Summary and Analysis: Obama Administration Report to Congress on GSE Reform: “Reforming America’s Housing Finance Market”
2550 M Street, NW Washington, DC 20037 202-457-6000 Facsimile 202-457-6315 From: Patton Boggs Financial Services Public Policy Practice GroupDate: February 15, 2011Subject: Summary and Analysis: Obama Administration Report to Congress on GSE Reform: “Reforming America’s Housing Finance Market” Following is an executive summary and some analysis of the Obama Administration’s Report,“Reforming America’s Housing Finance Market,” (the “Report”) delivered to Congress onFebruary 11, 2011 as required by the Dodd-Frank Wall Street Reform and Consumer ProtectionAct (the “Act”).BackgroundSection 1074 of the Act expressly required the Secretary of the Treasury to submit to Congressby January 31, 2011 a study that both (i) evaluated the various options for bringing Fannie Maeand Freddie Mac out of conservatorship and (ii) recommended reforms to their role in thebroader U.S. housing finance markets. The Treasury Department and the Department ofHousing & Urban development jointly released the required Report on February 10th, ten daysafter the anticipated release. While the Act called for the Report to focus on possible futureroles of Fannie Mae and Freddie Mac, including their possible dissolution, it also specificallyrequired the Obama Administration to analyze: (i) the Federal Government support for a stable,well-functioning housing finance system and (ii) whether, and to what extent, it is appropriatefor the U.S. Government (and thus indirectly all U.S. taxpayers) to take on the risk of having torescue Fannie Mae, Freddie Mac and the Federal Home Loan Banks (together the “GSEs”) inorder to achieve the broader policy objective of promoting home ownership, economic stabilityand the availability of affordable housing in general.While the Report is long on analysis and short on specific action items, the Report will be thestarting point for numerous Congressional hearings and eventual legislation on this major issueleft unaddressed by the Act.Highlights • As opposed to making one specific recommendation as to how to restructure the Federal Government’s role in the mortgage finance system, the Report lays out four key factors that the Obama Administration believes should be taken into consideration in formulating any GSE reform legislation: o Preserving access to mortgage credit. o Creating incentives for private investment in housing. o Ensuring that taxpayers are protected from a future bailout. o Preserving the financial and economic stability of the U.S.
• The centerpiece of the Report is that it offers three viable alternatives for the long term restructuring of the U.S. Government’s direct and indirect role in the housing finance markets. o A privatized market with FHA/VA/USDA the only government role. o A system that has a very limited government role but provides the ability for government’s role to scale up in times of crisis in addition to FHA/VA/USDA continuing their roles. o A system where the government is fully involved by providing a reinsurance backstop for insurance of MBS created and insured by the private sector in addition to FHA/VA/USDA continuing their roles. • The Report focuses in particular on the need to incentivize private capital to re-enter the mortgage finance arena thereby enabling the Federal Government to steadily reduce its role during normal market conditions. • The Report also makes recommendations regarding how pools of guaranteed residential mortgages should be serviced once they are packaged, securitized and the resulting cash flows guaranteed by HUD, Fannie Mae and Freddie Mac. • The Report makes recommendations regarding the origination process, loan servicing, and loan standards. • The Report also (i) summarizes the history of the Federal Government’s involvement in the mortgage finance markets; (ii) examines what caused the severe losses at both Fannie Mae and Freddie Mac; and (iii) describes the current state of the broader U.S. mortgage finance system.SummaryDiscussion of the Failure of Fannie Mae and Freddie MacThe Report states that for many years, both Fannie Mae and Freddie Mac held true to theiroriginal missions of promoting home ownership. It notes that year after year of economicstability and steadily increasing valuations led to the flawed expectation that national home pricescould only increase. This phenomenon led to borrowers and lenders alike becoming increasinglydesensitized to the risk of a collapse in home prices, including senior management at the GSEs.Therefore, in 2006, when housing prices began to turn, participants in the housing financemarkets were unprepared for the ensuing spike in defaults and resulting foreclosures, and noone, including the GSEs, had enough capital supporting their investments to absorb theresulting losses. Fannie Mae and Freddie Mac experienced catastrophic losses as a result of theirguarantees to investors regarding the repayment of principal on large pools of conforming homemortgages, which eventually led to the Federal Housing Finance Agency (“FHFA”) placing theminto conservatorship in the Summer of 2008, under supervisory powers the newly formedagency was granted earlier that year.The Report also concludes that several fundamental flaws in the U.S. housing market systemcontributed to the crisis and recommends that each of the following flaws must be corrected inorder to protect American families: (i) the existence of poor consumer protections that allowrisky, low-quality mortgage products and predatory lending to proliferate; (ii) an inadequate and 2
