Tag Archives: government-sponsored enterprise

Rising Mortgage Rates

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graphic by Chris Butterworth

NBC News quoted me in Mortgage Rates Just Hit 5 Percent: What Does That Mean for Homebuyers and Owners? It opens,

Mortgage rates crossed the 5 percent line on Wednesday for the first time since 2011, marking a new era for a generation of Americans raised on super-low borrowing rates and highlighting the downside of a burgeoning national economy.

Strengthening economic growth, near-record low unemployment, inflation rates and policy moves by the Federal Reserve have all contributed to move the needle beyond the psychological 5 percent barrier.”It has only been in this decade that they have fallen below 5 percent, rates not seen since the 1960s,” said David Reiss, an expert in real estate law and professor at the Brooklyn Law School.

From 1971 through early October 2008, the average rate for a 30-year mortgage was 8.1 percent. The day before Halloween 1981, the number spiked at 18.44 percent, according to data from Freddie Mac, the government-sponsored mortgage rebundler.

Psychology aside, there’s a real money impact as well. Every increase of 10 basis points, or 0.1 percentage point, means another $6 per month per $100,000 of mortgage, said Danielle Hale, chief economist for Realtor.com.

Over the last year, the mortgage on a typically priced home of $295,000 has increased by $115 to $120 a month.

Growing monthly payments are just one of the factors contributing to tougher times for many buyers. House prices also have been on the increase, and potential homeowners must contend with the loss of the so-called SALT deductions in last year’s tax cut legislation, which complicate things in high-tax states.

Hope for GSE Shareholders

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Judge Lamberth issued an opinion in Fairholme Funds, Inc. v. FHFA (Civ. No.13-1439) (Sept. 28, 2018) that gives some hope to the private shareholders of Fannie Mae and Freddie Mac. These shareholders have been on the losing end of nearly every case brought against the government relating to its handling of the conservatorships of the two companies.  Readers of this blog know that I have long been a skeptic of the shareholders’ claims because of the broad powers granted the government by the Housing and Economic Recovery Act of 2008, passed during the height of the financial crisis, as well as the highly regulated environment in which the two companies operate. This highly regulated environment means that GSE profits are driven by regulatory decisions much more than those of other financial institutions. As such, Fannie and Freddie live and die by the sword of government intervention in the mortgage market.

Judge Lamberth had dismissed the plaintiffs’ claims in their entirety, but was reversed in part on appeal. In this case, he revisits the issues arising from the reversal of his earlier dismissal. Once again, Judge Lamberth dismisses a number of the plaintiffs’ claims, but he finds that that their claim that the government breached the duty of good faith survives.

The opinion gives a road map that shareholders can follow to success. The judge identifies allegations that, if true, would be a sufficient factual basis for a holding that the government breached the implied covenant of good faith and fair dealing. It is plausible that the preponderance of proof may support these allegations. Some evidence has already come to light that indicates that at least some government actors had good reason to believe that Fannie and Freddie were on the cusp of sustained profitability when the government implemented the net worth sweep. The net worth sweep had redirected the net profits of the two companies to the U.S. Treasury.

Judge Lamberth highlights some of aspects of the plaintiffs’ argument that he found compelling at the motion to dismiss phase of this litigation. First, he notes that absence of “any increased funding commitment” is atypical when senior shareholders receive “enhanced disbursement rights,” as was the case when the government implemented the net worth sweep. (21) He also states that the plaintiffs would not have expected that the GSEs would have extinguished “the possibility of dividends arbitrarily or unreasonably.” (22)

While this opinion is good news for the plaintiffs, it is still unclear what their endgame would be if they were to get a final judgment that the net worth sweep was invalid. Depending on the outcome of regulatory and legislative debates about the future of the two companies, the win may be a pyrrhic one. Time will tell. In the interim, expect more discovery battles, motions for summary judgment and even a trial in this case. So, while this opinion gives shareholders some hope of ultimate success, and perhaps some leverage in political and regulatory debates, I do not see it as a game changer in itself.

In terms of the bigger picture, there are a lot of changes on the horizon regarding the future of the housing finance system. The midterm elections; Hensarling and Corker’s departure from Congress; and the Trump Administration’s priorities are all bigger drivers of the housing finance reform train, at least for now.

