Tag Archives: secondary market

Trump’s Plans to Privatize Fannie and Freddie

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from Cato Institute website, https://www.cato.org/people/mark-calabria

Mark Calabria, OMB Associate Director for Treasury, Housing, and Commerce

I was interviewed on  WBUR-FM’s On Point (distributed by American Public Radio), hosted by Meghna Chakrabarti for an episode on How Trump Plans To Get Government out of the Mortgage Business. The link has the recording of the show as well as a transcript.

The transcript of the interview starts,

CHAKRABARTI: Now that President Trump is back in the White House, it seems that he intends to get the job done this time around. Mark Calabria has returned to Trump’s administration, this time working on housing policy at the Office of Management and Budget. Bill Pulte is now director of FHFA, and he just made the highly unusual move of appointing himself chair of both Fannie Mae and Freddie Mac, making the regulator and the regulated basically the same.

Pulte also fired 14 of the 25 sitting board members at Fannie and Freddie. A shakeup many are suspecting is a first step in leading these two companies out of government control and into privatization. We’re talking about a huge part of the U.S. economy that underpins the housing market. So this hour, we want to explore what privatization of Fannie and Freddie actually means, what it should look like, and how it might have an impact on homeowners and the housing market.

So to do that, David Reiss joins us. He’s a clinical professor of law at Cornell Law School and Cornell Tech, an expert in housing finance and policy. Professor Reiss, welcome to On Point.

DAVID REISS: Meghna, thank you so much.

CHAKRABARTI: I have to tell you that I actually can’t believe that it’s been 17 years since the financial crisis of 2008.

Let’s dust off the memory banks professor and go back to before 2008 and start there. Can you just remind us like what Fannie Mae and Freddie Mac were, what their purpose was, who owned them, et cetera?

REISS: I’m gonna go even a little bit further back than Fannie and Freddie’s creation, because I think it’s really gonna help people visualize what’s at stake here.

And if you think back to the 19th century and somebody was trying to buy a house, they didn’t have that many options. A house has always been a very expensive thing to buy, so they need to borrow some money to buy a house. And how could you do that?

Maybe if you’re rich, you could do it, or had a rich uncle, but otherwise you need to go to somebody who has capital and that you could borrow it and give them some interest in return. And pay them back over time, and be able to live in that house while you’re paying back the amount of money that you borrowed. And so if people think of It’s a Wonderful Life where there’s the Bailey Brothers building in loans and where they, people deposit their small savings into the buildings and loan.

And then some people are then able to borrow some money from the buildings and loan for mortgages. And there’s the famous scene where there’s a panic at the bank. And Jimmy Stewart says, Mrs. Kennedy, your money is in Mrs. Smith’s house. And Mrs. Smith, your money is in Ms. Macklin’s house.

And that’s the way it was done in the 19th century and the early 20th century. But there were real limitations to that. Sometimes communities didn’t have a lot of capital to lend people, so maybe in out west or in the Midwest there wasn’t a lot of capital, like there might’ve been back east in Boston or New York.

And so people who could have handled the mortgage just didn’t have access to it. It was like they were living in a dry area, and the fresh flowing credit didn’t reach their dry community. So during the Great Depression and the New Deal the government started to intervene, to spread credit out across the country in a way that kind of provided liquidity to all the communities where people wanted to borrow.

And Fannie Mae was a creature of the New Deal, but really took off in the ’70s along with its sibling Freddie Mac. And effectively, what those two companies were designed by Congress to do was to ensure that capital could go across state borders in a way that banks were typically not allowed to do. And they effectively created at first a national market for mortgage credit, and effectively when they access the global credit markets over time, an international global market for credit. So they’re really intermediaries.

Move Fast and Break the Mortgage Market

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Bill Pulte, FHFA Director and Chair of Fannie Mae & Freddie Mac

I was quoted in the American Prospect’s story, Move Fast and Break the Mortgage Market. It reads, in part,

This week, the Donald Trump–appointed chief regulator for the two quasi-governmental companies that own or control about half of the residential housing market anointed himself the board chair of both those companies. This maneuver could signal a host of shenanigans: the culmination of a 17-year hedge fund get-rich-quick scheme, a balance-sheet fiction to justify tax cuts, a new favor factory for apartment developers with ties to the president, a data transfer so Elon Musk’s everything app can learn how to sell mortgages, or something equally problematic.

But what gives former board members, market observers, and officials at the regulator greater concern is the distinct possibility that mucking around with the $7.7 trillion secondary mortgage market could lead to breaking it.

If that happens, homebuyers may not be able to get mortgages, homebuilders may be reluctant to break ground, and uncertainty would abound in a market that has brought down the economy on more than one occasion in U.S. history, most recently in 2008. “It could freeze sales, freeze refinances, stop people from forming households, cause people to be afraid of moving, freeze up developers of housing and the secondary market,” said David Reiss, a professor at Cornell Law School.

