Mechanics of Finance: Housing Finance

A S H O RT P R IM E R O N T H E F U T U R E O F H O U S IN G FINANCE
MILKEN INSTITUTE CENTER FOR FINANCIAL MARKETS NATIONAL PRESS FOUNDATION TUESDAY, DECEMBER 17, 2013

Overview
2

Background

GSEs
Key Insights Future Design

Transition

3 7 12 18 27

From Headwind to Tailwind

Contribution to real GDP growth, %
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Housing Wealth Effect Residential Investment Total 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5

-2.0 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14
Source: Moodys Analytics

-2.0

Old Housing Finance System

4 4 Mae Fannie
+ Portfolio Freddie Mac + Portfolio Agency Debt Agency MBS

Banks & Other Lenders

Conforming Mortgages

MBS Investors

Debt Investors

Implicit Guarantee Government 1: Bundle conforming mortgages into MBS and provide a guarantee - Socially valuable, but put taxpayers at risk from underpriced insurance. 2: Purchase those guaranteed MBS for the firms own portfolios. - Firms borrowed at low rates to invest in higher-yielding MBS. Essentially a hedge fund made possible by the implicit government guarantee. 3: Affordable housing goals

Background on Fannie & Freddie

5

1: Bundle mortgages into MBS w/guarantee 2: Buy MBS for own portfolio investment
Enormous - $5.5 trillion in MBS & guarantees Insolvent - losses ate up thin capital Under Federal conservatorship since Sept 2008 Now very profitable - $20 billion/year Government owns 79.9 percent, has $187.5 billion senior preferred

shares, and has received $55.2 billion in dividends.

Mortgage Losses in Crisis

6
Table 2: Residential Mortgage Loan Realized Losses
Billions $ Total 2012 2006-2012 159.9 44.2 26.0 14.4 11.6 18.2 115.7 6.0 33.3 76.4 35.5 20.1 16.5 4.3 1.6 919.9 206.4 128.9 77.6 51.3 77.5 713.5 47.4 216.7 449.4 257.8 105.0 71.9 14.6 18.9 3,729 2,209 5.8 20.3 4,820 3.7 Debt Outstanding Year-end 2007 11,207 Losses as a % of Debt 8.2

2006 Total Government Backed Fannie Mae & Freddie Mac Fannie Mae Freddie Mac Federal Housing Administration Privately Backed Mortgage insurers Depository Institutions Private Label Mortgage Securities Subprime Alt-A Option ARMs Jumbo Note: Securitized HELOC 17.1 7.1 0.8 0.6 0.2 6.3 10.0 1.5 2.7 5.8 5.6 0.2 0.0 0.0 0.2

2007 38.5 7.7 1.8 1.3 0.5 5.9 30.8 6.9 7.3 16.6 15.5 0.9 0.2 0.0 1.5

2008 136.5 17.9 10.3 6.5 3.8 7.6 118.6 10.8 35.0 72.8 55.9 11.3 5.2 0.4 5.1

2009 216.1 31.8 21.3 13.4 7.9 10.5 184.3 9.6 54.9 119.8 71.6 28.0 17.9 2.3 5.1

2010 190.0 51.4 37.3 23.1 14.2 14.1 138.6 6.6 48.2 83.8 39.0 24.0 17.4 3.4 3.4

2011 161.8 46.3 31.4 18.3 13.1 14.9 115.5 6.0 35.3 74.2 34.7 20.5 14.8 4.1 2.1

449

17.3

Sources: Fannie Mae, Freddie Mac, HUD, FDIC, Federal Reserve Board, Moody's Analytics

Crisis Impact on Mortgage Market

7

Source: John Krainer, Recent Developments in Mortgage Finance, FRBSF Economic Letter, Oct 26, 2009

Overview
8

Background

GSEs
Key Insights Future Design

Transition

3 7 12 18 27

Benefits of the GSEs

9

Borrowers benefit from lower interest rates

Liquidity in secondary markets Implicit (now explicit) subsidies from federal guarantee kept interest rates a bit lower

Backed by federal guarantee, GSEs continued to finance mortgages in

depths of financial crisis

GSE securities provide a mechanism for the Fed to implement

extraordinary monetary policy and subsidize mortgage interest rates

Some affordable housing subsidies (even if not well targeted)

Value of Government Backing

10

Concerns about the GSEs

11

Private profit, socialized risk (moral hazard)

Systemic risk (until government guarantee)

Limited pass-through of government subsidy as lower interest rate to

borrowers Subsidies and risks not transparent Reduced innovation (for better or worse) Now: conduit for unlimited spending May be most expensive financial rescue

Principles for GSE reform

12

1. 2. 3. 4. 5. 6. 7.

