toward a new secondary mortgage market - milken...

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Toward a New Secondary Mortgage Market MichaelBrightandEdDeMarco

September2016

Executive Summary Thereisasimpleandsensiblewaytofinallyachievecomprehensivehousingfinancereforminourcountry.TheapproachweproposeinthispaperistoamendthechartersofGinnieMae,FannieMaeandFreddieMac,andtheFederalHousingFinanceAgency(FHFA).

SimplyamendingthesecharterscanaccomplishawideswathoftheobjectivesthathaveeludedlegislatorsandpolicymakerssincetheconservatorshipofFannieMaeandFreddieMacbeganin2008.Eachofthecharterchangesweproposecanstandonitsownrightassoundpolicy.Collectively,theyallowustotakeimportantstepstowardamorerobust,dynamic,andsecuremarketformortgagecreditrisk.

Allofthiscanbeachievedwhilenotmateriallyaffectingborrowerinterestrates,sinceweleverageawell-knownandwidelyacceptedgovernment-backedsecuritythatthemarketalreadyunderstands,aswellasrisktransfermechanismsthatthemarkethasacceptedsince2013.Thetransitiontothisreformcanbeaccomplishedsmoothly,leavingahousingsystemthatisefficient,opentocompetitionandinnovation,andensuresastablesupplyofmortgagefinancing.

Ourproposalwouldendtheconservatorships,reconstituteFannieMaeandFreddieMacaslender-ownedmutuals,andbuildonthecreditrisktransfer(CRT)initiativetocreateaprivatemarketformortgagecreditriskwhilepreservingagovernment-guaranteedratesmarketformortgage-backedsecurities.OtherfirmscouldcompetewithFannieandFreddieinthebusinessofaggregatingloansandgatheringtogethertheprivatecapitalthattakesonhousingriskaheadofthebackstopgovernmentguarantee.Weseektomakethesechangeswhilepreservingasmuchaspossiblehowlenders,servicers,andothersoperatetodaysoastokeepwhatworks,avoiddisruptiontocurrentbusinesspractices,andlimitriskintransition.

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Theframeworkoutlinedinthispaperfeaturesthefollowingkeyprovisions:

FannieMaeandFreddieMac! Passedthroughreceivershipandreconstitutedasentitiesmutuallyownedbytheirseller-

servicers.! Havetwoprincipalbusinessfunctionsinthesingle-familymortgagemarket:

! Providecreditenhancement.Astheyhavebeenforthepastfewyears,thecompanieswouldsyndicatemortgagecreditriskthroughavarietyofcreditrisktransferstructures,therebycontributingtoabroadanddeepmarketformortgagecreditriskthatdisperses,ratherthanconcentrates,riskandensuresongoingmarketanalysisofcreditrisk.

! Maintainacashwindowforsmallandmid-sizedlenderstosellmortgagesforcashandaggregatetheseloansforsecuritizationandcreditrisksyndication.

! Nolongerhavetheattributesoftheiroldgovernment-sponsoredenterprise(GSE)charters,norwouldtheymaintainaninvestmentportfoliooroperateinaprotectedduopoly.

GinnieMae! TakenoutoftheDepartmentofHousingandUrbanDevelopment(HUD)andmadeastand-

alonegovernmentcorporationliketheFDIC,withauthorityoveritsownbudget,hiring,andcompensation.

! Authorizedtoacceptprivate-sectorcreditenhancementfromentitieslicensedbytheFHFA.! Provideafull-faith-and-creditwraponmortgage-backedsecurities(MBS)issuedbyGinnieMae-

approvedissuerswheretheloanpoolsarecredit-enhancedeitherbyagovernmentprogram(suchasFHAorVA)orbyFHFA-approvedcreditenhancersthatarrangefortherequiredamountsofprivatecapitaltotakeonhousingcreditriskaheadofthegovernmentguarantee.

FHFA! Continuestoregulatethehousingfinancesystem,includingsecuritizationandthequantityand

qualityofprivatecapitalstandinginfrontofthegovernmentguarantee,asnotedbelow.! Overseesthewindingdownoftheconservatorships,includingoversightoftheoutstanding

FannieandFreddiesecuritiesbackedbytheTreasurysupportagreements.! Authorizedtosetstandardsforprivatecreditenhancementofloanpoolsandwouldlicenseand

examineentitiesprovidingsuchcreditenhancement.! Ensuresstandardizationacrossthehousingfinanceecosystemwithregardtodata,data

reporting,etc.toensureatransparentandliquidmarket.! EstablishesandoperatesaMortgageInsuranceFund(MIF)fundedbyindustryassessmentsto

backstopthecreditenhancementmarket.

Introduction Housingmattersforsomanyreasons—economicones,yes,butalsobecauseitisabasichumanneed,theplacewherefamiliesandlivesarebuilt.AndhousingformostpeopleinAmericaisthemostexpensiveitemintheirmonthlybudget,whethertheyrentorown.Therefore,howhousingisfinanced—oreveniffinancingisavailable—isofcriticalimportancetoeveryone.Fromthestandpointoftheoveralleconomy,investmentinhousingandconsumptionofassociatedproductsandservicesrepresentakeycontributortoGDP.Forfinancialmarkets,problemsinthehousingfinancesystemwereatthecenteroftherecentfinancialcrisis.Gettingthisrightmatters.

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Thehousingfinancesystemandwhateverchangeswemaketoitmustensuretheongoingavailabilityofcredittosupportthemanagementofrentalhousingandthefinancingofhomepurchasesforthosereadytotakethatstep.

TheU.S.housingmarketwasattheepicenterofthe2008globalfinancialcrisis,ofcourse.AndsincethenCongresshasallocatedhundredsofbillionsofdollarstokeepthesecondarymortgagemarketsolvent.Yettheemergencyandsupposedlytemporarystateofgovernmentownershipofone-fifthoftheeconomy1hasyettobeaddressedbyCongress.

Theimportanceofhousingtooureconomyhascontributedtothechallengesofmarketstructurereform.Theinfrastructureprovidingfinancetosupporthousingshowedfundamentalflawsduringthefinancialcrisisanditremainsinanunstablestate—conservatorship—eightyearslater.Theconstantpoliticizationofhousingfinancehasleftusatapolicyimpassedespitebroadareasofagreementonwhatneedstobedone.

Thisisinlargepartbecausethestructurethatundergirdstoday’shousingfinancemarketiscomplex.Andso,eightyearsafterthefinancialcrisis,withthegovernmentexplicitlybackingthecreditriskonthevastmajorityofmortgagesissued,andtheFederalReserveservingasthelargestholderofagencymortgage-backedsecurities,theentiresystemreliesheavilyonthepublicsectortofunction.

Inthefirstpaperinourseriesonhousingfinancereform,wemadethecaseforwhyreformisneededandsetforthitsobjectives.Aswenoted,thetrickistosolvethepolicyproblemsthatmustbeaddressedwhilebuildingefficientlyoffwhatalreadyworks.

Inthispaper,wewilloutlineadetailedpaththatnavigatessuchacourse.ThisstructurewouldreplacethefailedduopolisticGSEsystemwithoneofcompetitiveprivateinsurers,avibrantmarketformortgagecreditrisk,ownershipstructuresthatrequirelenderstohavesomeskininthegame,andappropriategovernmentstandard-settingandoversighttoensureadeepandliquidMBSmarket.

Since2008,severallegislativeattemptshavebeenmadetoendtheconservatorshipsoftheGSEs—FannieMaeandFreddieMac.Mostofthesebillsweregenerallydesignedtousherinamarket-basedsystemwhileprovidingautilityandregulatoryroleforthegovernmentinensuringequitableaccesstothesystemforasmanyAmericansaspossible.Suchproposalsalsohavegenerallyallowedthegovernmenttoprovideatransparentcatastrophicbackstop,thusminimizingtheneedforemergencycongressionalactionduringacrisisandallowingthegovernmenttochargeupfrontforthetailriskthatmanyunderstanditalreadyowns.

MuchoftheDNAofthesepastbillsremainsinwhatwepropose.Butweaimtoachievetheseobjectivesoflegislationviaamorestreamlinedpath.

1Examplesofthefederalgovernment’sownershipordirectsupportofthehousingfinancesystemincludetaxpayers’directsupportoftheFederalHousingAdministration(FHA),theTreasurysupportagreementsbackstoppingFannieMaeandFreddieMac,theHomeAffordableModificationProgram(HAMP),andtheFederalReserve’snearly$2trillionportfolioofmortgage-backedsecurities.

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Perhapsthemainconcernaroundmostreformproposalshasbeenviability.Themanymovingpartsofpastproposalshaveledlegislatorsandstakeholderstobecometrappedonasinglequestion:Willthiswork?ThatwasthemainconcernatplayindiscussionsintheSenatein2014,forexample,anditremainsahallmarkofmostreformdebatestoday.

Tohelpmitigatethisconcern,wetakeasastartingpointthatreformmustsufficientlyleveragetheaspectsofourhousingsystemthatweknowalreadyfunctionwell.Butitmustdothiswhiletakingstepstowardamodelthatridsusofthepre-crisissystemthatallowedprofitstoprivateGSEshareholdersingoodtimesbutrequiredanemergencytaxpayerbailoutduringatimeofextremestress.WealsoneedtomovepastasystemthatleansentirelyonasingleregulatoryagencyinWashingtontomakeunderwritingandmortgagepricingdecisionswhileaskingtaxpayerstoshouldermostoftherisk.

Ourplansolvesthesemultifacetedchallengesbyrelyingheavilyontheexistinginfrastructure,therebyeasingthetransitionandensuringthenewstructurewillhavemuchofthelookandfeeloftheexistingmarket.Ourproposalleverageswhatthemarketalreadyknowsandunderstands.Thereisnoleapoffaithinwhatwepropose.Thereis,instead,asteadywalktowardabettermarketstructure.

Howso?Weproposetosimplyamendthechartersthatformthefoundationofoursecondarymortgagemarketsystem:theGSEcharters,theGinnieMaecharter,andtheFHFAcharter.

Theamendmentsweproposewouldsimultaneouslyimprovethesystemandsolvemanyofthepolicyproblemsofthepaststructure.Theywouldpromotecompetitionformortgagerisk,alignincentivesthroughoutthemortgageecosystem,leveltheplayingfieldacrosslargeandsmallloanoriginators,andultimatelycouldstimulatecreditavailability.

Policy Challenges We Aim to Solve Reform,nomatterhowmuchfocusitgivestoensuringsimplicityandasmoothtransition,shouldsolveafewkeypolicychallenges.Thereisoftenatrade-offbetweenthemagnitudeofwhatcanbesolvedandtheamountofriskintransition—atrade-offwebelieveweoptimizeinoursimpleproposal.Still,onemustensurethatcertainkeyobjectiveshavebeenmet.