GSE Shareholders Floored, Again

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The United States Court of Appeals for the Eighth Circuit issued an opinion in Saxton v. FHFA (No. 17-1727, Aug. 23, 2018). The Eighth Circuit joins the Fifth, Sixth, Seventh and D.C. Circuits in rejecting the arguments of Fannie and Freddie shareholders that the Federal Housing Finance Agency exceeded its authority as conservator of Fannie Mae and Freddie Mac and acted arbitrarily and capriciously. The Court provides the following overview:

     The financial crisis of 2008 prompted Congress to take several actions to fend off economic disaster. One of those measures propped up Fannie Mae and Freddie Mac. Fannie and Freddie, which were founded by Congress back in 1938 and 1970, buy home mortgages from lenders, thereby freeing lenders to make more loans. See generally 12 U.S.C. § 4501. Although established by Congress, Fannie and Freddie operate like private companies: they have shareholders, boards of directors, and executives appointed by those boards. But Fannie and Freddie also have something most private businesses do not: the backing of the United States Treasury. 

     In 2008, with the mortgage meltdown at full tilt, Congress enacted the Housing and Economic Recovery Act (HERA or the Act). HERA created the Federal Housing Finance Agency (FHFA), and gave it the power to appoint itself either conservator or receiver of Fannie or Freddie should either company become critically undercapitalized. 12 U.S.C. § 4617(a)(2), (4). The Act includes a provision limiting judicial review: “Except as  provided in this section or at the request of the Director, no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as a conservator or a receiver.” Id. § 4617(f). 

     Shortly after the Act’s passage, FHFA determined that both Fannie and Freddie were critically undercapitalized and appointed itself conservator. FHFA then entered an agreement with the U.S. Department of the Treasury whereby Treasury would acquire specially-created preferred stock and, in exchange, would make hundreds of billions of dollars in capital available to Fannie and Freddie. The idea was that Fannie and Freddie would exit conservatorship when they reimbursed the Treasury.

     But Fannie and Freddie remain under FHFA’s conservatorship today. Since the conservatorship began, FHFA and Treasury have amended their agreement several times. In the most recent amendment, FHFA agreed that, each quarter, Fannie and Freddie would pay to Treasury their entire net worth, minus a small buffer. This so-called “net worth sweep” is the basis of this litigation. 

     Three owners of Fannie and Freddie common stock sued FHFA and Treasury, claiming they had exceeded their powers under HERA and acted arbitrarily and capriciously by agreeing to the net worth sweep. The shareholders sought only an injunction setting aside the net worth sweep; they dismissed a claim seeking money damages. Relying on the D.C. Circuit’s opinion in Perry Capital LLC v. Mnuchin, 864 F.3d 591 (D.C. Cir. 2017), the district court dismissed the suit.

What amazes me as a longtime watcher of the GSE litigation is how supposedly dispassionate investors lose their heads when it comes to the GSE lawsuits. They cannot seem to fathom that judges will come to a different conclusion regarding HERA’s limitation on judicial review.

While I do not rule out that the Supreme Court could find otherwise, particularly if Judge Kavanaugh is confirmed, it seems like this unbroken string of losses should provide some sort of wake up call for GSE shareholders. But somehow, I doubt that it will.

The Costs and Benefits of A Dodd-Frank Mortgage Provision

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Craig Furfine has posted The Impact of Risk Retention Regulation on the Underwriting of Securitized Mortgages to SSRN. The abstract reads,

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 imposed requirements on securitization sponsors to retain not less than a 5% share of the aggregate credit risk of the assets they securitize. This paper examines whether loans securitized in deals sold after the implementation of risk-retention requirements look different from those sold before. Using a difference-in-difference empirical framework, I find that risk retention implementation is associated with mortgages being issued with markedly higher interest rates, yet notably lower loan-to-value ratios and higher income to debt-service ratios. Combined, these findings suggest that the implementation of risk retention rules has achieved a policy goal of making securitized loans safer, yet at a significant cost to borrowers.

While the paper primarily addressed the securitization of commercial mortgages, I was particularly interested in the paper’s conclusion that

the results suggest that risk retention rules will become an increasingly important factor for the underwriting of residential mortgages, too. Non-prime residential lending has continued to rapidly increase and if exemptions given to the GSEs expire in 2021 as currently scheduled, then a much greater fraction of residential lending will also be subject to these same rules. (not paginated)

As always, policymakers will need to evaluate whether we have the right balance between conservative underwriting and affordable credit. Let’s hope that they can address this issue with some objectivity given today’s polarized political climate.

Nonbanks and The Next Crisis

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Researchers at the Fed and UC Berkeley have posted Liquidity Crises in the Mortgage Markets. The authors conclusions are particularly troubling:

The nonbank mortgage sector has boomed in recent years. The combination of low interest rates, well-functioning GSE and Ginnie Mae securitization markets, and streamlined FHA and VA programs have created ample opportunities for nonbanks to generate revenue by refinancing mortgages. Commercial banks have been happy to supply warehouse lines of credit to nonbanks at favorable rates. Delinquency rates have been low, and so nonbanks have not needed to finance servicing advances.