* * *

Multifamily Glad-Handing

The GSEs have a pretty sober business on the single-family side, and since the housing collapse really originated there, a lot of work was done to clean up that part of the business. But Fannie and Freddie also make loans in the multifamily market to support building of apartments and condos. A former official with one of the GSEs told me that business is a little looser, with ways to enhance those loans.

This president, of course, is a multifamily real estate developer himself, who has friends in multifamily real estate development. Hamara, one of the new board members, is a vice president at Tri Pointe Homes, a major homebuilder. You could imagine these relationships leading to the GSEs pushing risk limits, loosening credit standards, or raising loan-to-value ratios for favored borrowers. There is a secret mortgage blacklist at Fannie Mae for condos without enough property insurance or in need of repairs; controlling the board could make that blacklist go away, at least for certain developers.

This kind of setup resembles the opportunity zones that were a feature of the 2017 Trump tax cuts. They gave significant tax breaks to investors in certain communities deemed in need of development. Trump administration officials credit opportunity zones with increasing housing construction, but critics argue that the investments were rife with corruption and favor-trading.

That could also be the case here: New criteria guiding the new boards might lead to more multifamily housing, but with uneven results, favors to friends, and idiosyncratic deals that would be more about boosting allies than building housing. And as Calabria has pointed out, Fannie and Freddie are likely under Trump to cancel affordable-housing initiatives, meaning that sweetheart deals might only extend to the developers, rather than the public. Plus, there is the potential for dramatic losses if lending standards erode.

Reiss, of Cornell, agreed that this was all a possibility. “If someone gets to one of the directors, and they are there not acting as a fiduciary for the company, it opens the door to political favoritism,” he said.

* * *

What If It Breaks

Pulte is expected to force job cuts at the GSEs, which employ roughly 15,000 people. He has already been making familiar noises about DEI and remote work. One possibility on the table at the GSEs is merging Fannie and Freddie; you don’t usually have the same person chair the boards of two direct competitors. The regulatory agency is also likely to see cuts; already at FHFA, according to one source, fair lending and consumer protection groups have been put on administrative leave, along with employees at the Division of Research and Statistics.

Controlling the boards would limit dissent about these actions. But cuts in the name of efficiency could strain or even rupture the numerous functions the GSEs carry out, with consequences for the entire housing market.

Due to the conservatorship, the GSEs are limited in what they can pay their employees, which has led to a talent drain. Some systems have not been integrated, and others are not up to industry standards. Fannie and Freddie have a cautious internal culture that doesn’t move quickly. Hacking away at their already weakened structure could easily create operational harm.

But Reiss explained that nothing has to overtly break to lose the confidence of the markets; even a lack of workforce to move the paper around could create that impression, and disrupt the flow of credit. “If there is any kind of uncertainty, the spread between Fannie and Freddie securities and Treasury bonds will increase,” he said. “Investors will ask if the government will make good on Fannie and Freddie bonds. This uncertainty and direction could increase costs over time for all borrowers.”

Why Does a Bank Sell Your Mortgage?

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I was quoted in Marketplace’s story, Why Does a Bank Sell Your Mortgage? You can listen to it here. The transcript opens,

Right after Marc Hill bought his first home, a townhouse north of Chicago, in the summer of 2019, he got a letter telling him his mortgage had been sold. He didn’t think much of it after Googling around.

“I read that was kind of normal. And then it happened again. And then again. And I was like, ‘Well, what’s going on here?’” he said with a laugh.

Recently, less than five years after his purchase, the mortgage on Hill’s townhouse changed hands for the fourth time.

“Welcome to the 21st century housing market,” said David Reiss, a professor of real estate finance and housing policy at Brooklyn Law School. Today, upward of 70% of mortgages are sold into the secondary market.

“A lot of people have a sense that mortgages work like they did maybe in ‘It’s a Wonderful Life,’” he said. “Where you walk into your bank and if they think you’re a good risk, they’re going to give you some mortgage, and that’s going to come from money that they have from deposits.”

Sometimes that is how it works. But for the most part, Reiss said, “instead of banks lending you money that they have in deposit, once the bank makes the mortgage they then sell it to investors.”

When the bank or lender that originated your mortgage sells it, they get back all the money they lent you right away, plus a chunk of the interest you’re expected to pay over the life of your mortgage. They also get some of your closing costs.

De Facto Housing Finance Reform

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photo by The Tire Zoo

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)

Housing Affordability and GSE Reform

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Jim Parrott and Laurie Goodman of the Urban Institute have posted Making Sure the Senate’s Access and Affordability Proposal Works. It opens,

One of the most consequential and possibly promising components of the draft bill being considered in the Senate Banking Committee is the way in which it reduces the cost of a mortgage for those who need it. In the current system, Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) deliver subsidy primarily through the level pricing of their guarantee fees, overcharging lower-risk borrowers in order to undercharge higher-risk borrowers. While providing support for homeownership through cross-subsidy makes good economic and social sense, there are a number of shortcomings to the way it is done in the current system.