outdated regulatory regime that failed to keep the GSE’s role in the broader system in check; (iii)the proliferation of a complex chain of transactions whereby home mortgages were sold,serviced, and securitized in a manner that lacked transparency, standardization, andaccountability; (iv) the prevalence of inadequate capital levels by key participants in the systemthat left insured banks, financial guarantors and other financial institutions unable to adequatelyabsorb the resulting losses; and (v) the growth of a mortgage servicing industry that was ill-equipped to promptly and reasonably address the needs of borrowers, lenders, and investorsonce housing prices fell and borrower defaults accelerated.Actions to Manage GSEs Post-Crisis and Going Forward During ConservatorshipIn regards to the past two years of conservatorship, the Report states that the ObamaAdministration has worked with Congress to help stabilize the housing market, provide supportfor struggling homeowners, and provide ongoing financial support for Fannie and Freddie,policies which have helped avert a deeper economic collapse. The Report goes on to alsoacknowledge that the U.S. housing market and private sources of housing financing remainfragile and will take years to fully recover.The Report discusses several initiatives that the Obama Administration and previousadministrations have already taken to reform the housing market, including: (i) passage of thesecuritization and mortgage lending provisions of the Act; (ii) aggressively moving to placeFannie Mae and Freddie Mac into conservatorship; (iii) strengthening underwriting and creditstandards at all the GSEs; (iv) raising premiums on FHA mortgage insurance; and (v) placing theFederal Home Loan Banks (“Home Loan Banks”) under stricter regulatory oversight.Going forward, the Obama Administration endorsed a number of ideas to address pre-crisisflaws in the housing market. The Report claims that “taken together, these reforms will improveconsumer protection, support the creation of safe, high-quality mortgage products with strongunderwriting standards, restore the integrity of the securitization market, restructure theservicing industry, and establish clear and consolidated regulatory oversight.”According to the Report, the Administration’s goals are to (i) responsibly and gradually reduceFannie Mae and Freddie Mac’s overall role and size in the housing finance system, including theeventual winding down and dissolution of both entities; (ii) increase private capital’s role in thehousing markets, and (iii) refine the government’s appropriate role in this sector of the debtcapital markets. The Report identifies a number of reforms to the current system that theAdministration is willing to support. It also asserts that the Obama Administration is preparedto work proactively with Congress and the GSEs to adopt all necessary changes as quickly as ispracticable, recognizing the sensitivity of the markets to reform efforts.Among the specific key reforms to the existing system called for in the Report are: • Requiring the FHFA to price their guarantees as if they had to meet private bank capital requirements. • Decreasing the maximum loan size eligible for FHA insurance. • Increasing private capital’s role by requiring larger down payments for Fannie Mae and Freddie Mac mortgages, eventually getting them up to 10% of purchase price. 3
• Reducing the Federal Home Loan Banks portfolio investments to better serve their mission of providing liquidity and access to capital for insured depository institutions. • Reducing Fannie Mae and Freddie Mac’s conforming loan size. • Continuing to wind down Fannie Mae and Freddie Mac’s investment portfolios by at least 10% each year. • Requiring securitizers or originators to retain some “skin in the game” by requiring them to retain five percent of a securities’ credit risk when sold to investors. • Improving mortgage servicing and foreclosure processing by establishing national standards, creating alternative servicing compensation structures, and better disclosure of second liens. • Reforming mortgage originations by, among other things, prohibiting origination of high-cost loans with certain abusive features, establishing consistent rules for all financial services providers to follow, and requiring lenders to make a reasonable and good faith effort to ascertain a borrower’s ability to repay the mortgage. • Maintaining the availability of affordable rental housing by exploring ways to secure capital and liquidity for low and middle-income rental options as Fannie Mae and Freddie Mac are wound down and exit this space.Discussion of Long Term Policy Options for Government Support of Mortgage FinanceLooking forward, beyond the existing system, the Report does not make one individualrecommendation as to how to restructure the government’s role in the mortgage finance system.Rather, it outlines three (3) options that fall between what they call the “extremes”, fullyprivatized model and a fully government backed model. They also lay out the advantages anddisadvantages of each option, which we have summarized and paraphrased below:Option 1: What could be called “The FHA/USDA/VA Only” option: Privatized system ofhousing finance with the government insurance role limited to FHA, USDA and theDepartment of Veterans Affairs assistance for narrowly targeted groups of borrowers.”Advantages”: Minimizes distortions in capital allocation across sectors, reduces moral hazard inmortgage lending and drastically reduces direct taxpayer exposure to private lenders’ losses.”