Inourpreviouspaper,weidentifiedthreeaspectsofthesecondarymortgagemarketasitworkstodaythatshouldbepreserved:

1. AliquidMBSmarket,including:a. TheTo-Be-Announced(TBA)marketb. Standardizationofmortgagedata,servicingrules,andMBSsecuritystructureand

disclosure2. Nationwide,uninterruptedaccesstothesecondarymortgagemarket3. Competingoutletsconnectingtheprimarymarkettothesecondarymarket

Wealsoidentifiedfivebroadobjectivesforreform,citingaspectsofthecurrentsystemthatmustbefixedorreplaced:

1. Eliminateemergencybailouts2. Buildsomedegreeofconsensusonamodernizedaffordabilityandaccessibilityparadigm

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3. Bringmarketsignals,privatecapital,competition,andinnovationbacktothemarket,butwithstandardsandguardrails

4. EliminatehiddenorimpliedguaranteesandallvestigesofthecronycapitalismthatcharacterizeFannieandFreddie’scharters

5. Alignincentivesasmuchaspossiblethroughoutthesystem

The Government’s Role in Guaranteeing Mortgage CreditBeforeproceeding,itisworthtakingamomenttolookatthegovernment’sroleinthemortgagecreditsystem.

Thefundamentalquestionofhousingfinancereformistheroleofthegovernment,(i.e.taxpayers),inbearingmortgagecreditrisk.Consideringthisrolemeansassessingwhetheraccomplishingtheobjectivessetforthaboverequiresthegovernmenttoensureorbackstopinvestorsintheeventofmortgagedefaults.

Today,thegovernmentdirectlysupportsthemajorityofmortgagecreditriskinthemarketthroughmortgage-guaranteeprogramssuchasFHAandVAandthroughtaxpayerbackingofFannieMaeandFreddieMac.Whilevirtuallyallpolicymakersagreethatthisisfartoomuchtaxpayerinvolvement,noneofthelegislativeproposalsofthepastfewyearshaveadvocatedcompleteeliminationoffederalsupport.

Forexample,noneoftheproposalsadvocatedeliminatingtheFHAandVAloan-guaranteeprograms.Moreover,theCorker-WarnerandJohnson-CrapobillsintheSenatewouldhavereplacedthecurrenttaxpayersupportofFannieMaeandFreddieMacwithanewgovernmentcorporationthatwouldexplicitlyprovidecatastrophicinsuranceofMBSintheeventthatprivatecapitalprovedinadequate.TheHousebills,onesponsoredbyRepublicanRep.ScottGarrettofNewJerseyandanotherbyDemocraticRep.JohnDelaneyofMarylandandothers,wouldhaveutilizedGinnieMaetoprovidesomelevelofgovernmentguarantee,albeiteachinadifferentway,andGarrett’sPATHActonlywhenmarketconditionswarranted.

Likemanyreformadvocates,weconcludedthatthevastmajorityofmortgagecreditriskinherentintheconforming,conventionalmortgagemarket—themarketsegmentservedbyFannieMaeandFreddieMac—canandshouldbebornebytheprivatesector.Thereisamplecapitalableandwillingtounderwrite,price,andmanagemortgagecreditriskprovidedthemarketoperateswithtransparencyandclarityregardingtherules,includingtherulessurroundingborrowerdefaults.Hence,thereisacrucialroleforthegovernmentinestablishingandenforcingsuchrules.

Importantly,webelievetheresidualcreditrisk,sometimescalledthecatastrophicrisk,shouldultimatelybetheresponsibilityoftheprivatehousingfinancesectoraswell,withthegovernmentprovidingonlytemporalsupportduringaneconomiccrisissoastosmoothoutlossesthatultimatelyremainthemarket’sresponsibility.Still,agovernmentroleinsomeformisprobablykey.

Wecametothispolicyconclusionforfourreasons:1. Thecreditrisktransfermarketinitiatedseveralyearsagodemonstratesthecapacityand

interestofmarketparticipantsinthiscreditmarket.Yetfromourexperienceandinteraction

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withnumerousmarketparticipants,weconcludedthatthevastmajorityofthembelievethe$10trillionsingle-familymarketisincapableofabsorbingalltheembeddedcreditriskinthismarket,largelybecauseofthedifficultyinpricingandreservingfortheveryinfrequentandcatastrophiccrediteventsinhousing.

2. AgovernmentguaranteeofMBSthatreplacestheFannie-Freddiemarketsegmentwouldcleanlyseparatethemarketformortgagecreditriskfromthefundingmarketformortgages(knownastheratemarket),whichundertakestheinterestrateriskinmortgagelending.Onlyagovernmentbackstopguaranteeperfectlybifurcatesthosemarkets.Removingcreditriskfromtheratemarketusingagovernmentguaranteehasthesubstantialbenefitofwideningthepoolofeligibleinvestorsintheratemarket,thusloweringmortgageinterestrates.Withtheprivatesectorbearingallthecreditandinterestraterisk,thesubsidywouldbesmall,therebyreducingthemarket-distortingeffectsofthecurrentbuilt-insubsidies.

3. SuchaguaranteewouldalsopreservetheTBAmarketasitfunctionstoday,removingakeyelementofuncertaintyinthereformdebate.

4. Acatastrophicguaranteeactsasanautomaticstabilizer,enhancingmarketstabilityandhousingfinanceliquidityduringaneconomiccrisis.

Thepre-conservatorshipFannieandFreddiemarketconcentrated$5trillionofmortgagecreditriskontwobalancesheets—FannieandFreddie’s—whileinvestorsintheirMBSsawthroughtheFannieandFreddiecorporatecreditguaranteestothetaxpayersstandingbehindthem.Foryears,thiswaswidelydescribedastheimplicitguaranteeinherentintheFannie-Freddiemodel.YetthegovernmentofficiallydeniedsuchsupportwouldbegivenandthusneverreceivedcompensationfortheeconomicbenefititprovidedFannieandFreddieshareholders.Therealityofthisimpliedguarantee,however,wasmademanifestin2008.

Inconservatorship,thetaxpayerguaranteeisexplicitthroughtheTreasurysupportagreementsthatallowFannieandFreddietocontinuetooperatedespitetheirfailureduringthecrisis.Theexistenceofthisguaranteehasallowedtheenterprisestocontinuetofunction,andbecauseofittheFederalReservehasbeenabletopurchasetheMBSissuedbytheenterprises,inanefforttolowerborrowingcostsforhomeowners.

Butoverthepastfewyears,attheirconservator’sdirection,bothFannieandFreddiehavebegunsellingoffmortgagecreditrisktoprivateinvestors,buildingasmallbutgrowingprivate-capitalbufferinfrontofthetaxpayer.Webelievethesecreditrisktransfertransactionshavebeenimportantstepsinclearingapathtowardarobustmarketformortgagecreditrisk,whichissomethingourfinancialsystembadlyneeds.2

Ourreformproposalcontinuestowardanendstatewithadeepandliquidmarketformortgagecreditrisk.Infact,thehallmarkofourproposalisthecreationofavibrantcreditmarketmanagedbyregulatedcredit-enhancemententities,mostofwhichwouldoperateasmortgageguarantorsandreinsurers.WeproposeestablishingabackstopMortgageInsuranceFundmanagedbythegovernmentasacatastrophicriskpoolfundedbytheparticipantsin(thatis,beneficiariesof)thehousingfinancesystem.

2Foradditionalbackgroundonthestepstakentodateandthosestillneededtofullydevelopamarketformortgagecreditrisk,seeEdwardJ.DeMarco,“(Re-)CreatingaMarketforMortgageCreditRisk,”October28,2015;http://www.milkeninstitute.org/publications/view/748.

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FeeswouldbeleviedontheindustrytoprefundtheMIF,andanylateruseoftaxpayermoneytoaddtothefundwouldberepaidbyindustryassessments.ThisissimilartohowthedepositinsurancefundsoperatedbytheFDICprotectinsureddepositorstoday.

Uptothispoint,ourproposalissimilartonumerouslegislative,industry,andthinktankproposalsthathavecirculatedinrecentyears.Butitpartswayswithmanyofthembyrelyingonanexistingfederalcorporation—theGovernmentNationalMortgageAssociation(GinnieMae)—ratherthancreatingoneormorenewfederalentitiestoaccomplishitsgoals.3

GinnieMaeisagovernmentcorporationwithintheDepartmentofHousingandUrbanDevelopment.Itdoesexactlywhatwejustdescribed,exceptitdoesitformortgageswhosecreditriskisguaranteedbyFHA,VA,orotherfederalprograms,notbyprivatecapital.WebelievethatusingGinnieMae’splatformandworld-recognizednameplateasaU.S.governmentbackstopguarantorofMBS,butwithprivatecapitalinfront,providesaneasytransitionthataccomplishesthegoalsdescribedabove.GettingtherewillrequireamendingGinnie’scharter,thechartersofFannieandFreddie,andtheFHFAcharter,butitdoesnotrequirecreatinganynewfederalprogram,corporation,oragency.Moreover,manyoftheparticipantsinthehousingfinancesystemenvisionedinourproposalalreadyexist;thereisnoneedtorelyonentrybyunknownfuturefirms.Suchentryandcompetitionissupported(evenencouraged)inourmodel,tothebenefitofbothtaxpayers,throughincreasedsafetyandreducedsystemicrisk,andfuturehomeowners,throughlowermortgagecosts.

Intheremainderofthispaper,weoutlinehowweproposeamendingthesethreesetsofcharterstocreateasmoothpathtoanewsecondarymortgagemarketthatallowsaccessforalllendersandareliableandstablesupplyofcapitaltofundmortgagesacrossthecountry.

Step One: Amendments to the GSE Charters Webeginbyasking:Whatistobecomeofthesetwoentities,FannieMaeandFreddieMac,whichcurrentlyoperateongovernmentlifesupportbutlargelykeeptheconventionalmortgagemarketfunctioning?Afterall,thelifesupportwasputinplaceinrecognitionoftheimportanceofnotupsettingtheroughly$5trillionsegmentofthemortgagemarketservedbythesetwoenormousenterprises.Transitiontoanewsystemmustaccountforthecurrentoperationsofthesetwocompaniesandthemanylendersandmortgageservicersthatrelyonthem.

Yetwestronglybelievethatanewsystemmustopenthedoortocompetitiveforcesandtoamortgagemarketthatismoreholisticallyresponsiblefortheperformanceoftheloansoriginated.Ensuringthatlendershadskininthegame(thatis,hadtheirowncapitalatriskintheirlendingdecisions)wasakeyobjectiveoftheDodd-Frankfinancialregulatoryreformbill,butithasbeeneffectivelyevisceratedby

3WearenotthefirstonestoproposeusingGinnieMaeasthecenterpieceofhousingfinancereform.OtherswhohaveproposedacentralroleforGinnieMaeincludetheDelaney-Carney-Himesbill(https://delaney.house.gov/news/press-releases/delaney-carney-himes-file-housing-finance-reform-legislation-to-protect-30-year);RobertCouchandJoeMurin(http://www.housingwire.com/articles/14005-former-ginnie-mae-execs-submit-gse-reform-plans);GaryAcosta,JoeMurinandGaryPark(http://www.urban.org/policy-centers/housing-finance-policy-center/projects/housing-finance-reform-incubator/gary-acosta-jim-park-and-joe-murin-future-gses-ginnie-mae-20-solution);andAndyDavidson(https://www.ad-co.com/analytics_docs/GSERoundtableSummary_2015.pdf).

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decisionstakenbythevariousregulators.Wechangethis.Achievingthesepolicyobjectivesputsusonapathtowardamorestablehousingmarket.

Withthesegoalsinmind,wesettoanalyzinghowthecrucialfunctionstheGSEsperformcanbepreservedwhilethesystemmovestowardsounderfootingthroughreforms.