First, it does not effectively target those who need the help. While Fannie Mae and Freddie Mac are both pushed to provide secondary market liquidity for the loans of low- and moderate-income (LMI) borrowers in order to comply with their affordable housing goals and duty to serve obligations, almost one in four beneficiaries of the subsidy are not LMI borrowers (Parrott et al. 2018). These borrowers receive the subsidy simply because their credit is poorer than the average GSE borrower and thus more costly than the average guarantee fee pricing covers. And LMI borrowers who pose less than average risk to the GSEs are picking up part of that tab, paying more in the average guarantee fee than their lower-than-average risk warrants.

Second, the subsidy is provided almost exclusively through lower mortgage rates, even though that is not the form of help all LMI borrowers need. For many, the size of their monthly mortgage is not the barrier to homeownership, but the lack of savings needed for a down payment and closing costs or to cover emergency expenses once the purchase is made. For those borrowers, the lower rate provided in the current system simply does not help.

And third, the opacity of the subsidy makes it difficult to determine who is benefiting, by how much, and whether it is actually helping. The GSEs are allocating more than $4 billion a year in subsidy, yet policymakers cannot tell how it has affected the homeownership rate of those who receive it, much less how the means of allocation compares with other means of support. We thus cannot adjust course to better allocate the support so that it provides more help those who need it.

The Senate proposal remedies each of these shortcomings, charging an explicit mortgage access fee to pay for the Housing Trust Fund, the Capital Magnet Fund, and a mortgage access fund that supports LMI borrowers, and only LMI borrowers, with one of five forms of subsidy: a mortgage rate buy-down, assistance with down payment and closing costs, funding for savings for housing-related expenses, housing counseling, and funding to offset the cost of servicing delinquent loans. Unlike the current system, the support is well targeted, helps address the entire range of impediments to homeownership, and is transparent. As a means of delivering subsidy to those who need it, the proposed system is likely to be more effective than what we have today.

If, that is, it can be designed in a way that overcomes two central challenges: determining who qualifies for the support and delivering the subsidy effectively to those who do. (1-2, footnote omitted)

This paper provides a clear framework for determining whether a housing finance reform proposal actually furthers housing affordability for those who need it most. It is unclear where things stand with the Senate housing finance reform bill as of now, but it seems like the current version of the bill is a step in the right direction.

Time Is Ripe For GSE Reform

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photo by Valerie Everett

Banker and Tradesman quoted me in Time Is Ripe For GSE Reform (behind a paywall). It opens,

Federal Housing Finance Agency (FHFA) Director Melvin L. Watt told the U.S. Senate Committee on Banking, Housing and Urban Affairs last month that “Congress urgently needs to act on housing finance reform” and bring Fannie Mae and Freddie Mac out of conservatorship after almost nine years.

Conservatorship is temporary by its very nature. There is universal agreement that it can’t go on forever, but there is widespread disagreement about what the government-sponsored entities (GSEs) should look like after coming out of conservatorship – and how to get there.

“Only a legislative solution can provide political legitimacy and long term market certainty for the housing finance system,” according to a recent Mortgage Bankers Association (MBA) white paper on GSE reform. MBA President and CEO Dave Stevens said now is the time for Congress to tackle the changes that will maintain liquidity, but protect taxpayers and homebuyers.

“The last recession destroyed many communities throughout the country,” he said. “The GSEs played a large role in that. They fueled a lot of the capital that allowed all varieties of lenders to make risky loans and then received the single-largest bailout in the history of this nation. They are not innocent.”

Connecticut Mortgage Bankers Association President Kevin Moran said his organization supports the positions of the MBA.

“There’s going to be change no matter what,” Stevens said. “We’re stuck with this problem. It’s technical and complicated and needs to be done. They can’t stay in conservatorship forever.”

Taxpayers Need Protection

Professor David Reiss at Brooklyn Law School said that future delays are not out of the question.

“Change is coming, but the Treasury and FHFA can amend the PSPA [agreement] again,” Reiss said. “It’s been amended three times already. There’s a little bit of political theatre going on here. It’s incredibly important for the economy. You really hope that the broad middle of the government can come to a compromise. If there isn’t the political will to move forward, they can simply kick the can down the road.”

Reiss said the fact that Fannie Mae and Freddie Mac are both going to run out of money by January 2018 is a factor in why reform is needed soon, but the GSEs aren’t in danger of imminent collapse.