“Disadvantages”: Acute costs on access to credit. The cost of mortgage credit for those who donot qualify for an FHA-insured loan – the majority of borrowers – would likely increase. Maybe more difficult for many Americans to afford the traditional pre-payable, 30-year fixed-ratemortgage. Smaller lenders and community banks could have a difficult time competing forbusiness outside of the FHA segment of the market. Decreases ability of the government toeffectively step in to ensure access to capital during a crisis. Absent sufficient governmentsupport to mitigate a credit crisis, there would be greater risk of a more severe downturn, andthus the risk of greater cost to the taxpayer. Potentially fails to eliminate the risk of moralhazard. 4
Option 2: What could be called “The National Guard” option: Privatized system of housingfinance with assistance from FHA, USDA and Department of Veterans Affairs for narrowlytargeted groups of borrowers and a guarantee mechanism to scale up during times of crisis.”Advantages”: Designed to address inability of the government to soften a contraction of creditduring crisis – without taking on costs associated with a broad government guarantee duringnormal times. During normal times would avoid the distortions in housing market associatedwith a broad-based guarantee and reduce both moral hazard and taxpayer risk. Private capitalwould be more likely to flow to the most productive assets in the economy, private actors wouldbe on the hook for their own risky decisions and the government would not be putting taxpayersat direct risk in backing the nation’s mortgage market. Government would be in a betterposition than under Option One to manage another downturn in the housing market. Asprivate capital pulls back, government could better step in to ensure the availability of credit andhelp to stabilize declining market.“Disadvantages”: Significant operational challenge in designing and managing an organizationthat can remain small during normal economic times, yet has the capacity to take on much morebusiness quickly during these times of need. Potential issues with access to credit, particularlythe pre-payable, 30-year fixed-rate mortgage, would likely be more expensive under this optionthan under the following one.Option 3: What could be called “The Reinsurance Option”: The FHA, USDA and Departmentof Veterans Affairs would continue to play their roles. In addition, the US Government wouldcreate a private corporation to offer “catastrophic” reinsurance for privately created mortgagesor mortgage backed securities. This government reinsurance would only pay out to the investoronce the shareholders of private mortgage guarantors are wiped out. The report does not limitthis option to either individual mortgages or MBS.“Advantages”: Provides lowest-cost access to mortgage credit of the three options. “Whilemortgage rates would be increased by the cost of the premium and the first-loss position ofprivate capital, this reinsurance will likely attract a larger pool of investors to the mortgagemarket, increasing liquidity.” Could help to lower the prices and pricing volatility of mortgagesand increase the availability of the pre-payable, 30-year fixed-rate mortgage. Governmentreinsurer’s broad presence in the market could put it in a position to scale up to provide creditduring a time of stress in the market more effectively.“Disadvantages”: Increased flow of capital into the mortgage market could draw capital awayfrom potentially more productive sectors of the economy and could artificially inflate the valueof housing assets. Reinsurance of private-lending activity, by its nature, exposes the governmentto risk and moral hazard. If the oversight of the private mortgage guarantors is inadequate orthe pricing of the reinsurance too low or recoupment of costs too politically difficult, thenprivate actors in the market may take on excessive risk and the taxpayer could again bear thecost.Conclusion, Political Analysis and Recommendation for StakeholdersAgain, the report should not be seen as an architectural plan for fundamental GSE reform, butas the starting point for fundamental bi-partisan discussions with Congress and stakeholdersover the short and medium term. 5
In the days since the report was released there has been marked opposition from somestakeholders across the political spectrum. There has also been some positive reaction fromboth sides of the aisle. With a U.S. mortgage market roughly valued at $11 trillion and the realitythat any potential solution will fundamentally change the system for all participants, we expect adifficult path to any agreement. Coming to such an agreement in Congress and forming alegislative product will most likely take up all of 2011 and 2012. We believe that even if theHouse of Representatives passes a GSE reform bill in this Congress, the Senate will likely notpass a bill until 2013.While legislative action will be in the deliberative phase, it will be important for stakeholders toengage policy makers at all levels during the next 12-24 months of this debate as they wadethrough the pros and cons of this proposal as well as other proposals from voices on GSEreform. Effective engagement with policy makers and key staff are critical, as an inevitablereform plan will have significant effects on all participants.A copy of the Administration’s Report may be found here:http://www.treasury.gov/initiatives/Pages/housing.aspx 6