Support liquidity in secondary market Avoid systemic risks Protect taxpayers Help homeowners Encourage beneficial innovation Promote transparency Recognize relative strengths of government agencies and the private sector

Overview
13

Background

GSEs
Key Insights Future Design

Transition

3 7 12 18 27

Key Insights
14

Agreement on many aspects of housing finance reform Private capital at risk ahead of a secondary government guarantee Government share shrinks as private sector takes on housing risk No GSE portfolios or affordable housing goals; instead explicit support for affordable housing (owner and rental) Foster competition in mortgage origination and guaranty Certainty on housing finance system will help housing

today. Transition steps are the same for all plans being considered.

1. Investment portfolios? No.

15

Portfolios expose taxpayers to large risks (in essence,

government backstops a hedge fund)

Portfolios provide only limited benefits to borrowers (under

normal conditions)
Portfolios are an invitation to non-transparent policy creep

(pressure from legislators)

Transition: Need to manage or sell the existing $1.5 trillion

portfolio

2. Lender of last resort? No.

16

Fed should do this for monetary purposes Treasury should do this for fiscal purposes

Subsidies conflict with goals of private GSEs Subsidies now hidden via conservatorship

Capability would require a portfolio

3. Affordable housing mission? No.

17

Past efforts had limited success, lack of oversight, and

contributed to GSE collapse

FHA is better suited to this mission Spending or tax programs would be more transparent

Policymakers could levy an explicit fee on GSE activities to

fund affordable housing programs

4. Backstop mortgage market? Yes.

18

Likely inevitable. Guarantee is latent.

Fed & Treasury intervened in 2008 Money Markets

GSE/government guarantee has boosted liquidity in the

secondary mortgage market

Government has unique ability to insure against

macroeconomic shocks such as a nationwide decline in home prices

Key question: What design?

Overview
19

Current State of Public Finance

Municipal Bond Market Principles

Key Insights Future Design

Transition

3 8 12 18 27

Treasurys Potential Options

20

Design Options
21

Government-sponsored enterprises Explicit government guarantee & associated fee Are two enough? Government agencies (like FHA / GNMA ) Agencies guarantee and securitize MBS Other GSE activities privatized Mixed model Government agency sells MBS guarantees Private firms, including GSE successors, securitize mortgages and purchase guarantees

Summary of the Plan

22

Fully private. Former GSEs have no special status.

No portfolios. Existing portfolios wind down.

Explicit guarantee. Government guarantees MBS of conforming mortgages against default. The guarantee kicks in after shareholders are wiped out.

Higher insurance premiums. The former GSEs pay a premium that covers expected costs. But government still underprices insurance, so
Entry & competition. Other firms can purchase the guarantee and securitize confirming MBS. Competition reduces risk and increases benefits for borrowers. No affordable housing requirements. Affordable housing is pursued through other means (e.g., FHA). A tax on conforming MBS activities finances these subsidies.

How conforming mortgages would be financed

23

Fannie Mae Freddie Mac Banks & Other Lenders Conforming Mortgages Securitizer A Insured MBS

MBS Investors

Securitizer B
Securitizer C Fee Explicit Guarantee

Five Changes 1. Competing securitizers 2. Explicit guarantee 3. Guarantee applies to MBS, not institutions 4. Fee for the guarantee 5. No portfolios, no associated debt

Government

Future Mortgage Finance System

24

"A Pragmatic Plan For Housing Finance Reform," by Ellen Seidman, Phillip Swagel, Sarah Wartell and Mark Zandi. Prepared by Moody's Analytics, the Urban Institute and the Milken Institute, June 19, 2013. Available at http://www.milkeninstitute.org

Private Capital
25

Private MBS guarantors are not backed, explicitly or implicitly, by the government. Guarantors purchase catastrophic reinsurance from the government for the benefit of MBS investors, paying a g-fee to the government for this insurance. Several sources of private capital bears the bulk of the credit risk in housing, taking losses ahead of the government and protecting taxpayers.

At the level of individual mortgages, private capital sources include homeowners down payments and the capital of any private mortgage insurers.
At the level of the mortgage-backed security, capital sources would include, but not be limited to the capital of the MBS insurer and the capital put at risk by global investors who take on housing risk from MBS insurers.

Entry of new sources of private capital is essential to provide for competition in the new housing finance system.
FMIC ensures that institutions of all sizes have access to the housing finance system.

"A Pragmatic Plan For Housing Finance Reform," by Ellen Seidman, Phillip Swagel, Sarah Wartell and Mark Zandi. Prepared by Moody's Analytics, the Urban Institute and the Milken Institute, June 19, 2013. Available at http://www.milkeninstitute.org

Federal Mortgage Insurance Corporation

26

Independent government agency oversees the housing finance system and covers losses on guaranteed MBS after the private capital of MBS insurers is exhausted. Oversees the Mortgage Insurance Fund, which is funded by guarantee fees charged to MBS insurers for the catastrophic government reinsurance. Sets standards for single- and multifamily loans in government-guaranteed MBS to ensure strong mortgage loan quality. Sets standards for and supervises servicers of guaranteed mortgages, in coordination with other regulators. Ensures that sufficient high-quality private capital is at risk before the government guarantee. Approve mechanisms by which private capital is brought in ahead of the government guarantee, and sets standards and supervises MBS insurers. Oversees the single securitization platform and sets securitization requirements. Ensures that a to-be-announced (TBA) market continues for guaranteed mortgages, coordinating with the SEC as needed.