In this paper, we ask “What happens next?” What happens if interest rates rise and nonbank revenue drops? What happens if commercial banks or other financial institutions lose their taste for extending credit to nonbanks? What happens if delinquency rates rise and servicers have to advance payments to investors—advances that, in the case of Ginnie Mae pools, the servicer cannot finance, and on which they might take a sizable capital loss?

We cannot provide reassuring answers to any of these questions. The typical nonbank has few resources with which to weather these shocks. Nonbanks with servicing portfolios concentrated in Ginnie Mae pools are exposed to a higher risk of borrower default and higher potential losses in the event of such a default, and yet, as far as we can tell from our limited data, have even less liquidity on hand than other nonbanks. Failure of these nonbanks in particular would have a disproportionate effect on lower-income and minority borrowers.

In the event of the failure of a nonbank, the government (through Ginnie Mae and the GSEs) will probably bear the majority of the increased credit and operational losses that will follow. In the aftermath of the financial crisis, the government shared some mortgage credit losses with the banking system through putbacks and False Claims Act prosecutions. Now, however, the banks have largely retreated from lending to borrowers with lower credit scores and instead lend to nonbanks through warehouse lines of credit, which provide banks with numerous protections in the event of nonbank failure.

Although the monitoring of nonbanks on the part of the GSEs, Ginnie Mae, and the state regulators has increased substantially over the past few years, the prudential regulatory minimums, available data, and staff resources still seem somewhat lacking relative to the risks. Meanwhile, researchers and analysts without access to regulatory data have almost no way to assess the risks. In addition, although various regulators are engaged in micro-prudential supervision of individual nonbanks, less thought is being given, in the housing finance reform discussions and elsewhere, to the question of whether it is wise to concentrate so much risk in a sector with such little capacity to bear it, and a history, at least during the financial crisis, of going out of business. We write this paper with the hope of elevating this question in the national mortgage debate. (52-53)

As with last week’s paper on Mortgage Insurers and The Next Housing Crisis, this paper is a wake-up call to mortgage-market policymakers to pay attention to where the seeds of the next mortgage crisis may be hibernating, awaiting just the right conditions to sprout up.

De Facto Housing Finance Reform

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David Finkelstein, Andreas Strzodka and James Vickery of the NY Fed have posted Credit Risk Transfer and De Facto GSE Reform. It opens,

Nearly a decade into the conservatorships of Fannie Mae and Freddie Mac, no legislation has yet been passed to reform the housing finance system and resolve the long-term future of these two government-sponsored enterprises (GSEs). The GSEs have, however, implemented significant changes to their operations and practices over this period, even in the absence of legislation. The goal of this paper is to summarize and evaluate one of the most important of these initiatives – the use of credit risk transfer (CRT) instruments to shift mortgage credit risk from the GSEs to the private sector.

Fannie Mae and Freddie Mac have significant mortgage credit risk exposure, largely because they provide a credit guarantee to investors on the agency mortgage-backed securities (MBS) they issue. Since the CRT programs began in 2013, Fannie Mae and Freddie Mac have transferred to the private sector a portion of the credit risk on approximately $1.8 trillion in single-family mortgages (as of December 2017; source: Fannie Mae, 2017, Freddie Mac, 2017). The GSEs have experimented with a range of different risk transfer instruments, including reinsurance, senior-subordinate securitizations, and transactions involving explicit lender risk sharing. The bulk of CRT, however, has occurred via the issuance of structured debt securities whose principal payments are tied to the credit performance of a reference pool of securitized mortgages. A period of elevated mortgage defaults and losses will  trigger automatic principal write-downs on these CRT bonds, partially offsetting credit losses experienced by the GSEs.

Our thesis is that the CRT initiative has improved the stability of the  housing finance system and advanced a number of important objectives of GSE reform. In particular the CRT programs have meaningfully reduced the exposure of the Federal government to mortgage credit risk without disrupting the liquidity or stability of secondary mortgage markets. In the process, the CRT programs have created a new financial market for pricing and trading mortgage credit risk, which has grown in size and liquidity over time. Given diminished private-label securitization activity in recent years, these CRT securities are one of the primary ways for private-sector capital market investors to gain exposure to residential mortgage credit risk.

An important reason for this success is that the credit risk transfer programs do not disrupt the operation of the agency MBS market or affect the risks facing agency MBS investors. Because agency MBS carry a GSE credit guarantee, agency MBS investors assume that they are exposed to interest rate risk and prepayment risk, but not credit risk. This reduces the set of parameters on which pass-through MBS pools differ from one another, improving the standardization of the securities underlying the liquid to-be-announced (TBA) market where agency MBS mainly trade. Even though the GSEs now use CRT structures to transfer credit risk to a variety of private sector investors, these arrangements do not affect agency MBS investors, since the agency MBS credit guarantee is still being provided only by the GSE. In other words, the GSE stands in between the agency MBS investors and private-sector CRT investors, acting in a role akin to a central counterparty.