Tobegin,weproposethatthenewsystempreserveaplacefortheentitiesreconstitutedfromFannieandFreddiebutthatthereconstitutedentitieslosethespecialprivilegesoftheirGSEcharters(includingtheirprotectedstatusasthegatekeepersofallmortgagecreditrisk).Thereconstitutedfirmswouldhavetocompeteandsurviveinamarketplaceopentodisruptionandcompetitiveforces.Wealsobelievethattheirlendersshouldhaveoversightoftheiroperationsandskininthegametoprotectagainstlosses.

Inthissection,weoutlinethecharterchangesthatwouldallowFannieandFreddietocontinueperformingmanyofthebusinessfunctionstheyhaveperformedfordecades,butwithoutmanyofthespecialprivilegesthattookthemoffcourse.Wealsoseektoeliminatetheconflictingmandatestoserveshareholdersaspubliclytradedcompanies,servelendersastheonlytwooutletsforsecuritization,andservethepublicinterestthroughtheircongressionalcharters.

TheGSEs,inourview,shouldbecomecreditrisksyndicatorsthattakeoncreditriskfromtheirlenders,sellittoinvestorsthroughcreditrisktransfer,andhelpdrivethemarkettoinnovateandevolve.Andthelendersthatutilizetheseenterprisesshouldhaveastakeintheirmanagementandperformance.AndwebelievethatnomatterwhatwedowithFannieandFreddie,theyshouldNOTbetheentiremarketformortgagecreditriskinthiscountry.Theyshouldoperateinacompetitivemarketplace.And,ofcourse,theywillneedcapitalbeyondCRTtooperatesafely.

Gettingthereinvolves,one,changingFannieandFreddie’sownershipstructure;two,requiringtheuseofrisktransfer;andthree,leveraginganalready-builtgovernmentsecuritytoallownewentrantsintothemarket.MutualizationIfwearekeepingFannieandFreddie,albeitinanewmarketwheretheymustcompete(moreonthisinthenextsection),someoneneedstoownthem.Someoneneedstoprovideentity-levelcapitaltoensuretheiroperations.

Acriticalfailingofthepre-2008setupwasthat,becausetheywerepubliclytradedcompanies,theGSEs—despitehavingamandatetoleadandservetheprimarymortgagemarket—hadanoverridingfiduciarydutytotheirshareholderstomaximizetheirabilitytomakemoney.

Mutualization,anownershipstructurethatallowstheGSEstobecapitalizedandownedcollectivelybytheirseller-servicers,avoidsthechallengesofotherownershipmodels.

Thisisnotanewidea.Therearesomeveryhelpfulprecedentsthatdemonstratetheviabilityandbenefitsofthismodel.Infact,itistheownershipmodelemployedbytheFederalHomeLoanBanks

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(FHLBs).IntheFHLBstructure,memberspurchasesharesandhavecollectiveoversightoftheFHLBs.Theonustokeeptheenterprisessolventisonthosewhousethem—theoriginators.Themutualownershipmodeliscommonintheinsuranceindustryaswell,includingamongsuchgiantsasStateFarmandNewYorkLife.

Creditunions,too,aremutual,andtheU.S.hasalonghistoryofmutualsavingsandloans.

Oneoftheworld’slargestinvestmentcompanies,Vanguard,isamutual,asisanewandinnovativemunicipalbondinsurer,BuildAmericaMutual,formedin2012.

Thereismuchtoborrowfromthismodel,andwebelievetheownershipstructurealignsincentivesinawaythatcanminimizethedesireto“chasemarketshare,”astheGSEsdidinthemid-2000s.

BytransformingFannieandFreddiefromGSEsintomutuallyownedandoperatedinsurers,lendersthatarefamiliarwithsellingloanstoFannieandFreddiewillhavethechoicetocontinuetodoso.Buttoalignincentivesproperly,theselenderswillbecometheownersofthemutual.

Moreover,thecharterswouldnotbeexclusive.Lenderscouldbemembersateither,both,orneithermutual.

Themutualownershipstructurealignsincentivesoncreditrisk,meaningthatboththeloanoriginatorsandthecreditenhancershavedirectexposuretocreditriskandeachwillwanttocarefullymonitormarketconditionsgenerallyandthequalityofloanproductionacrossthemembersofthemutuals.Importantly,themutualapproachachieveswhatDodd-Franksoughttoaccomplish—skininthegameforlendersandsecuritizers—butfailedtoachievebecauseofthewaytheregulationswerewritten.

Thistypeofstructureachievesoneveryimportantpolicygoal:alignmentofincentivesthroughoutthesystem.Ifthisalignmenthadbeeninplacebeforethecrisis,theincentivetosimplysellallrisktotheGSEswithoutcareforloanquality—asinaccuracyofunderwriting—wouldnothavebeensoprevalent.Andwhenwetalkaboutunderwritingqualityhere,thisisourprimaryfocus.Itisnotjustcreditscoreorloan-to-value(LTV)ratio,butaccuracyofdocumentationandtheavoidanceofcarelessnesswiththeunderwritingprocess.

WhentheoriginatorsthemselveshaveastakeintheperformanceofFannieandFreddie,theincentivetoensurehigh-qualityunderwritingcanbemaintained.TheFHFAwouldhavestrongregulatoryoversighttomakesureofthis,asitdoesnowwithboththeGSEsandtheHomeLoanBanks.Thecollectivepressureofanindustrywithastakeintheperformanceoftheloansitoriginatesisalsohelpful.

Anotherbenefitofthemutualstructureisthatitrewardsthelender-ownersforproducinggood-qualitymortgages.Intechnicalterms,thelenderscan“monetize”thevalueofproducingperformingmortgages.Thismayproveespeciallybeneficialtocommunitylendersascomparedwiththeoldmodel.Intheoldmodel,FannieandFreddieshareholderscapturedtheeconomicbenefitofgoodlending,whereaslendershadnoeconomicincentivetobebetterunderwritersthanthenextguy.CommunitylendersoftenarguedthattheyknewtheirlendingmarketsbetterthanthenationalplayersbuttheGSE

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secondarymarketdidnotrewardthemforthat.Infact,communitylenderstypicallyreceivedlessfortheirmortgageswhensellingthemtoFannieandFreddiebecausethenationalplayerswererewardedforvolume.Amutualownershipstructurehelpstoshiftthisdynamic.

Goingastepfurther,ifcommunitylendersconcludethattheFannieandFreddiemutualsarenotservingtheirneeds,andinparticulararenotmonitoringandrespondingtopoorunderwritingbyothermembersofthemutual,theycanformanewmutual.Andsoasmalllender-onlymutualwouldallowthemtobenefitfromthequalityofloanstheyproducewhilenothavingtoworryaboutachievingsufficientscaleforliquidity,sincetheGinnieprogramdoesthatforthem.

AnotherbenefittomutualizationofFannieandFreddie,inadditiontobringinginasteadyanddedicatedsourceofcapitalfromlenders,istheinstitutionofaculturalchangeattheenterprises,inparticular,themanagerialfocus.Nolongerwouldtheenterprisesseetheirprimarymissionasmaximizingreturnsforcommonshareholders.TheownersofthereconstitutedFannieandFreddiewouldwant—need,actually—themtobesteady,responsible,andreliablesourcesofcreditenhancement.

Again,thisisnothingnew.Indeed,ithasaback-to-the-futureelementtoitsinceFreddieMacwasfirstformedasamutualin1970andremainedsountilthelate1980s.EvenFannieMaeusedtorequireitsseller-servicerstoinvestinFannieMaeshares.

Followingourapproach,theservicesFannieandFreddieprovidetodaywouldcontinuetobeavailabletolenders.Andtheworktheyhavedoneinthepastfewyearstodevelopcreditrisktransferswouldcontinue,sothatthemutualswouldnotwarehousemortgagecreditriskasintheoldmodelbutinsteadwouldsyndicateitacrossprivate-capitalmarketinvestors.

Asforgovernanceandownershiprules,weproposestartingwiththeownershiprulesoftheFHLBs.Essentially,eachseller-servicerforthenewlycreatedmutualswouldpurchasesharesinthemutualcommensuratetotheamountofloanstheydeliver,buttopreventanyonelargelenderfromdominatingmanagerialdecisions,nolenderwouldhavevotingrightsthatexceedtheaverageownershipsharesize.Therewouldbeacaponvotingrightsthatlevelstheplayingfield.Again,thishasworkedfortheFHLBsandcertainlycanforthenewFannieandFreddieandanyapprovednewentrants.4CapitalTogettoasetofwell-capitalizedenterprises,weproposethatthenewlymutualizedFannieandFreddiehavecapitalthatcomesintwoforms.

First,theywouldberequiredtodocreditrisktransferonasubstantialportionoftheiroriginations,astheyaredoingtoday.Areasonabletargetfortheamountoffirst-lossriskthattheywouldhavetoshedcouldbethefirst300to500basispointsoflossonroughly80percentto90percentofannual4Thedetailsofthegovernancestructureandthedevelopmentofatransitiontimelinearebeyondthescopeofthispaper.WeexpectthattheFHFAwouldinitiateaprocessforlicensingorcharteringcredit-enhancementmutuals,includingthereconstitutedFannieandFreddie,beforetheconservatorshipsareended.Wealsoexpectthatissuesinvolvingtheinitialseedcapitalandallocationofthatcapitalwouldberesolvedbeforetheconservatorshipsendedinordertoensurethereisnogapinservice.

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production.5Onceagain,thisisessentiallywhattheGSEsaredoingtoday,sotheimpactonrateswouldbepracticallynonexistent.

Creditrisktransfercanserveastheprimarysourceof“capital”inareformedFannieandFreddieandamongnewentrants.Thereconstitutedenterpriseswouldbegiven,underFHFAauthority,theabilitytochoosethetypesandstructuresoftheseCRTtransactions,leveragingwhatworksbest,andwouldberequiredtoreportregularlytotheFHFAonthestructuresbeingused.Buttheywouldbesyndicatorsofrisk,notmassivetakersandholdersofmortgagecreditrisk.6

Still,evenwithCRT,someoneneedstoownentity-levelcapital,whichwouldprovideasecondarycapitalsupportafterthecreditrisktransfer.Theentity-levelcapitalsuppliedbythemember-ownersofthemutualformsthebasisofthis.ItallowsthemutualtocontinuetooperateinasolventwayevenifcreditlossesexceedthoseabsorbedbyCRTstructures.Thisishowmanyothermutualsoperate.

IfCRTamountstoroughly400basispointsofcapital,or4percent,webelievetheownersofthemutualshouldberequiredtoputupsomewherearound2percentofadditionalenterprisecapitalinthecompanies.Iflossesweretomount—exceedingthecapacityofCRTandtheownershipshares,puttingsolvencyatrisk—theownerswouldberequired,underFHFAdirection,toaddmorecapitaltokeepthemutualfunctioningandsolvent.Onewaytoavoidpro-cyclicalitywiththistypeofstructurewouldbefortheindustrytoovercapitalizethemutualintimesofeconomicandlendinggrowth,sothatintimesofstressthecapitalbasecouldshrinkabitwhilestayingabove2percent.

Finally,aswewilldiscussinalatersection,aMortgageInsuranceFund,paidforbytheindustry,wouldbackstopthesysteminatimeofextremestress.CashWindowsAnimportantroleplayedbyFannieandFreddietodayistheirabilitytopurchaseloansforcashfromsmallerlendersandthensecuritizetheseloansintoanMBSthemselves.Inourproposal,thenewmutualizedenterpriseswillhavecashwindowswheretheycancontinuetopurchase,forcash,loansfromthesesmalllenders.

