We support steps to continue the gradual reduction in the size of the portfolios maintained by Fannie Mae and Freddie Mac, and a gradual increase in the amount of the guarantee fees charged by the GSEs. Guarantee fees and portfolio limits are issues that should continue to be addressed with the current GSEs and as part of the larger reform effort.
The guarantee fees charged by the GSEs should be at a level that reflects the risk they are taking and that also allows private competition to develop. In hindsight, it is clear that guarantee fees charged by Fannie Mae and Freddie Mac were insufficient to cover the risks of the mortgages they acquired. In early 2008, the GSEs began to impose additional fees, but in earlier years, the GSEs’ guarantee fees and their capital levels were inadequate to support the risks they were taking. Given this experience, HPC supports the gradual implementation of guarantee fees that are more properly aligned with the credit risk assumed by the GSEs. Today, the GSEs’ g-fees have become more accurately priced and additional increases in the g-fees should be phased-in over a period of time to avoid any undue disruption to the housing recovery.
In the past, the size of the GSEs’ portfolios grew far beyond what was necessary to facilitate the securitization of mortgage loans. The portfolios are now being reduced and that process should continue. Additional reductions in the portfolios should be managed in a manner that the market can absorb. Some limited portfolios are needed to facilitate the securitization of mortgages, to warehouse whole loans from community banks, to make a market in less liquid loans, such as multifamily housing loans. The regulator should have the authority and flexibility to manage the gradual reduction of the portfolios in a manner that does not negatively affect the current fragile housing market.
Under a reformed secondary mortgage market system, new private companies performing the credit guarantee role of the GSEs should not have large portfolios, but only those needed for the purposes explained above to facilitate the smooth functioning of mortgage securitizations.
The series of bills just introduced identify and seek to address valid problems with the current GSE system. These bills are a start to the reform effort, but should not be the end of the legislative process on GSE reform. They should be part of more comprehensive reform legislation that provides for the transition from Fannie Mae and Freddie Mac to the simultaneous creation of a new, privately based secondary market system for conventional mortgages. The Housing Policy Council has made a proposal to reform the secondary mortgage market and to transition from Fannie Mae and Freddie Mac.
HPC’s proposal addresses the problems inherent in the structure of Fannie Mae and Freddie Mac and is intended to achieve several objectives:
• Encourage private sector capital to support the secondary mortgage market.
• Ensure a steady flow of reasonably priced conventional mortgages to borrowers.
• Limit the role of the federal government and the risks taken by the taxpayer in the secondary mortgage market.
• Provide strong oversight and regulation of new system.
Provide a flow of funding to support affordable owner-occupied and rental housing.
We propose to achieve these objectives by dividing the existing functions of Fannie Mae and Freddie Mac with private companies and capital assuming the primary roles and risk.
A central feature of the HPC proposal is the creation of new privately capitalized firms to perform the credit enhancement or guarantee function of the GSEs. Currently, the GSEs purchase mortgages from mortgage originators, package those mortgages into securities, and guarantee the payment of interest and principal on those securities. In exchange for the guarantee, the GSEs charge mortgage originators a “guarantee fee.” We propose that these functions be assumed by privately capitalized firms called Mortgage Securities Insurance Companies.
A MSIC would purchase conventional mortgages from mortgage originators, guarantee the payment of principal and interest on the securities and charge mortgage originators a fee for the guarantee.
Under our proposal, these privately capitalized entities would be chartered and supervised by a strong federal regulator, much like national banks and federal savings and loans are chartered and supervised by the federal government. However, these companies would not be backed by the federal government, either explicitly or implicitly.
We do not propose a particular organizational structure for the MSICs. Instead, we propose that the investors in a MSIC determine the most appropriate organizational and governance structure for the entity. The validity of the organizational structure and the ability of the investors to manage the entity would be reviewed as part of the chartering process.
We believe multiple MSICs are needed but do not call for a specific limit on the number. We assume that at least four will be needed to serve the market, but probably not more than eight are necessary. The greater the number of MSICs, the better insulated the housing finance market would be from the failure of any one MSIC. On the other hand, too many MSICs—with different underwriting systems and procedures—could be overly burdensome to lenders, particularly smaller lenders.
An explicit federal guarantee is needed to ensure a steady flow of mortgage finance at a reasonable cost to borrowers. While MSICs would not be backed by the federal government, our proposal does call for the federal government to provide an “explicit” backup or catastrophic guarantee on the mortgage securities that are issued by MSICs. To be clear, this guarantee would not apply to the MSICs themselves; it would guarantee the payment of principal and interest to investors in mortgage backed securities packaged by MSICs. A MSIC would pay a fee to the government for this guarantee, and this fee would be placed in a reserve.
The challenge we face is designing a secondary market system that ensures a steady flow of reasonably priced mortgages to borrowers while protecting the taxpayers from undue risk. Our proposal addresses this challenge by putting several layers of private capital in front of the limited federal guarantee, and as I discuss below, subjecting MSICs to “world class” regulation.
Standing before the federal guarantee would be the downpayment on a mortgage made by the homebuyer, private mortgage insurance or other credit enhancement on the mortgage loan, the shareholders’ equity in the MSIC and the reserve established by fees paid by MSICs in return for the government’s guarantee.
These layers of private capital should insulate the taxpayers from paying claims on the guarantee. However, in the event of a catastrophe that exhausts all of these private resources and the federal government is called upon to make payments under the guarantee, we support the imposition of a “special assessment” on MSICs to recoup any costs incurred by the government. Thus, the system we propose would operate much like the Federal Deposit Insurance Fund does today.
Finally, if the fees for the federal guarantee are set properly, the federal guarantee would be budget neutral. Under existing federal credit procedures, the cost of federal credit activity in a budget year is the net present value of all expected future cash flows from guarantees and direct loans disbursed in that year. For loan guarantees, cash inflows consist primarily of fees charged to insured borrowers, and cash outlays consist mostly of payments to lenders to cover the cost of loan defaults. FHA and Ginnie Mae are models for this budgetary treatment. In the case of both FHA and Ginnie Mae, the fees paid for the federal guarantee normally cover claims on the guarantees and other operational expenses.
Attracting sufficient private capital to MSICs is a key to the success of our proposal. Based on our initial research and discussions with capital markets participants, we believe that a range of private investors would be willing to invest in these new companies. The capital levels for these new companies would be set by their federal regulator and would be significantly higher than those of the current GSEs. This model could produce a reasonable return to investors and provide the capital needed to cover losses in a severe housing downturn.
John Dalton is president of the Housing Policy Council of the Financial Services Roundtable.
