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From Banking and Finance Law Daily, November 25, 2013

Hearing examines transitioning to stronger housing finance system

By J. Preston Carter, J.D., LL.M.

In the latest of a series of hearings examining issues surrounding housing finance reform, the Senate Banking Committee, on Nov. 22, 2013, heard from speakers discussing the transition to a stronger housing finance system.

Critical issue. Calling this a “critical issue,” Chairman Tim Johnson (D-SD) offered a number of items for discussion, starting with how best to wind down Fannie Mae and Freddie Mac (GSEs); the timing and sequence of the transition plan; the best way to verify that risk-sharing structures work; what kinds of emergency powers are needed to deal with unforeseen events during the transition; whether a common securitization platform should be fully operational before shutting down the old system; and what steps are necessary to ensure legacy mortgage-backed securities issued by the GSEs do not become orphaned?

Currently, the Senate Banking Committee is considering legislation co-sponsored by Sen. Bob Corker (R-Tenn) and Sen. Mark Warner (D-Va), S. 1217, the “Housing Finance Reform and Taxpayer Protection Act.” The Corker-Warner bill would overhaul the mortgage-backed securities markets and reform the government-sponsored enterprises. Among other things, the legislation would require that private market participants hold 10 percent of the first loss of any mortgage-backed security that purchases a government reinsurance wrap and dissolve the GSEs within five years of enactment of the legislation.

Another provision of the bill would create the Federal Mortgage Insurance Corporation (FMIC) as an independent federal agency to capitalize the housing finance system by separating credit risk from interest rate risk and bringing in private capital to take on both.

Protection for investors and taxpayers. Ranking member Mike Crapo (R-Idaho) also spoke of the need for a seamless transition, one that minimizes disruption in the financial markets, ensures accountability in the process, and provides protection for investors and taxpayers. Crapo said that "S. 1217 seeks to address the questions we will face through a five-year phase-in for the future regulator—the Federal Mortgage Insurance Corporation, or FMIC. This phase-in would coincide with the beginning of a wind-down of the GSEs supervised by the Federal Housing Finance Administration or FHFA.” He urged a continuing consideration of “ how the GSEs’ assets might be best utilized in a future housing finance system.”

Transition fraught with difficulty. Transition to the new system contemplated by S. 1217 is “fraught with difficulty and needs serious re-thinking to mitigate three significant risks that any credible transition plan must address, according to James E. Millstein, Chief Executive Officer of Millstein & Co.

1. “[O]ur fragile economic recovery cannot afford the risk of a significant disruption in mortgage credit,” Millstein said. Borrowing rates will need to rise in the new system to reflect the cost of the first-loss capital and new reserves required to protect taxpayers on their guarantee. At the same time, he continued, “we need to protect against a significant contraction in the availability of housing credit that would push us back into recession.”

2. The government must end its ongoing backstop of the GSEs in conservatorship in a way that minimizes the likelihood that Treasury will need to cover future losses on their $5.5 trillion of liabilities. Millstein said that, while the substantial guarantee fees and net interest margin that the companies are currently earning and paying over to Treasury may look like an asset to be seized by taxpayers as the quid pro quo for their bailout, it could easily turn out to be a substantial liability if there were another significant housing downturn. He added that managing that liability in a responsible way to avoid future taxpayer losses is a critical challenge of the transition.

3. There must be a credible path toward the development of the substantial layer of private “first loss” capital on which the functioning of the new system will depend. Millstein said that, “if you build the new government reinsurer but the required layer of first-loss capital doesn’t come in the size or at the pace of your contemplated wind down of the GSEs, the whole system will shut down before it has a chance to start. The idea that “if you build it, they will come”, may work in the movies, but you are playing with the nation’s housing finance system. Hope is not a credible strategy.”

FMIC success dependent on employees. Based on his experience at the Federal Deposit Insurance Corporation and the Resolution Trust Corporation, John F. Bovenzi, Partner, Oliver Wyman, said that “ultimately the employees of the two government sponsored enterprises and the Federal Housing Finance Agency (FHFA) will determine whether the start-up is a success or a failure.”

Bovenzi noted that S. 1217 abolishes the FHFA and transfers its staff, infrastructure, technology, and other resources to the FMIC, but it is silent as to the fate of the employees of the GSEs. If those two enterprises are to be shut down, he said, some of their operations will have to be transferred to the FMIC or elsewhere, which means some jobs would become available in other organizations. But, Bovenzi warned, the uncertainty surrounding how many jobs will be available, on what terms, and who will get them will create significant complications in ensuring a smooth transition. “The experience and the expertise of the GSEs’ employees will be needed to have an effective transition, so some thought needs to be given as to how that skill and talent can be preserved.”

Transition objectives. In his testimony, Dr. Mark Zandi, Chief Economist and Cofounder, Moody's, set out a number transition objectives:

  • Protect the economic recovery by not prematurely withdrawing government support of the housing finance system;

  • Make taxpayers financially whole during the transition by repaying the government’s support to the GSEs;

  • Ensure that private capital standing in front of the government’s guarantee is adequate to absorb mortgage losses resulting from all but the most severe financial crises and economic downturns;

  • Reduce the system’s reliance on large and complex financial institutions such as the GSEs; and

  • Maintain access to affordable owner-occupied and rental housing through the transition.

“It is important to recognize the possibility that the transition process may not go as smoothly as planned,” he said. Any legislation to reform the housing finance reform system should allow for some flexibility in the timing of the transition process, Dr. Zandi continued. In S.1217, he said, the transition process must be completed within five years. There should be some flexibility in this deadline, as the FMIC needs the ability to speed or slow the process if it jeopardizes the housing market and capital markets more broadly.

Ensure sufficient liquidity. “I believe the most important priority in structuring the transition should be to ensure that there continues to be sufficient liquidity across all market segments,” stated David Min, Assistant Professor of Law, University of California, Irvine School of Law. Min said the guiding principle for the legislators and regulators structuring the housing finance transition must be, “Do no harm.” Avoiding the disruption of mortgage liquidity, either systemwide or in individual market segments, should be a paramount concern during this period. “A failure to adhere to this principle would be catastrophic for the housing markets and the broader economy,” he said.

Min’s recommendations for transition include:

  • delegating more responsibility to regulators and removing arbitrary timetables;

  • phasing in the transition in parts, not all at once;

  • converting legacy securities into new FMIC-backed mortgage backed securities;

  • pre-approving the new MBS for use in the to-be-announced, or TBA, market and as collateral;

  • giving a “running start” to institutions focused on underserved markets; and

  • providing expanded emergency powers to FMIC to deal with housing prices.

Companies: Fannie Mae; Freddie Mac; Millstein & Co.; Moody's; Oliver Wyman

MainStory: TopStory FinancialStability GovernmentSponsoredEnterprises Loans Mortgages

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