“They are literally going to run out of money,” Reiss said. “But keep in mind they will continue to have a $2.5 billion line of credit. It’s partially political. They’re trying to get the public conscious of this. I don’t think anyone in the broad middle of the political establishment thinks it’s good that they’ve been in limbo for nine years.”
The MBA’s proposal to reform Fannie Mae and Freddie Mac aims to ensure that crashes like the one in 2007-2008 never happen again, in part by raising the minimum capital balance GSEs have to maintain to a level at least as high as banks and other lenders.

“They have a capital standard that is absurd,” Stevens said. “Pre-conservatorship they had to have less than 0.5 percent capital. Banks are required to maintain 4 percent of their loan value against mortgages. That’s a regulated standard. Fannie and Freddie are not as diversified as banks are. Our view is to make sure they are sustainable; they should at least a 4 to 5 percent buffer to protect them against failure.”

To put that into context, a 3.5 percent buffer would have been just large enough for the GSEs to weather the last housing crash without the need for a taxpayer-funded bailout. Stevens said the MBA would go even further.

“They should also pay a fee for every loan that goes into an insurance fund in the event all else fails,” he said. “In the event of a catastrophic failure, that would be the last barrier before having to rely on taxpayers. Keep in mind: for years, shareholders made billions and when they failed taxpayers took 100 percent of the losses.”

Stevens said the MBA would like to see more competition in the secondary market, and that the current duopoly isn’t much better than a monopoly.

“There should be more competitors,” he said. “If either one [Fannie or Freddie] fails, you almost have to bail them out. Our goal is to have a highly regulated industry to support the American finance system without using the portfolio to make bets on the marketplace.”

A Bipartisan Issue

While some conservatives like Chairman of the House Financial Services Committee Rep. Jeb Hensarling (R-Texas) have called for getting the government out of the mortgage business altogether, Stevens said that would likely mean the end of the 30-year, fixed-rate mortgage.

Furthermore, GSEs are required to serve underserved communities. Private companies would be more likely to back the most profitable loans.

“The GSEs play a really important role in counter-cyclical markets,” Stevens said. “When credit conditions shift, private money disappears. We saw that in 2007. It put extraordinary demands on Fannie Mae, Freddie Mac and Ginnie Mae. You need a continuous flow of capital. You can put controls in place so it can expand and contract when needed.”

Reiss said getting the government out of the mortgage business would certainly mean some big changes.

“I think there is some evidence that some 30-year, fixed-rate mortgages could still exist,” Reiss said. “It would dramatically change their availability, though. Interest rates would go up somewhere between one-half and 1 percent. Some people might like that because it reflects the actual risk of a residential mortgage, but it would also make housing more expensive.”

Budding GSE Reform

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The Mortgage Bankers Association has released a paper on GSE Reform: Creating a Sustainable, More Vibrant Secondary Mortgage Market (link to paper on this page). This paper builds on a shorter version that the MBA released a few months ago. Jim Parrott of the Urban Institute has provided a helpful comparison of the basic MBA proposal to two other leading proposals. This longer paper explains in detail

MBA’s recommended approach to GSE reform, the last piece of unfinished business from the 2008 financial crisis. It outlines the key principles and guardrails that should guide the reform effort and provides a detailed picture of a new secondary-market end state. It also attempts to shed light on two critical areas that have tested past reform efforts — the appropriate transition to the post-GSE system and the role of the secondary market in advancing an affordable-housing strategy. GSE reform holds the potential to help stabilize the housing market for decades to come. The time to take action is now. (1)

Basically, the MBA proposes that Fannie and Freddie be rechartered into two of a number of competitors that would guarantee mortgage-backed securities (MBS).  All of these guarantors would be specialized mortgage companies that are to be treated as regulated utilities owned by private shareholders. These guarantors would issue standardized MBS through the Common Securitization Platform that is currently being designed by Fannie and Freddie pursuant to the Federal Housing Finance Agency’s instructions.

These MBS would be backed by the full faith and credit of the the federal government as well as by a federal mortgage insurance fund (MIF), which would be similar to the Federal Housing Administration’s MMI fund. This MIF would cover catastrophic losses. Like the FHA’s MMI fund, the MIF could be restored by means of higher premiums after the catastrophe had been dealt with.  This model would protect taxpayers from having to bail out the guarantors, as they did with Fannie and Freddie at the onset of the most recent financial crisis.

The MBA proposal is well thought out and should be taken very seriously by Congress and the Administration. That is not to say that it is the obvious best choice among the three that Parrott reviewed. But it clearly addresses the issues of concern to the broad middle of decision-makers and housing policy analysts.

Not everyone is in that broad middle of course. But there is a lot for the Warren wing of the Democratic party to like about this proposal as it includes affordable housing goals and subsidies. The Hensarling wing of the Republican party, on the other hand, is not likely to embrace this proposal because it still contemplates a significant role for the federal government in housing finance. We’ll see if a plan of this type can move forward without the support of the Chair of the House Financial Services Committee.