Onecriticismwehaveofthecashwindowisthatattimesitmaynotperformasmuchqualityassuranceoftheunderwritingasitshould.Thisisstillaconcernwehave.However,whenthisprocessiscarriedoutunderamutualownershiparrangement,thelender-ownerswillhaveanincentivetoensurethatthequality-controlmechanismsinplacearerobust.Infact,wewouldexpectthemutualtohavearobust,lender-levelreportingsystemsothatthemember-ownerswouldseeandappropriatelyrespondtolenderssellingpoorlyperformingloanstothemutual.Thoughit’sbeyondthescopeofthispapertooutline,thereareseveralwaysinwhichtheincentivealignmentcanbetightenedfurtherbycreatinga

5Weputthisrange,andatargetof90percent,asopposedtoahardfirst-lossamounton100percentofproductionsothatcreditrisktransfercanflexandbowascreditmarketsfluctuateduringthenormalcourseofeachyear’smarketcycles.Byallowingabitofflexibility,themutualscanberesponsivetothemarket’sdynamicsandsmoothinanychangesincreditmarketinterestrates.6Themutualcandecide—indeed,maybewisetodecide—torequireindividuallenderstoinvestintheCRTstructureofanypooltowhichtheycontributeloans.

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formofriskretentionwherelendersretainsomespecificcreditexposuretotheloanstheyselltothemutual.

Finally,weproposethatthenewmutualizedenterprisesbenotonlyasourceofcreditenhancement,butthatonloanstheypurchaseforcash—andonlyonloanstheypurchaseforcash—theybeallowedtobetheissuerofagovernment-backedMBS.

Thisisanimportantpoint.Forthelargestlenders,thereconstitutedmutualswouldoperatemorelikemortgageinsurers,guaranteeingtheprincipalandinterestpaymentstotheMBSholder,buttheywouldnotbetheissuerofthesecurity(moreonthisinthenextsection,inourexplanationoftheGinnieMaeprogram).Thischangesubstantiallylessenstheirroleinthemarket,butitwouldaffectonlytheirlargestseller-servicers,becausewewouldnotchangehowtheyoperatethecashwindowsfortheirsmallerlendingpartners.Thatisbecausetheenterpriseswouldbepermittedtobeaggregatorsandissuersofagovernment-backedsecurityforloanstheypurchasefromsmallerandmid-sizedlendersforcash.

Inordertomakesurethatnolargelenderstriedtoarbitragethisexecutionoption,wewouldproposethattheserulescomewithastipulationthatnolendercanrepresentmorethan5percentofeitherenterprise’scashwindowvolume.So,bydefinition,thecashwindowwouldbeforsmallerandmid-sizedlendersalmostexclusively.Largerlenderswouldneedtobetheissuersoftheirownsecurities,thusgivingthemmoreofanincentivetounderwritehigh-qualityproductionandbedirectlyresponsibleforthatproduction.

Thiswouldgivesmallerandmid-sizedlendersthreechoicesinhowtheyaccesstheMBSmarket.One,theycouldissuesecuritiesthemselves(whichmanyalreadyaredoingthroughtheGinnieIIprogram,asGinnieMaeallowssingle-loanpoolsandhasroughly400issuersalready).Second,smalllenderscouldsellloansforcashtoeithernewmutual,andthemutualwouldissuetheMBSontheirbehalf.Third,smalllenderscouldcreatetheirownnewmutualorcouldselltheirloanstoanyoftheexisting400-plusGinnieMaeissuers(again,asalreadyhappenstoday).

ItwouldbesensibletoassumethatothernewentrantsthatemergetocompetewiththereconstitutedFannieandFreddie—whichwewilldiscussinthenextsection—wouldwant,andshouldhave,thesamecapabilitytopurchaseloansforcashandissueagovernment-backedsecurity.

Step Two: Amendments to the Ginnie Mae Charter GinnieMaeRefresherGinnieMae,theGovernmentNationalMortgageAssociation,isoneofthemostimportantyetleastunderstoodpillarsoftoday’shousingfinancesystem.Thissectionprovidesabriefreviewofhowtheagencyfunctions.

GinnieMaetracesitsrootstotheestablishmentoftheFederalHousingAdministrationin1934andtheFederalNationalMortgageAssociation(FannieMae)in1938.CongressestablishedGinnieMaeasagovernmentcorporationwithintheDepartmentofHousingandUrbanDevelopmentin1968bysplittingFannieMaeintotwoentities:GinnieMaeanda“privatized”FannieMae.GinnieMae’srolewasto

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guaranteemortgage-backedsecuritiescomposedofmortgagesinsuredorguaranteedbyfederalentitiessuchastheFHAandVA.Infact,GinnieMaeissuedthefirstmortgage-backedsecurity(MBS).

TodaythetotaloutstandingamountofGinnie-guaranteedMBSis$1.7trillion.Withoutmuchfanfare,GinnierecentlysurpassedFreddieMacintermsoftotalMBSoutstandingandisnowsecondonlytoFannieMae,whichhas$2.8trillionoutstanding.In2016,accordingtosomeestimates,GinnieMaemaysurpassevenFannie.Inshort,theGinnieMaeprogramisgrowingfast.

Moreover,GinnieMaeMBStradesatapremiumtobothFannieandFreddieMBSinthemarket,meaningthepriceforGinnie-backedbondsishigherandthereforetheyieldofthesebondsislower.Thiscantranslateintoalowermortgagerateforthehomebuyer.ThispremiuminGinnieMBSstemsfromtheglobalacceptanceofthesecurity,includingbycentralbanksfromTokyototheEuropeanUnion,and,mostimportantly,thefactthatGinnieMaeMBSprovidesafull-faith-and-creditgovernmentguaranteethatiswellknownbytheinvestorcommunity.

OnethingthatisdifferentaboutGinnievis-a-visFannieandFreddie,apartfromthefactthattheplatformalreadyhasagovernmentwrap,isthatGinnieMaeisnottheissueroftheMBSwhenaGinniesecurityiscreated.Theselleroftheloans—theoriginator—istheissuerofaGinniesecurity.TheissueractuallypurchasesinsurancefromGinnieMae,whichprotectstheGinnieMBSinvestorincaseofissuerdefault.

AnissuercanbeanyoneapprovedbyGinnieMae,andtodaytherearemorethan400approvedGinnieissuers.ComparethiswithestimatesthattheGSEshaveroughly100institutionsthatsecuritizeMBSthroughthem(allothersusingthecashwindow).TheGinnieMaeprogramissubstantiallymoresmall-lender-friendlythanthoseoftheGSEs.

Ginnieissuersrangefromcommunitybankstothelargestmegabanksandalsoincludenonbanksofallsizes.Thevolumeofloansissuedalsovariesgreatlybyissuer,fromsomethatmayissueapoolcontainingjustasingleloan(note:Ginnie’splatformcanhandlesingle-loansecurities)tolargenonbanklenderssuchasQuicken,ormegabankssuchasWellsFargoandChasethatmayissuepoolswiththousandsofloansinagivenmonth.7

ToissueaGinnieMaeMBS,theoriginatorneedstodothreethings:obtaincreditenhancement—essentiallyaformofmortgageinsurance—fromanapprovedsource;maintaincapitalandliquiditystandardsforissuerssetbyGinnieMae;andretainresponsibilityforloanservicing.TheGinniecharterisveryshortandstraightforward.Amendingitasweproposewouldberelativelyeasy.

ThefirstrequirementforissuingaGinniesecurity—thepurchaseofcreditenhancementfortheloanssecuritizedintoaGinnieMBS—mustadheretotherulesoftheGinnieMaecharter.Today’scharterapprovesthreemainformsofcreditenhancementprovidedbygovernmentagencies.8Theseagencies

7http://www.nationalmortgagenews.com/news/secondary/nonbank-lenders-usurp-banks-as-ginnie-mbs-leaders-1051188-1.html.8http://www.ginniemae.gov/about_us/what_we_do/Documents/statutes.pdf.

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are:FHAinsurance,VAinsurance,andUSDAinsurance.Havingobtainedthecreditenhancement,theissuerthenpurchasesMBSissuerinsurancefromGinnieMae.

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CreditEnhancementItisthepurchaseofcreditenhancementthatwefocusonforreform,whilealsofocusingonchangestoGinnieMae’scharterthatwouldallowittohavegreaterauthority,flexibility,andresourcestofulfillitsmissionofissueroversight.

Creditenhancementisanyformofcreditprotectionthatpaysadefinedamounttothelenderorinvestorintheeventofaborrowerdefault.Creditenhancementisessentiallyjustinsuranceprovidedagainstcreditlossesfromborrowerdefaults.Therearemanywaystocredit-enhanceamortgageorpoolofmortgages.

FannieandFreddietoday,throughtheirguaranteeofloansthatgointotheirMBS,aretheworld’slargestcreditenhancers.TheFHA,atmorethan$1trillioninsize,isenormousaswell.ThecoreofourproposalistoamendtheGinniechartertoallownewprivateentrantstocomeintothismarketforcreditenhancementandcompete.

ByallowingnewentrantsbesidestheFHAtotakeonthisriskascreditenhancersaheadofGinnie,wecanleveragetheGinnieMBSmulti-issuerplatformwhilecreatingavibrantprivatemarketformortgagecreditrisk.

Likeotherformsofinsurance,creditenhancementspreadsrisk.Inapoolof100loans,forexample,defaultmodelscanprojectthattwoarelikelytodefault,butwedon’tknowwhichtwotheywillbe.Modelsandhistoricaldataalsotelluswhichonesaremore(orless)likelytodefault;thatis,whichloansaremore(orless)riskythanothersinthepool.

Forthepurposesoftheremainderofthispaper,weseetwoformsofcreditenhancementbeingusedtocapitalizethecreditenhancersinthesystem.

First,wewouldallowthereconstitutedFannieandFreddietobecreditenhancersunderanewownershipstructure,asdiscussedearlierinthispaper.Butwewouldletthemdosoinacompetitiveenvironmentwhereothernewentrants—onceapprovedandregulatedbytheFHFA—areallowedaswell.IngeneralonecanthinkofthesefirmsandthereconstitutedFannieandFreddieas“guarantors”oreven“mortgageinsurers.”Yetwearecarefulwiththeword“insurance”fortworeasons:One,thesewouldnotbestate-charteredinsurancecompanies,andtwo,theywouldberesponsiblefortheentireriskoftheoutstandingunpaidprincipalbalanceofeachloantheyguarantee.Thisisdifferentthantraditionalmortgageinsurance,whichinsuresonlyaportionoftheloanbalance.Also,itisconceivablethattheprivatecreditenhancementweproposewouldworkwithlessthan100percentofthepossiblecreditriskbeingtransferred.Forthattowork,however,theresidualcreditrisk,whichwouldremainwiththeMBSissuer,wouldneedtobesufficientlyremotetoavoidtheloansbeingconsolidatedbackonthebooksoftheissuer.9

9With100percentoftherisktransferred,thecatastrophicriskendsupwiththeMortgageInsuranceFunddescribedlaterinthispaper.Withlessthan100percentrisktransfer,thecatastrophicriskwouldbedistributedacrossalltheissuers.Ineitherevent,sincewewouldrequireallissuerstohaveskininthegamewithregardtocreditenhancementviatheirownershipinterestinthecreditenhancer,theissuersretainmeaningfulresponsibilityforthecreditqualityoftheloanstheysecuritize.