Ensuring that Fannie Mae and Freddie Mac’s credit risk sharing efforts occur independently of the agency MBS market is important for both market functioning and financial stability. The agency MBS market, which remains one of the most liquid fixed income markets in the world, proved to be quite resilient during the 2007-2009 financial crisis, helping to support the supply of mortgage credit during that period. The agency market financed $2.89 trillion of mortgage originations during 2008 and 2009, experiencing little drop in secondary market trading volume during that period. In contrast, the non-agency MBS market, where MBS investors are exposed directly to credit risk, proved to be much less stable; Issuance in this market essentially froze in the second half of 2007, and has remained at low levels since that time.4 (1-2, citations and footnotes omitted)

One open question, of course, is whether the risk transfer has been properly priced. We won’t be able to fully answer that question until the next crisis tests these CRT securities. But in the meantime, we can contemplate the authors’ conclusion:

the CRT program represents a valuable step forward towards GSE
reform, as well as a basis for future reform. Many proposals have been put forward for long-term reform of mortgage market since the GSE conservatorships began in 2008. Although the details of these proposals vary, they generally share in common the goals of

(1) ensuring that mortgage credit risk is borne by the private sector (probably with some form of government backstop and/or tail insurance to insure catastrophic risk and stabilize the market during periods of stress), while

(2) maintaining the current securitization infrastructure as well as the standardization and liquidity of agency MBS markets.

The credit risk transfer program, now into its fifth year, represents an effective mechanism for achieving these twin goals. (21, footnote omitted)

Mortgage Insurers and The Next Housing Crisis

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photo by Jeff Turner

The Inspector General of the Federal Housing Finance Agency has released a white paper on Enterprise Counterparties: Mortgage Insurers. The Executive Summary reads,

Fannie Mae and Freddie Mac (the Enterprises) operate under congressional charters to provide liquidity, stability, and affordability to the mortgage market. Those charters, which have been amended from time to time, authorize the Enterprises to purchase residential mortgages and codify an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families. Pursuant to their charters, the Enterprises may purchase single-family residential mortgages with loan-to-value (LTV) ratios above 80%, provided that these mortgages are supported by one of several credit enhancements identified in their charters. A credit enhancement is a method or tool to reduce the risk of extending credit to a borrower; mortgage insurance is one such method. Since 1957, private mortgage insurers have assumed an ever-increasing role in providing credit enhancements and they now insure “the vast majority of loans over 80% LTV purchased by the” Enterprises. In congressional testimony in 2015, Director Watt emphasized that mortgage insurance is critical to the Enterprises’ efforts to provide increased housing access for lower-wealth borrowers through 97% LTV loans.

During the financial crisis, some mortgage insurers faced severe financial difficulties due to the precipitous drop in housing prices and increased defaults that required the insurers to pay more claims. State regulators placed three mortgage insurers into “run-off,” prohibiting them from writing new insurance, but allowing them to continue collecting renewal premiums and processing claims on existing business. Some mortgage insurers rescinded coverage on more loans, canceling the policies and returning the premiums.  Currently, the mortgage insurance industry consists of six private mortgage insurers.

In our 2017 Audit and Evaluation Plan, we identified the four areas that we believe pose the most significant risks to FHFA and the entities it supervises. One of those four areas is counterparty risk – the risk created by persons or entities that provide services to Fannie Mae or Freddie Mac. According to FHFA, mortgage insurers represent the largest counterparty exposure for the Enterprises. The Enterprises acknowledge that, although the financial condition of their mortgage insurer counterparties approved to write new business has improved in recent years, the risk remains that some of them may fail to fully meet their obligations. While recent financial and operational requirements may enhance the resiliency of mortgage insurers, other industry features and emerging trends point to continuing risk.

We undertook this white paper to understand and explain the current and emerging risks associated with private mortgage insurers that insure loan payments on single-family mortgages with LTVs greater than 80% purchased by the Enterprises. (2)

It is a truism that the next crisis won’t look like the last one. It is worth heeding the Inspector General’s warning about the

risks from private mortgage insurance as a credit enhancement, including increasing volume, high concentrations, an inability by the Enterprises to manage concentration risk, mortgage insurers with credit ratings below the Enterprises’ historic requirements and investment grade, the challenges inherent in a monoline business and the cyclic housing market, and remaining unpaid mortgage insurer deferred obligations. (13)

One could easily imagine a taxpayer bailout of Fannie and Freddie driven by the insolvency of the some or all of the six private mortgage insurers that do business with them. Let’s hope that the FHFA addresses that risk now, while the mortgage market is still healthy.