future state of multifamily finance. The talent and expertise at the
GSEs, their existing books of business, their market executions, and
any profits generated by their multifamily businesses are valuable to
U.S. taxpayers and should be deployed in a manner that supports the
future state of multifamily housing finance. Preserving and dedicating
such resources would support an orderly transition to a new mortgage
finance system and optimize potential returns to taxpayers.
Fundamentally, the ``do no harm'' principle should govern, particularly
in light of the stability and successes of the multifamily market
overall.
We wish to underscore that as policy makers deliberate the future
of the Government's role in multifamily housing finance, it is vital
they ensure that capital continues to be available to support this
essential source of housing.
In conclusion, I appreciate this opportunity to again present
testimony before this Committee, and look forward to answering any
questions you may have.