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Second,boththenewFannieandFreddieandanynewentrantswouldberequiredtotransfercreditrisktothemarket,makingthempartconduitsofmortgagecreditriskandpartholdersofmortgagecreditrisk.ThisislargelytheoperationalstructureoftheGSEstoday,astheyhaveslowlybeentransformingthemselvesintocreditsyndicatorsviathecreditrisktransferprogramsinitiatedbytheFHFAin2012.This,too,isaformofcreditenhancement,andwewouldadvocatethatthenewsystembuildoffthisworkandtheseprograms.LeveragingGinnieforReformOnestepthatpolicymakerscanandshouldtake,eitheronitsownoraspartofcomprehensivereform,istogiveGinnieMaegreatercontroloveritsbudgetandresources.Asalreadynoted,theprimaryriskGinniefacesisthatoneofitsissuerswillbeunabletomakegoodonremittanceofscheduledprincipalandinterestpayments.Typically,aGinnieissuerwillrelyonthecreditinsuranceofferedbytheFHAoranotherfederalprogramtoensurethatitcanmakebondholderswholeintheeventofborrowerdefaults.Butuntiltheloanmodificationprocessortheforeclosureiscompleted,theissuermustadvancepaymentstoinvestorseachmonth.

Historically,whenbanksandthriftsdominatedGinnieMaeissuance,GinnieMae’sriskwaslargelybasedonanissuerlosingaccesstoliquidityorrunningoutofcapitalduetounrelatedevents(suchaslossesonitsotherbankingactivities).Today,however,withcomplexandcostlyloss-mitigationrequirements,lengthyforeclosuretimelines,andtheriseofnonbankservicersthatdonothaveaccesstobanks’traditionalfundingsources(suchasdeposits,FHLBadvances,andtheFederalReserve),theriskofanissuerliquiditycrisisissomethingGinniehasbecomemorefocusedon.GinnieMaestillchargesitsissuers6basispointsinrateforthisinsurance,which,ona$1.7trillionMBSbase,generates$1billionperyear.

However,withGinnieoperatingaspartofHUD,thesefundsaredepositedatTreasuryandthendirectedelsewhereviatheappropriationsprocess.Ginnie,forexample,hasbeenunabletospend$4milliononadditionaloversightresourcesrequestedtoexaminethenonbankissuersusingitsplatform.Ginniehasbeenseeking,evenifnotaspartofbroaderreform,theauthoritytospendasmallfractionofthemoneyitbringsinonaprocessformorerobustoversightandstresstestingofitsissuers.Butbecauseitdoesnotcontrolitsownrevenues,itcannotspendtheseresources,eventhoughtheyaremeagerrelativetothefundsGinniegeneratesfortheTreasury.Ataminimum,thisdynamicneedstochange.

WhencoupledwiththepowerofusingtheGinnieplatformasabridgetoanewhousingmarketstructure,however,afewchangestoGinniecanbeenormouslysignificant.

Thefirststepswepropose—whichcomewiththesupportofpastGinnieMaepresidents10—istoamendtheGinnieMaechartertobringitoutofHUDandallowittosetitsownbudgetoutsideoftheappropriationsprocess.Operatingamultitrillion-dollarfinancialguaranteeandsecuritizationbusinessrequiresfinancialsophistication,andGinnieMaeshouldbetreatedlikethebankregulatoryagenciesintermsofemployeehiringandcompensationrules.

10http://www.scotsmanguide.com/News/2016/05/Ginnie-Mae-should-be-separated-from-HUD--former-Ginnie-president-says/.

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OnceGinnieisgivenenhancedbudgetautonomyfromoutsideofHUD,itisarelativelyeasysteptoallowittobetheplatformthatcreatesabridgetoanewandmorecompetitive,dynamicmortgagecreditsystem.NewCreditEnhancersAssumingGinnieMaeastheplatformandthesourceofthegovernmentguaranteeincreatingaratesinstrumentforthemortgagemarket,howdoesthismodeldealwithcreditrisk?Today,loansinGinniepoolsreceivecreditenhancementfromoneofseveralgovernmentguaranteeprograms(chieflyFHAandVA).Weproposethatanadditionalsourceofcreditenhancementbepermitted:privatecreditenhancementprovidedbyalicensedcreditenhancerthatraisesprivatecapitaltosupporteachindividualpoolandthathasadditionalentity-levelcapitaldedicatedtobackstopthecreditguarantee.

Thisiswhatallreformproposalshavesought:dispersing$5trillionofmortgagecreditriskthattraditionallyhasbeenentirelyconcentratedonthebalancesheetsofFannieMaeandFreddieMac.Thisfigureshowsthebefore,current,andafterviewofwhatwearetryingtoachieve.Before2013,FannieandFreddieretainedallthecreditriskonallthemortgagestheyboughtorsecuritized,beyondanyloan-levelmortgageinsuranceonlow-down-paymentmortgages.Aswelearnedin2008,thiswasaperfectrecipeforsystemicrisk.

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Beginningin2013,FannieandFreddie’sconservator(oneofthispaper’sco-authors)directedthemtobeginsellingaportionofthisriskexposuretoprivateinvestors.Usingavarietyoftransactiontypes,FannieandFreddiehavebeensellingoffanincreasingamountofthisexposure.(AtechnicaltermforthisisthatFannieandFreddiehavebeensyndicatingtherisk,thatis,buyingitallupandthendistributing[syndicating]alargeportionofittootherinvestors.)

Inthenewsystemweareproposing,thisrisksyndicationwouldbebroadenedtocoverallsecuritizedloanpoolsandcouldbeperformedbyawidearrayofmarketparticipants,notjustthereconstitutedFannieandFreddie.Thisopensthefieldtoallownewparticipantsintothecredit-enhancementmarketformortgages.WedonotwantFannieandFreddie,evenifreconstitutedasmutuals,tobetheonlyplayersinthemarketplace.

Inshort,creditenhancementonGinnieMaeMBSwouldcomefromarangeofentities,allofwhichwoulduse—astheGSEsdotoday—creditrisktransfermarkettransactionsinwhichthecashforpotentialloanlossesisprovidedupfrontandheldinreservetooffsetlossesandhelpbuildavibrantmarketformortgagecreditrisk.

ByopeningtheGinniechartertootherapprovedentrantstoprovidecreditenhancement,wecanendtoday’srelianceonalimitedsetofgovernment-runentitiestoprovidethismortgageinsurance.Wecanalsogreatlyreducesystemicrisk,becausethe$5trillioninmortgagecreditriskthatistodayconcentratedonFannieMaeandFreddieMac’sbalancesheetswouldbemorewidelydispersedacrossthefinancialsystem,whereitcanbereviewedbycountlessinvestorsandanalystsandbepricedandtradedintransparentmarkets.Mostimportantly,withinwell-definedparametersthatensureequitableandnationalaccesstothesystem,wecanallowfordisruptionandinnovationinthesecondarymortgagemarketfromnewcompetitors.

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IfpolicymakersusetheGinnieMaeplatform,whatwedescribe—usheringinanewmarketformortgagecreditrisk—wouldnotbeverydifficulttodomechanically.Ginniealreadyhasinplaceasystemthatverifiesthatanissuerhasobtainedapprovedcreditenhancementfromoneofthesourcespermittedinitscurrentcharter.Byaddingadditionaloptionstothisquery,itwouldverifythesourceofthecreditenhancement,includingfromlicensednongovernmentsources.

Say,forexampleandforsimplicity’ssake,thattheGinniecharterwasamendedtoallowacreditenhancementobtainedbyareconstitutedFannieMaetocountasaneligiblecreditenhancement.GinniecouldamenditssystemtoestablishaprocesstocheckwithFanniethatloansbeingbroughtforGinniesecuritizationhadinfactobtainedcreditenhancementfromFannie.Inthisway,aloancredit-enhancedbyFanniecouldaccessafull-faith-and-credit-guaranteedMBS.

Alternatively,andmoreinterestingly,assumethatanewentranthadaviableideatodisruptandimprovehowmortgagecreditrisk-takingandsyndicationcouldwork.Thisisnotentirelytheoretical.Infact,sometraditionalmortgageinsurersareevolvingtheirbusinessmodelstobeinnovativedevelopersofcreditrisksyndicationtoday.Byallowingthemtocompeteinthismarket,wecannotonlyenhancecustomerservicebutcanresponsibly(e.g.,subjecttoqualifiedmortgage[QM]rules)expandaccesstohomeownershipopportunities.

NewentrantswouldsimplyapplytotheFHFAtobeanapprovedcreditenhancerforloansissuedofftheGinnieMaeplatform.Oncetheywereapproved,Ginniewouldaddthemtoitsprocessforcheckingfortheexistenceofsuitablecreditenhancement.

Then,aGinnieissuerputtingtogetherapoolofmortgagestobesecuritizedthroughGinniecouldpurchasecreditenhancementfromthenewlyapprovedentrantwhilesimultaneouslypurchasingaGinniewrapontheMBS.Byallowingnewentrants,wewouldmorebroadlydispersecreditriskanddosoinawaythatreliesonprivatecapitalandallowsfornewcompetition.Theissuerwouldstillberesponsibleforensuringtimelypaymentstoinvestors,asitistoday.

Inthistypeoftransaction—thatis,whenanissuerobtainscreditenhancementfromanewentrant—therewouldbenoinvolvementwhatsoeverfromFannieorFreddie.Bydefinition,then,openingtheGinniecharterwouldreducethesizeofFannie,Freddie,andpotentiallytheFHA.HowWouldItWork,Mechanically?WeproposethatCongressamendtheGinniechartertoallownewprovidersofcreditenhancement.Toestablishrulesthatprovidemarketstability,wewouldrequirethatGinnieandtheFHFAjointlyapproveanynewformofcreditenhancementandestablishclearpolicycriteriaforanynewentranttobeapproved.

Onthelatter—theoutlineofpolicycriterianecessaryforanynewentranttobeapproved—weadvocatethattheGinniecharterbeamendedtostatethefollowing:

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NewentrantsmaybeapprovedascreditenhancersaspartofaGinnieMaesecuritizationsolongasthey:

a. Canshowadedicationtomortgagecreditthroughtheeconomiccycle,nationally,servingallmarkets

b. Canofferanownershipstructure,suchasamutualorco-op,thatgivesloanoriginatorsameaningfullevelofownershipintheperformanceofloanstheycredit-enhancethroughanewentrant

c. Cansyndicateasubstantialportionoftheirfirst-losscreditrisktothemarkets,astheGSEsaredoingtoday

d. Arewell-capitalizedandcanpassstringentregulatorycriteriatoensurecapitalandliquidityinseverelystressedeconomicenvironments

e. Improveaccesstocreditforlow-incomeborrowersf. Havemanagementwithextensivemortgagefinanceandmortgagecreditriskmanagement

experienceg. Canstructureexecutionthatachievestruesaleaccountingfortheoriginatorh. Canenhanceexecutionoptionsforsmalllendersandareprohibitedfromgivingpricingfor

volumediscountstolargelenders

Byestablishingthesepolicycriteriainlegislation(thatis,byaddingthemtotheGinnieMaecharter)butallowingGinnieandtheFHFAtojointlyapprovenongovernmentsourcesofcreditenhancement,wewouldallowthemarkettoreplacetaxpayercapitalwithprivatecapital,bemoredynamic,andevolvewithshiftingmarketdynamics,withinthesedefinedpolicyparameters.WhatIfaGinnieIssuerWantedtoCredit-EnhanceItsOwnProduction?OneoftheinterestingpossibilitieswithusingtheGinnieMaeplatformisthatanissuercould,intheory,decidethatitwantedtocredit-enhanceitsownloans.Wethinkthisisascenariothatshouldbepermitted.