"A Pragmatic Plan For Housing Finance Reform," by Ellen Seidman, Phillip Swagel, Sarah Wartell and Mark Zandi. Prepared by Moody's Analytics, the Urban Institute and the Milken Institute, June 19, 2013. Available at http://www.milkeninstitute.org

Market Access Fund

27

R&D Fund to support research, development and testing of innovation in products, underwriting, and servicing. Examples include mortgages with reserve accounts; equity sharing; and new housing counseling models. Credit Support Fund to provide capital ahead of the secondary guarantee for activities such as bi-weekly payment mortgages; small rental properties; manufactured housing; assisted living housing; and more. Capital Magnet Fund to support affordable housing for low-income families. Competitive awards to CDFIs and non-profit housing developers, with at least $10 of outside funding for every $1 granted. National Housing Trust Fund to support the production, preservation, and rehabilitation of rental housing for low income families.

"A Pragmatic Plan For Housing Finance Reform," by Ellen Seidman, Phillip Swagel, Sarah Wartell and Mark Zandi. Prepared by Moody's Analytics, the Urban Institute and the Milken Institute, June 19, 2013. Available at http://www.milkeninstitute.org

Criticisms
28

Maintains government role

Hard to price this insurance Anti-housing because mortgage rates go up

(Another) sop to Wall Street lets them go into

securitization and they will engineer the government guarantee to cover the rest of their activities Stress on definition of a conforming loan

The Cost of Housing Finance Reform

Minimum cost, bps
PATH privatized system
Corker-Warner, 10% capital Nationalized, 5% capital Current system Pre-housing crash 0
Source: Moodys Analytics

25

50

75

100

125

150

Overview
30

Current State of Public Finance

Municipal Bond Market Principles

Key Insights Future Design

Transition

3 8 12 18 27

Transition
31

Low-income housing subsidies

Multi-family activities
Setting appropriate premiums Definition of conforming mortgage

Future of private mortgage insurance

Future of the FHLBs Wind down of existing portfolios

How to bring in private capital

Policy Levers
32

Higher guarantee fee

Reduce quantity of government insurance capacity

Require increased private capital Narrow scope of guaranteed mortgages

QUESTION: Why were proponents of

reform called anti-housing in the past?

Policy Levers
33
Policy Lever Price for government insurance on MBS (guarantee fee) Amount of government insurance capacity What policy would entail Charge a higher price for the government guarantee on MBS. Auction off a limited amount of government insurance on MBS. Impact Higher mortgage interest rates as the increased g-fee is passed on to home buyers Offering to insure only a limited amount of conforming mortgages would increase the guarantee fee (as set in an auction) and thus interest rates. Will foster a non-guaranteed market by forcing some mortgage loans outside the conforming standard. These nonguaranteed loans could face higher interest rates (they will not pay the insurance but will not benefit from the guarantee).

Definition of conforming loans that qualify for a guarantee

Lower the loan limit for conforming loans or otherwise narrow the scope of mortgages that qualify for the guarantee.

Amount of private capital required in front of the guarantee

Require securitizing firms to Limits government risk but arrange for private capital to take mortgage interest rates will rise, losses before taxpayers. reflecting the cost of the private capital.

Housing Finance Reform Timeline

34
FMIC fund established Set MBS servicing standards on platform Private label RMBS market fully operational

FMIC sets G fees

FF assets sold to MBS insurers

FHFA reconstituted as FMIC MERS reforms

Securitization platform established MBS insurance standards set

FF conservatorship ends

Year 1

Year 2 FF securitization moved to new platform

Year 3

QM, QRM, Basel III rules in place

FF gfees to FMIC fund Private label RMBS market restarts

Establish MAF and set fee

MBS insurance charters granted

FF portfolios sold off

FMIC and MAF funds operational

Requires Congressional Authorization

"A Pragmatic Plan For Housing Finance Reform," by Ellen Seidman, Phillip Swagel, Sarah Wartell and Mark Zandi. Prepared by Moody's Analytics, the Urban Institute and the Milken Institute, June 19, 2013. Available at http://www.milkeninstitute.org

Timing and Politics

35

What will drive forward reform?

Fannie & Freddie are making $20 bn per year in

profits. What incentive does this give the government? What are the reasons to move forward with reform? Why not insist on a fully private system? When do you expect reform to happen?