[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

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

                                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

                               __________

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





[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]




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



                               __________

                         U.S. GOVERNMENT PRINTING OFFICE 

86-598 PDF                     WASHINGTON : 2014 
-----------------------------------------------------------------------
  For sale by the Superintendent of Documents, U.S. Government Printing 
  Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800 
         DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, 
                          Washington, DC 20402-0001
















            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

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

                       Charles Yi, Staff Director

                Gregg Richard, Republican Staff Director

                    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

                              ----------                              

                       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

                              ----------                              


                       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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
     \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.


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



                 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.


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



    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\
---------------------------------------------------------------------------
     \1\ 2011 American Housing Survey.
     \2\ Joint Center for Housing Studies Tabulations of 2009 American 
Housing Survey, U.S. Census Bureau.
---------------------------------------------------------------------------
    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.