Forexample,sayalenderoranaggregatorthatwasaGinnieMaeissuerwantedtoissuesecuritiesofftheGinnieplatform,butinsteadofobtainingcreditenhancementfromaseparateentityitwantedtostructureandsyndicatethecreditriskitself.Thisisverymuchakintosomeoftheso-calledfront-endcreditrisktransferdealstheGSEsaredoingtoday(e.g.,PennyMacandRedwood).Wethinkthisshouldbeallowedsolongasthefollowingrequirementsaremet:

a. TheissuerwouldneedtosyndicatethesameamountofriskaswearerequiringthenewFannieandFreddieandanynewentrantstoshed:300to500basispointsoffirstloss.

b. Theissuerwouldneedtoproduce“representativesample”poolssothatitcouldnotdothisononlyoneriskcohortofloans.Thiscanalsobethoughtofas“nocherrypicking.”Again,thereisprecedentforthisinsomeofthefront-endCRTdealsbeingdonetoday.

c. Theissuer—andthisiswhereweaddanewdimension—wouldneedtoretainonitsbalancesheetamezzanineownershiptrancheinthepools,inordertoretaintheskin-in-the-gameframeworkweproposeforthemutuals.ThiswouldmeanthataGinnieissuerwouldsellapieceof,say,zeroto400basispointsoffirstlossbutthenretainonitsbalancesheetthenext200basispointsoflosstobackstopthefirst-losspieces.Inthiswaytheissuersstillhaveanincentivetoproducewell-underwrittenpools,becausetheysharesomeofthelossrisk.Andwewouldachievecapitalequivalencyacrossallexecutiontypes.

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Itisunclearwhethersuchamarketwouldgrowandevolve,butwewouldnotruleoutthepossibility,anditcouldoffersomesubstantialbenefitstocreatingawideanddeepcreditriskmarket.Itmayverywellbethatthemarketwouldbewillingtopurchaseonlythefirst400basispointsoflossiftheissuer(whichisalsotheservicer)alsoheldaportionofthefirst-lossrisksothatthemarkettrustedthefirm’scommitmenttoservicetheloansproperly.Thishasbeenadynamicthathasplaguedtheattemptsatrevitalizingtheprivate-labelsecurities(PLS)market.Butwewouldleavethattotheoriginatorandmarketparticipantstoworkout.SolongasthecapitalisaheadofGinnie,somuchthebetteriftheissuerholdsapieceoffirst-lossrisk.

Aslongasthesepoolsachieveallofthepolicyobjectivesbehindthemutual—nationalanddiverseloans,abilitytoservelow-incomemarkets,skininthegamefortheissuer,andcollateralizedcreditrisktransferaheadoftheGinniewrap—webelieveitcouldbeahelpfulandadditivepartofthemixofoptionsforlenders.CommunityBanks,Thrifts,andCreditUnionsAcommonconcerninhousingfinancereformdebatesisthatanysystemthatisnotbasedonFannieandFreddieastheyexisttodaywouldleavecommunitybanks,othersmalldepositoryinstitutionssuchassavingsandloansandcreditunions,andevenmid-sizedlendersandnonbanklendersoutinthecold.Theframeworkweproposehasmanyadvantagesforthesesmallerplayers.

AcriticalfeatureoftheGinnieMaeplatformisthatsmallerissuersgetthesamepricingaslargerissuers,therebybenefitingdirectlyfromthescaleprovidedbylargeissuers.RelativetotheFannie-Freddiemodel,smallerplayersthatdonotwanttobeissuersthemselveshavehundredsofissuerstosellto,notjusttwo.

Intheframeworkproposedinthispaper,smallerlenderswouldstillhavetheFannieandFreddiecashwindowsavailable,withtheaddedbenefitofbeingpart-ownersofthesemutual.Asmutuals,thereconstitutedFannieandFreddiewouldservetheirmember-ownerswithmuchimprovedincentivealignmentrelativetotheoldsystem.

Evenwithallofthat,additionalopportunitiesremainthatwouldbenefitsmallerlenders.Acommunitybankcreditrisksyndicationactuallyexiststoday.ItistheoriginalMortgagePartnershipFinance(MPF)programoftheFHLBs.Thatprogramsyndicatescreditriskamongcommunitybankswhileseparatelyfinancingthelong-termmortgages.Moreover,thisexamplealsopointstoanotherimportantcompetitorintheframeworkwepropose:theFederalHomeLoanBanks.TheFHLBsarealreadyGinnie-approvedissuersandtheMPFandrelatedprogramshaveabuilt-ininfrastructuretohelpcommunitybanks,savingsandloans,andcreditunionsaggregatemortgages,syndicatecreditrisk,andaccessthesecondarymortgagemarket(throughGinnieandFannieandFreddie).WebelievethattheFHLBsarealogicalcompetitivealternativetothemutualizedFannieandFreddieandtoothercreditenhancementoptions.Theyalreadyhavethemutualstructure,communitybankfocus,andthemortgagemarket

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expertisetobuilduponinprovidingacompetitivealternativeinthemarketstructureweproposehere.11WhyGinnieandNottheFMIC/CSP?Thosewhohavefollowedorparticipatedinhousingfinancereformdiscussionsthepastseveralyearsknowthatin2012,theFHFA(atthetimeledbyoneofthispaper’sco-authors)initiatedacommonsecuritizationplatform(CSP)toreplaceFannieandFreddie’srespectiveproprietarysecuritizationsystems.TheCSPwasfoldedintomostsubsequentreformproposalsandisstillbeingdevelopedtoday.IntheJohnson-Crapobillandotherproposals,theCSPwastobethesecuritizationinfrastructureonwhichMBSguaranteedbyanewfederalagency—theFederalMortgageInsuranceCorporation(FMIC)—wouldbeissued.

Whilethisremainsaviablepolicyalternative,concurrentdevelopmentsatGinnieMae,inourview,nowprovideabetteralternative.AtaboutthesametimeworkontheCSPbegan,GinnieMaeinitiatedanoverhaulofitssecuritizationplatform.Thisworkhasproducedanoperating,multi-issuersinglesecuritywrappedbyafederalguarantee—thesameoutcomeasenvisionedinthesevariouslegislativeproposalsfortheCSP.Moreover,thetechnologyisalreadytested,thepipesareworking,andtheloan-leveldisclosuresenvisionedwhentheCSPwasannouncedarealreadyarealityintheGinniemodel.

Inaddition,theGinnieplatformisalreadybuilttoacceptmultipleformsofcreditenhancementandcanbeadaptedtoaddmore.TheCSP,ontheotherhand,hasbeenfocusedonservingjustFannieandFreddiethepasttwoyearsandisstillmorethanayearfrombeingfullyoperationaljustforthoseenterprisesalone.

Itisentirelypossible,infactlikely,thattheCSPcouldbeusedtoenrichthecurrentGinnieMaeplatform.12Thus,ifCongressweretopursueusingtheGinnieMaeframeworkaswearerecommending,webelieveitshoulddirectGinnieMaeandtheFHFAtocollaborateonadetaileddue-diligencereviewoftheCSPtodetermineitsoptimaluseinthisnewframework,whetherthatmeansadaptingitintotheGinnieplatformordistributingsomeorallofitscomponentstothenewcredit-enhancementmutuals,orsomeotherpath.Inanyevent,sincetheCSPisajointassetofthetwoconservatorships,everyeffortshouldbemadetomaximizethereturnonthisinvestmentforthebenefitofthefuturesecondarymortgagemarket.

11TheevolvingcompositionofhousingfinanceplayerssuggestsotherpolicyquestionsinvolvingtheFHLBs,suchaswhethermortgageREITsorothersshouldbeofferedmembershipinthesystem.TheFHLBswerecreatedmorethan80yearsagotoprovideasourceofliquidityforsavingsandloans,whichatthattimeweretheprincipalsourceoffinancingmortgages.Sincethenmuchhaschanged.Securitizationthatproducesamortgagecreditmarketseparatefromthefundingmarket,andtheincreasingdominanceofnonbankloanoriginators,servicers,andholdersofmortgage-relatedassetssuggestssomepolicyrethinkingaboutthepurposeandroleoftheFHLBsinthe21stcenturymortgagemarket.TheFHLBsareadifferenttypeofgovernment-sponsoredenterprisethanFannieandFreddiebutareGSEsnonetheless.Whetherchangesorexpansionintheirmembershipandpurposearewarrantedrequirescarefulpolicyconsiderationandisnotasteptotakelightly.Inanyevent,animportantoperationalissueinhousingfinancereform,includingwiththisframework,istheavailabilityandstabilityoffundingforwarehousingmortgageproductionandforpaymentadvancestoMBSholders.Wewillexplorethatissuefurtherinalaterpaper.12ForFHFA’smostrecentstatusreportonthecommonsecuritizationplatform,seehttp://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Details-Plans-and-Timelines-for-the-SS-and-CSP.aspx.

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SmalllendersbenefitfromaGinniemodelinparticularbecauseofhowtheGinniepoolswork.UnderGinnieII,whichisbyfarthedominantGinnieprogram,allloansdeliveredinagivenmonthforsecuritizationinaGinniesecurityareaggregatedtogetherandissuedunderthesamealphanumericcode.ThussmalllendersthatareapprovedGinnieissuershaveaccesstothesecuritizationmarketandbenefitfromthescaleprovidedbyother,largerissuerswhosepoolsareallaggregatedtogetherbyGinnieeachmonth.ThisisabenefituniquetotheGinnieMaeplatform.Itisdesignedtobeaplayingfieldequalizer.

WhiletherestillmaybebenefitstobedrawnfromtheCSPdevelopment,theGinnieplatformisoperationaltoday.Moreover,itcomeswithagovernmentcatastrophicguaranteeofthesecurityalreadybuiltin.Thus,thereisnoneedtocreateanddevelopanewfederalentity.

Finally,andimportantly,thesecurityisalreadyhighlyliquid.Wecanbuildoffa$1.7trilliongovernment-backedGinnieMBSmarketthatiswidelyacceptedacrosstheglobe.Tosummarize,weproposetwomainchangestotheGinnieMaecharter:

1. MoveGinnieMaeoutofHUDandgiveitcontrolofitsfinances2. AllowcreditenhancementapprovedbyGinnieandtheFHFAthatisoutsideFHA,VA,orUSDA

insurance

Step Three: Amendments to the FHFA Charter ConsolidatedHousingFinanceRegulatorCrucialtothereformsweproposeisastrongcentralregulator,whichwebelieveshouldbetheFederalHousingFinanceAgency.TheFHFAcurrentlyhasoversightauthorityfortheGSEsandtheFederalHomeLoanBanks.Weproposegivingitadditionalauthoritytoapprovenewformsofcreditenhancementandnewentrantsintothecredit-enhancementmarket.

