Potential Problems with Privatization
In the past two weeks, senior republicans in the House and Senate have introduced comprehensive legislation to reform the nation’s housing finance system. On October 31, House Committee on Financial Services’ member Scott Garrett (R-NJ) released proposed legislation to replace the current government-sponsored enterprise (GSE) model with a private mortgage-backed securities (MBS) market established under a regulatory framework based on a clear-cut, risk-based pricing system and without a government guarantee. On November 9, Senate Banking, Housing and Urban Affairs Senior Senator Bob Corker (R-TN) introduced the Residential Mortgage Market Privatization and Standardization Act (S.1834), legislation to unwind the GSEs Fannie Mae and Freddie Mac and replace them with a private, forward-funded MBS market based on certain deliverability rules and technology established by the Federal Housing Finance Agency and banks, servicers, originators, GSEs, and mortgage investors.
While both bills are intended to reform and replace the current GSE MBS mortgage-finance model, only Senator Corker’s bill includes provisions to wind-down Fannie Mae and Freddie Mac. The primary reason Representative Garrett’s proposal lacks “wind-down” provisions is the fact that the House Financial Services Committee has already passed 15 bills to wind-down different aspects of Fannie Mae and Freddie Mac’s current business that Representative Garrett, in his legislation, assumes to have been enacted. The Democrat-controlled Senate Banking Committee has yet to mark up legislation that would impose a piecemeal or comprehensive measure to wind-down and overhaul the GSEs; Senator Corker’s legislation reflects that fact.
Representative Garrett’s proposed bill (click here for a Housing Think summary):
- Requires the Federal Housing Finance Agency (FHFA) to establish classifications for mortgages-backed securities (MBS) – to be known as Qualified Securities (QS) – and set standards around key features of the securities in order for investors to appropriately price credit risk into the QS market
- Grants the FHFA director broad supervisory and enforcement capabilities, with the authority to issue regulations, orders, and interpretations in order to establish a fully-liquid forward market for QS
- Directs the FHFA to establish mandatory arbitration procedures under which all disputes between an owner of a QS and the qualified sponsor of such QS shall be subject in the event of a disagreement between investors and issuers
- Repeals Section 15G of the Securities Exchange Act of 1934 (the Credit Risk Retention provisions of the Dodd-Frank Act)
- Directs the SEC to issue regulations within six months of the bill’s enactment that require the dissemination of transaction, volume, and pricing information of trades of all ABS other than QS
- Prohibits a servicer from servicing a first mortgage if the same servicer has an interest in a second lien secured by the same property
Senator Corker’s legislation (click here for a summary):
- Reduces Fannie Mae and Freddie Mac’s conforming loan limits to zero within 10 years
- Creates an industry-financed database that makes uniform performance and origination data on mortgages available to the public
- Initiates a process for creating deliverability rules and technology necessary for the “to-be-announced” (TBA) futures market with no government guarantee
- Directs the sale of any technology, home price indices, and systems currently owned by the GSEs to private investors
- Replaces the Qualified Residential Mortgage and risk retention with a 5 percent minimum down payment and full documentation requirement
- Creates a uniform pooling and servicing agreement (PSA) and a new electronic registration system (MERS 2) where all loans are transferred under one system regulated by the FHFA
Both pieces of legislation rely heavily on and maintain confidence in the private market to absorb the mortgage origination and securitization business of the GSEs when the latter exits from the marketplace. While this is a laudable effort – and a necessary one in order to remove the government’s support from the housing finance market – the extent to which private enterprise will be able to pick up the slack the GSEs leave behind is unknown. The private market might be able to take the helm of the mortgage finance system eventually, but at what cost to homeowners? Many industry experts predict that a full transition from the government guaranteed market to a fully privatized market could significantly increase the cost of owning a home. Others suggest that the increased cost of homeownership would realistically reflect the risk priced into obtaining a mortgage in the current market environment.
Further, the negative impact that could result from the transition from a public to private market are difficult to accurately gauge. Both bills require that issuers of MBS undertake substantially more due diligence than is required presently in order to meet the new requirements of a government-endorsed private securitization. Issuers would be expected to increase the transparency of the loans that they securitize or have securitized; a modification that would likely result in increased costs. As the market transitions from the GSE model to the private model, these costs might be such that only those market participants with the most capital and greatest stake in the mortgage market will be able to achieve federal compliance – resulting in smaller market participants dropping out of the mortgage finance industry. In this way, the two bills could lead to a concentration problem: in which the private securitization market is concentrated in the balance sheets of four or five major banking institutions. This is a potential problem that could lead to some depository institutions being deemed, “too-big-to-fail,” and result in another round of bank bailouts in the future (a result that conservatives would find difficult to support).
Another issue that concerns some market participants is both bills’ dependence on the FHFA to accurately predict and price the credit risk associated with and regulate a market made up entirely of private label securities. While the FHFA has competently regulated the GSEs since they were place into conservatorship, there has been little evidence to suggest that the Agency has the resources it might require to price and regulate the MBS market. And although Senator Corker’s bill attempts to provide FHFA and the private market with some tools to better regulate the MBS market, it is unknown if the necessary human capital will be allocated to the appropriate corners of the market to sufficiently prevent another housing bubble.
In addition, the bills fail to coherently and comprehensively explain how the GSEs’ TBA markets will be replicated in the new housing finance systems. The importance of maintaining this efficient forward market, which reduces costs and enables borrowers to know what rate they will be paying well before they get to the closing table, cannot be understated. The current TBA market operates efficiently because the number of different classifications for MBS is limited in such a manner that the homogeneity allows for a fully-liquid market. The numerous classifications of loans and preponderance of potential issuers that could exist under both pieces of legislation could negatively impact the liquidity of the forward-funded MBS markets they propose. The current system works because the homogeneous pools of loans are similar in few enough characteristics that the market is relatively liquid. The FHFA lacks the innovation necessary to create such a regulatory mechanism and the Agency is short on the human capital that it would require to maintain such a financial market.
Finally, with the creation of a purely private mortgage finance market, we see the disappearance of any government involvement or potential for intervention during times of economic contraction (other than simply a regulatory role, which would tend to be reactive as opposed to proactive). The domestic economy is heavily based on the survival and proliferation of the housing market. Homes are the largest asset by dollar value on most Americans’ personal balance sheets, and mortgages the largest collateralized asset by percent of the multi-trillion dollar ABS market. How will the private market intervene in the housing industry if we have a recession similar the one we recently experienced? Could the Treasury Department, the Federal Reserve, or the Federal Home Loan Banks play a role in a market with the standardized structures described in these bills?