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TheFHFAwouldbetaskedwithoverseeingthecapitaladequacyandotherrequirementsimposedonallcreditenhancers(includingonthereconstitutedFannieandFreddie);allacceptableformsofcreditenhancement;andanynewcredit-enhancerentrants.Inparticular,weenvisiontheFHFAhavingexpressauthoritywithregardtoprudentialoversightofanycreditenhancersinthesystem,asthesefirms’veryexistenceandbusinessoperationsareentirelydependentonthisnationalmarketthatwouldrunthroughGinnieMae.ThisoversightauthorityisalreadywellwithintheFHFA’scorecompetency.

BybringingallGinniecreditenhancersundertheFHFAregulatoryumbrella,theFHFAcangetaconsolidated,bird’s-eyeviewofnearlytheentirehousingmarketandensurethatitissafelyandsoundlyfulfillingtheneedsofAmericanhomeowners.ItwouldalsolenditssupervisoryexpertisetoassistGinnieMaewithGinnie’skeychallengetoday:howtoset,monitor,andenforceprudentialguidelinesonGinnieissuers,particularlynonbankissuers(sincebankissuersarealreadysupervisedbyaprimaryfederalbankingagency).

TheamendmentstotheFHFAcharterwouldnotbeonerousorlong.Theywouldsimplyneedtoaddresourcesandpersonneltooverseetheapprovalofnewentrantsandnewformsofcreditenhancement.Inmanyways,thisissimplyanextensionoftheworktheFHFAisdoingnowinexploringdifferenttypesofcreditrisktransfer.

Ultimately,thereformsweareproposingcouldlargelybelookedatascreditrisktransfersthatdonotrelyonnegotiationswithFannieorFreddie.Anoriginatorwillhavemultipleoptionsforwhatitcandowiththecreditriskontheloansitoriginates.ItcouldsellittotheFHA,totheFannieorFreddiemutual,ortoanewlyapprovedmutual,oritcouldcredit-enhanceitsownpoolsandretainsomeownershipintheirperformance.

Creditenhancers,inturn,couldsyndicatesomeoftheriskbypurchasingdeepermortgageinsurancefromanapprovedinsurer;theycouldraisecashcollateralfrominvestorsinfirst-losscreditrisk,suchasaninsurerorREIT;ortheycouldfindnewandinnovativewaysoffosteringamortgagecreditriskmarket.Aslongastheyretainsomeskininthegame,wewouldallowthemarketforthesestructurestoevolveandgrow.

TheFHFA’sjobwouldbetoensurethatalloftheseentitieshaveadequatecapitalandoperationalcapacity,justasitdoesnowformorethan$5trillionincreditriskmanagedbytheGSEs.AndtheFHFAwouldbechargedwithensuringeconomiccomparabilityacrossallformsofcreditenhancementandcreditenhancerssoastomitigatecapitalarbitragegamesthatwereinherentinthepre-crisisGSEmodel.MortgageInsuranceFundFinally,weproposeamendingtheFHFAchartertomanageabackstopMortgageInsuranceFund(MIF).TheFHFAshouldcollectasmallfee,ontheorderof5to10basispointsperloan,fromallapprovedsecondarymarketcreditenhancers,includingtheGSEmutuals.Overtimethisfundshouldbebuiltuptoroughly1percentto2percentoftotaloutstandingproduction;itwouldserveasabackstoptoallowtheFHFAtofacilitatethewindingdownandtransferofthebookofbusinessfromanycreditenhancerfacinginsolvency.

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LiketheFDIC’sDepositInsuranceFund,theMIFwouldallowfortheorderlydispositionofabookofbusiness.AswiththeFDIC,MIFpremiumswouldbuildareservethattaxpayerswouldbackstop.IntheeventtheMIFwasdepleted,ongoingMIFpremiumswouldrepaytaxpayersandrebuildtheMIFreserve.

Anadditionalpossiblefeaturewarrantsconsideration.ThehousingfinancereformproposaladvancedbyReps.Delaney,DemocratJohnCarneyofDelaware,andDemocratJimHimesofConnecticutalsoproposedrelyingonGinnieMaeratherthancreatinganewfederalguarantoragency.Importantly,theirproposalalsocalledonGinnieMaetoreinsureaportionofitscatastrophicriskwiththeprivatereinsurancemarket.Thatideacouldbeappliedtoourmodelaswell,andtheMIFcouldberequiredtoreinsureaportionofitsriskandusethemarketpricefromthatreinsurancetohelpinformthefeeitchargesforitsbackstop.

Operational Questions for Our Proposal Belowisasummaryofafewoftheoperationalquestionsourproposalraises.

1. Whathappensifanissuerbecomesinsolvent?TodayGinnieMaefacestheprincipalriskofanissuerbecomingcash-flow-insolventandthereforeunabletoremitprincipalandinteresttotheGinnieMBSholder.Weproposenochangetothisstructure.Inthecaseofanissuerfailure,GinnieMae,asitdoestoday,wouldinitiateitswell-understoodprocessfortransferringtheissuer’sbookofbusinesstoanother,well-capitalizedGinnieissuer.

2. Whathappensifacreditenhancerbecomesinsolvent?SimilartohowGinnieresolvesanissuer,theFHFAwouldresolve/transferthebookofbusinessofafailedcreditenhancer.If,forexample,theFanniemutualwasnearinsolvency,theFHFAwouldinitiateaprocessofattemptingtorecapitalizeitthroughitsowners.Ifitbecameclearthatsuchrecapitalization,forwhateverreason,wasnotviable,theFHFA,byleveragingitsMIF,wouldinitiateaprocessoftransferringthisbookofbusinessaswell.Itisforthisreasonthathavingmultiplecreditenhancersthatleveragemultipleformsofcapitalandcreditrisktransfermakessense.Itallowsforthefailureofindividualcreditenhancers,withthecostofthosefailuresbeingbornebythehousingfinanceindustry.AnydrainingoftheMIFbyaninsolventcreditenhancerwouldrequireitsrecapitalizationbyremainingsecondarymarketparticipantsoncemarketconditionssettleddownandrecapitalizationwasviable.

3. Whathappensifaborrowergoesintodefault?Inthecaseofborrowerdefaults,theGinnieMaeissuerwouldfirstpursueloss-mitigationeffortstoavoiddefault(assetforthinConsumerFinancialProtectionBureauservicingrequirements).Itwouldtheninitiateaprocessoffilinganinsuranceclaimwiththeentitythatprovidestheinsuranceandcreditenhancement.ThisisperfectlyanalogoustotheprocesstodayattheFHA.InaGinniesecuritizationtoday,whenaborrowergoesintodefault,theissuercontinuestoremitP&IuntilsuchtimeasitcanfileaninsuranceclaimwiththeFHA.Underourproposedsystem,thisprocesswouldbethesame,regardlessofwhetherthecreditenhancementwaspurchasedfromtheFannieorFreddiemutualoranewentrant.TheissuerpaystheGinnieMBSholderparfortheloanonapredeterminedschedule,asdonetoday.

4. WhathappenstotheCommonSecuritizationPlatform?WeproposeGinnieMaebedirectedtoundertakeaduediligencereviewoftheCSP.Ifitfindsavaluepropositionforitsoperations,GinnieMaeshouldbeauthorizedtopurchasetheCSPonacost-plusbasis.IfGinnierejectssuchapurchase,thentheFHFA,asconservator,inconsultationwiththeTreasury

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DepartmentundertheexistingTreasurysupportagreements,wouldoffertheCSPforsaletothemarket,perhapsasautilityforanylicensedcreditenhancer,includingtheFannieandFreddiemutual.Athirdoptionistoselltheplatformtosupportarevitalizedprivate-labelmarket.

5. WhatistheprocessforendingtheconservatorshipsoftheGSEs?OnceFannieandFreddiearereadytoberecapitalizedasmutualsbytheirlenders,andanewgovernancestructureisestablished,theywouldbeputthroughreceivershipandemergeasnewlender-ownedcreditenhancers.TheFHFA,asreceiver,couldcontractwiththesenewentitiestomanagetherunoffoftheconservatorshipbooksofbusiness.

Atthetimetheconservatorshipsareended,alloutstandingFannieandFreddiesecurities,includingtheirMBS,wouldremainbackedbytheTreasurysupportagreements.Anoptionthatcouldbeexplorediswhethertopermittheresecuritizationofsome(themostrecentlyissuedMBS,say),orperhapsall,ofthesesecuritiesthroughGinnie.

Summary of Taxpayer Capital Protection Tosummarizetaxpayerprotections,thecapitalunderourstructurecomesfromthreesources:

1. ThenewFannieandFreddiemutualsandanynewapprovedcreditenhancerswouldberequiredtoshedcreditriskviacreditrisktransfersasrequiredbytheFHFAandGinnieMaetoachievetherequiredlevelofcreditenhancement;400basispointsisasensiblestartingpointfordiscussion,asitistheamountofrisk-basedcapitalacommunitybankmustholdformortgagesinitsportfolio.

2. Behindthis,eachcreditenhancerwouldhaveanoperatingcapitalcushionmadeupofshareownershipfromitsmembers.TheFHFAwouldbemandatedtodesigncapitalrulesforallmarketparticipantssubstantiallysimilartothetotalamountofcapitalrequiredoftheFannieandFreddiemutualsfromthecombinationofCRTandlender-ownedshares.Somethingintheareaof2percentseemstomakesense.TheFHFAwouldconductregularstresstests,similartothoseconductedbytheFederalReserve,ofallapprovedcreditenhancers,whileGinnieMaewouldconductregularstresstestingofitsapprovedissuers.Anycapitalinadequacyunderadverseconditionswouldrequiretheraisingofadditionalcapital.

3. Finally,anMIFofroughly1percentto2percentwouldbecreatedtobackstoptheentiresystemandmanageanorderlyresolutionofanyentitythatfacesinsolvency.

Intotal,thesystemwillhaveanapproximately8percentunexpected-lossabsorptioncapacityplussubstantiallyenhancedregulatoryoversightinfrontoftheGinnieMaebackstopguarantee.WewouldalsoproposethattheFHFAbegiventhemandatetoexplorethemarketforcatastrophicriskreinsuranceoftheMIF.

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Impact on Interest Rates Anyhousingfinancereformproposalwillofcoursepromptthequestion:Whatdoesthisdotoborrowerinterestrates?Webelievethatourapproachwillhaveaminimalimpactonrates,forafewreasons.

First,theprimarysourceofcapitalthatweare“bringing”intothesystemcomesviacreditrisktransfersecurities.Thisroughly400basispointsofcapitalwillbethefirstlineofdefenseagainstlosses.Butrequiringthisshouldnothavemuchofanimpactontoday’sborrowingcosts,ifanyatall,foronesimplereason:Guaranteefees(g-fees)chargedbyFannieandFreddietodayalreadyaccountforthiscostofcapital.FannieandFreddie,underFHFAdirection,havealreadyinitiatedaprocessofcomparingthecostofmortgagecreditimpliedbythemarketpriceforCRTsecuritieswiththeg-feestheycharge,andtheFHFAbelievesthesecostsarealreadypricedin.Sothefirstlineofcapitalprotectionwerequiredoesnotimpactrates.

Second,thenextlineofdefenseagainstlossinoursystemistheentity-levelcapitalrequiredofthemutual.Butthisisamezzaninetrancheofrisk,notafirst-losssourceofcapital—itkicksinonlyafterCRTisexhausted—sotheyieldhurdleiswellbelow10percent.Additionally,thesesharesaremutualownershipshares.Theirprimarypurposeisnottogeneratesubstantialprofitfortheendinvestorbuttokeepcreditenhancerssolventandoperationalforthelendingindustry.Butforthesakeofargument,let’ssaythiscapitalbufferis2percentand,evenunderconservativestandards,requireda10percentyield.Thiswouldincreaseratesbyjust20basispoints.(NotethatthisanalysisignoresthetargetreturnFannieandFreddiealreadyearnontheirholdingoftheresidualrisktheyretaintoday,sothisoverstatestheexpectedmarketimpact.)

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Finally,anMIFbackstopsthesystem,andtheFHFAwouldhavecontrolovertheamountitchargestocapitalizethis.Let’ssayforthesakeofargumentthatthisfeewasinitiallysetat10basispoints.

Puttingittogether,then,wewouldhavea20-basis-pointincreaseinpricingfromentitycapitalplus10basispointsfortheMIF.

However,wearemovingfromaFannieandFreddieMBStoaGinnieMBS.GinnieMBStradesataloweryieldbecauseithasanexplicitfull-faith-and-creditbackingandfavorableBaselaccordcapitaltreatment.Thismigrationactuallyreducessecondarymarketratesontheorderof15basispointssimplybecauseofthisdynamic.Theincreaseinliquidityfromhavingonesecuritycouldmakethisratereductionevenmoresignificant.

Thus,evenlookingatthisconservatively,wearetalkingaboutatotalofa15-basis-pointincreaseinborrowingrates(20+10–15)phasedinovermanyyears.Again,thistousisaconservativeestimateandassumesarequiredreturnonownershipsharesthatishigherthanwouldlikelyberequired.Webelievethisisapriceworthpayingtoputtheissueofhousingreformtobed,asthealternative—relyingonfulltaxpayersupportandapotentialfuturecrisis—comeswithmanyunpredictablevariables.

Summary of Benefits Under Our Approach CompetitioninLoanOriginationandCreditRiskSyndicationThefirstandmostobvioussourceofnewcompetitionwouldbeanewmutualiftheoriginationindustrycaredtoapplytocreateone.Mortgageinsurersandmortgagerealestateinvestmenttrusts(REITs)areotherpossiblesourcesofcompetition.If,forexample,theprimarymortgagemarketfeltthatFannieandFreddieasmutualswerenotbeingasresponsivetotheneedsofthemarketastheycouldbe,itcouldpetitiontheFHFAtoallowittocharteranewcorporation.Thesameruleswouldapplyforbothcapitalandaccessforthisnewentity.Itispossibletheindustrywouldnotfeeltheneedtodothis,asitwouldhaveownershipcontroloftheenterprises.Butitisonewaythatwecouldallowanewentrantortwotobreakanyduopolistictendenciesofsimplyhavingtwomegaenterprisesactingaslargemortgageinsurers.Asnotedearlier,acrucialcomponentofourproposalisthatFannieandFreddiemustoperateinacompetitiveenvironmentwhereadisruptorcanenterandimprovethemarket.MortgageinsurersandmortgageREITscouldbesourcesofsuchdisruption.Ofcourse,theywouldneedtosatisfythesamerequirementsasanyothermutualcreditenhancer.

Theframeworkweproposepromotescompetitioninloanorigination,creditrisksyndication,andmortgageservicing.Withloanorigination,thethousandsofmortgagelendersoperatingtodaywouldallbeabletooriginateandsellloansintoawell-functioningsecondarymarket.Moreover,theywouldhaveseveralvehiclestoaccessthatmarket,notthelimitedsettheynowhave.

Creditriskwouldshiftfromtwobalancesheetstoperhapscountlessbalancesheets,therebygreatlyreducingsystemicriskofthefailureofasingleentity—FannieandFreddieareperhapsthesinglegreatestexamplesof“toobigtofail”intheentireAmericanfinancialsystem—andcreatingameaningfulprivate-capitalmarketfunctionformeasuringandevaluatingmortgagecreditrisk.Theexistenceof

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severalhundredGinnieMaeissuersensuresnumerousoptionsformortgageservicingandforthemanagement/oversightofsuchservicingthroughmasterservicingresponsibilitiesoftheissuers.AlignmentofIncentivesInsomesense,theideaofmutualizationborrowsfromtheintellectualundercurrentsofriskretention,whichwereinitiallyahallmarkofsomeofthemortgagereformsinDodd-Frankbuthavesincebeenmodifiedtoaccommodateamarketplacewheremortgagecreditrisk-takingfromtheprivatesectorisstilllacking.ByrequiringlenderstoownsharesinthemutualsFannieandFreddieoranynewentrantsortoretainapieceofriskinanycreditenhancementtheydothemselves,weareofferingaverysimplewaytoachievemanyofthegoalsofcreditriskretention—namely,theindustryhasastakeinthequalityoftheloansitproduces.

Thisisacriticalelementtoensuringthatg-fee-for-volumedynamicsthatproducelow-quality,poorlyunderwrittenloansnolongerdistortthehousingsystem.Byaligningincentivesthroughoutthehousingfinanceecosystem,wecanhavegreaterfaiththatthemarketwillnotracetothebottomandsimplypassalongrisklikeahotpotato,ultimatelylandingatthefeetofthetaxpayer.Andbecausethemarketforcreditriskwouldbeaprivatemarket,disputesamongmarketparticipantsregardingloanperformance,repsandwarrants,andsoonwouldberesolvedusingnormalcontractualandjudicialmechanismsandwouldnotbesubjecttoFalseClaimsActliability.SimpleTransitionThesereformswouldtakeonlyafewyearstoaccomplish.Aswehavepointedout,wearesimplyproposingchangestochartersthatbuildefficientlyoffamarketstructurethatiswellknownandgloballyaccepted.AndGinnieMaealreadyhastheoperationalcapacitytoadoptthesechangesinrelativelyshortorder.

Affordability Strip InordertoenhancethesustainabilityofAmerica’shousingsystem,weproposethatallprivate-credit-enhancedsecuritizationthatgoesthroughGinnieMaerequirea10-basis-pointaffordabilitystrip,whichwouldbegintobecollectedoncetheMIFwassufficientlycapitalized.

Thesefundswouldbeusedtofundahousingtrustfundwithstrongcongressionaloversight.Inourforthcomingthirdpaper,wewilladvocateforthesefundstobeusedtoaugmentthebuildupofequityforfirst-time,low-incomehomeowners;tohelpimproveaccesstoaffordablerentals;forcounselingprogramsthathaveaproventrackrecordofloweringtherisksofdefaultandimprovingborrowereducation;toimproveaccesstoshelterforsomeofAmerica’smostvulnerablefamilies;andotherpurposes.

Conclusion Weproposethreestepstoachievinglastinghousingfinancereform.One,amendtheGSEcharterstomakethemmutualsownedandoperatedbytheirseller-servicers.Two,amendtheGinnieMaechartertomakeitanindependentagencywithcontrolofitsownbudgetandtheabilitytoacceptformsof

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creditenhancementotherthanjustFHA/VA/USDA.Andthree,amendtheFHFAchartertogiveitauthorityovertheentiresystemandapprovetheentryofnewcompetitorstotakeonmortgagecreditriskinaregulatedmanner,whilemanagingaMortgageInsuranceFundthatbackstopstheentiresystemasafinalbufferagainstemergencycongressionalbailouts.

Reformneednoteludepolicymakersanylonger.Perhapstrappedbythinkingthatreformmusteitherreturn,hatinhand,tothefailedmodelorrepresentarebuildingoftheentirehousingmarketinfrastructurefromthegroundup,wehavemadelittlelegislativeprogresssince2008.Butbyinsteadbuildingonwhatweknowworksandbysimplyamendingthechartersofthelegsthatholduptoday’shousingfinancestool,wecansubstantiallyreducetaxpayerrisk,improvemarketefficiency,keepmortgageratesaffordableforallAmericans,introducecompetition,andfinallybuypeaceonthisthornyandimportantpublicpolicyissue.

Next Steps Thecomplexityofthemortgagesecuritizationprocess,includingthecomplicatedinterplayofcapitalrules,accountingrules,andtaxrules,plusliquidityrequirementsandcontractstoensuresatisfactionofthoserequirements,meanthattheproposalherelikelyleavesunansweredsomeimportantoperationalquestions.Moreover,theframeworkweoutlinedheremaybeunclearasregardscertainfeaturesofthemarketplaceweenvision.Thuswelookforwardtoreceivingcommentsfrommarketparticipantsandanalystsontheframeworkandweexpecttorespondtokeyquestionsandissuesraisedbysuchfeedback.

Ourfirstpapermadethecaseforwhyreformisneeded,andthispapersetsforthourvisionforacompetitivemarketstructureforthesecondarymortgagemarket.Keyissuesstillremain.Insubsequentpaperswewilladdresshousingpolicy,includingmultifamilylending,underwritingstandards,andfundamentalpolicyquestionsregardingaffordablerentalopportunitiesandpromotinghomeownership,especiallyforlower-andmoderate-incomefamilies,first-timehomebuyers,andloansthatmaybemorechallengingtomake.Wewillalsoaddressanarrayoftopicsthatfallunderthegeneralheadingofthe“plumbing”ofourhousingfinancesystem,thatis,thelegalandoperationalinfrastructureaffectingeverydaylendingdecisionsandcreditavailability.

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About the Authors MichaelBrightisadirectorintheMilkenInstitute’sCenterforFinancialMarkets.Brightworkedasatraderofagencymortgage-backedsecuritiesandinterestratederivativesforsixyears,leavingWachovia’scorporateandinvestmentbankin2008attheheightofthefinancialcrisistocometoWashington.HeworkedattheOfficeoftheComptrolleroftheCurrencyinthedivisionoflargebanksupervisionbeforejoiningtheofficeofSen.BobCorker(R-TN)andservingasaprincipalauthorofS.1217,the“Corker-Warner”andlater“Johnson-Crapo”housingfinancereformbill.BrighthasalsobeeninvolvedinthedevelopmentofseveralcreditrisktransferdealssinceleavingCapitolHill.

EdDeMarcoisaseniorfellowinresidenceattheMilkenInstitute.Priortothat,hewasa28-yearcivilservant,culminatingwithhisroleasactingdirectoroftheFederalHousingFinanceAgencyfromSeptember2009toJanuary2014.Therehedealtwiththechallengesofmanagingthemega-institutionsFannieMaeandFreddieMac.DeMarcocraftedthe2012FHFAStrategicPlanforEnterpriseConservatorshipsandtheassociatedscorecardsandsetintomotionthecreditrisktransferandcommonsecuritizationinitiativesthatunderpinadministrativeeffortstoday.

About the Center for Financial Markets BasedinWashington,D.C.,theMilkenInstituteCenterforFinancialMarketspromotesfinancialmarketunderstandingandworkstoexpandaccesstocapital,strengthen—anddeepen—financialmarkets,anddevelopinnovativefinancialsolutionstothemostpressingglobalchallenges.

About the Milken Institute TheMilkenInstituteisanonprofit,nonpartisanthinktankdeterminedtoincreaseglobalprosperitybyadvancingcollaborativesolutionsthatwidenaccesstocapital,createjobs,andimprovehealth.Wedothisthroughindependent,data-drivenresearch,action-orientedmeetings,andmeaningfulpolicyinitiatives.©2016MilkenInstituteThisworkismadeavailableunderthetermsoftheCreativeCommonsAttribution-NonCommercial-NoDerivs3.0UnportedLicense,availableatcreativecommons.org/licenses/by-nc-nd/3.0/