Paths to Mortgage Securitization Reform Discussed in House

While mortgage securitization is critical to house financing reform, the path to get there remains a matter of debate.

The House Financial Services Committee has touted two different proposals.

mortgage securitizationOne was put forward by the chairman, Republican Jeb Hensarling from the State of Texas, during a speech on the future of housing finance.

“Comprehensive housing finance reform remains the great financial services challenge of our time, an elusive $14 trillion question in search of the political courage to answer it.  But courage must be mustered, memories of the second worst financial crisis in our history cannot be allowed to fade. After all, we saw median household incomes climb to a peak of more than $58,000 in 2007, before cratering and not regaining that lost value until last year.  In other words, a lost decade.” Hensarling stated.

In the same speech, Hensarling went on to lay out his support for the PATH Act: “It [a new house financing system] would need to promote long-term stability and prosperity by decreasing the crippling volatility that has destroyed so much household wealth.  It would effectively protect taxpayers against future credit risk.  In my mind, there is already one proposal out there that would accomplish all of those goals and then some: the PATH Act passed by the Financial Services Committee in the 113th Congress.”

The PATH Act would wind down the two Government Sponsored Entities (GSEs) – Fannie Mae and Freddie Mac. These two mortgage giants underwrite mortgages which are then securitized as mortgage bonds.

Hensarling noted that by eliminating Fannie–Freddie, a new paradigm for mortgage securitization would emerge, “It also builds on existing elements of our current system – a right-sized FHA, an independent and open common securitization platform, and transitional GSE financing – as well as providing new and enhanced ways to finance mortgage lending via greater portfolio lending, privately securitized transactions, and new covered bond options.”

Fannie Mae and Freddie Mac were created by the government but are publicly traded companies – both are now traded over the counter. They went into government receivership when accounting fraud and toxic loans forced both to need tens of billions in government funds and loan guarantees.

While Hensarling was giving this speech, the Housing and Insurance subcommittee of the House Financial Services Committee was holding a hearing entitled: “Sustainable Housing Finance: Private Sector Perspectives on Housing Finance Reform, Part IV

Among the witnesses was Dr. Michael Carter, Director of US Multi-Sector and Securitized Assets, at Alliance Bernstein L.P.

Dr. Carter, unlike Hensarling, argued that the GSEs should continue to securitize loans, but that reform comes from a process known as credit risk transfer (CRT).

“I view the process of Housing Finance reform as a continuum, noting that the Government Sponsored Enterprises that are at the center of the housing finance system and their regulator the Federal Housing Finance Agency [FHFA] have already made some progress in reforms post-crisis most notably through the introduction of the Credit Risk Transfer market. CRTs are debt issuances with payments linked to the credit performance of an underlying pool of loans, and they provide a layer of private capital as well as a source of market pricing of risk that the GSEs had lacked pre-crisis.”

A white paper by Voya Investments outlined how CRTs work and how they differ from previous methods of mortgage securitization: “In the wake of the crisis the FHFA outlined a strategic plan to reduce the risk posed to tax payers from Fannie Mae and Freddie Mac. As part of this plan, a primary challenge emerged: how to reduce risk to the U.S. tax payer and the financial system, but do so in a way that preserves efficient and reliable borrower access to mortgage credit. To assist in meeting this challenge, the ‘Credit Risk Transfer’ securitization market was created.

“After years of planning and consultation with capital market participants and regulators, CRT issuance commenced in 2013. Both Freddie Mac and Fannie Mae issued publicly registered securities, via Structured Agency Credit Risk (STACR) and Connecticut Avenues Securities (CAS) transactions. With the successful issuance of these fixed income instruments, the GSEs effectively purchased protection against potential default risk from their mortgage borrowers via capital markets investors. The GSEs continued to collect their normal guarantee fees from lenders for covering borrower credit risk, but now compensated investors in STACR and CAS transactions for taking portions of that same risk.”

Dr. Carter said, “Today the CRT market has $40 billion of securities outstanding referencing over $1.3 trillion of mortgages; that’s 32% of the GSE’s overall mortgage exposure. In fact, 50% of all GSE mortgages created today go into CRT transactions. So, without a doubt the CRT bond market is crucial to how mortgages get financed in the country.”

Dr. Carter continued by noting that securitizing mortgages – or turning mortgages into bonds – was the key to any house financing reform: “We see the fixed income market solution as the cornerstone to any system going forward.”

Dr. Carter listed several reasons why securitization is so critical 1) all mortgage bonds are fully funded, “there is no counterparty risk; there is no risk of non-payment.” 2) risk in bond form can be spread to a large number of people and entities 3) CRT bonds pay immediately and on a set schedule.

Dr. Carter contrasted this with using mortgage insurance (MI) to spread risk.

Currently, mortgage insurance is primarily used on loans where the loan-to-value ratio (LTV) is more than 80% of the value of the home. Dr. Carter noted that some proposals would reduce this figure – he referred to this as “Deep MI.”

With MI, a mortgage insurance company adds a monthly mortgage insurance payment on top of the regular mortgage payment and then guarantees the loan if it is defaulted.

In contrast, the use of MI to spread risk carries risk. “It is important to remember that the ability and willingness of MI companies to pay claims becomes highly questionable during times of stress; it certainly did during the crisis [2008 financial crisis].”

Dr. Carter also noted that there are only eight MI companies in existence, a stark contrast to the millions of traders and investors willing to buy mortgage bonds.

Reform would allow “the GSEs to take risk alongside the investors.  This alignment of interest has been crucial to investor’s comfort in buying CRT securities,” Dr. Carter said. “The  GSEs are trusted by investors for the power they have for not only setting underwriting and servicing but insuring they are enforced.”

Dr. Carter noted, without mentioning the PATH Act, that investors would not have the same confidence in a new set of mortgage securitizers, as the PATH Act imagines: “Such confidence, however, would be difficult for any new guarantors to develop.”

It is noteworthy that one of the reasons the financial crisis occurred was because this confidence was misplaced; both the GSEs loosened their underwriting standards until trillions in toxic loans filled the mortgage bonds. While Dr. Carter argues that secondary mortgage buyers have confidence in the GSEs, they may not have in new securitizers, it is also just as likely that, given their history, secondary buyers do not have this confidence.

He also argued that when competing against each other, the GSEs innovate: “There has been a healthy competition between the GSEs for investor dollars. This dynamic has allowed for innovation.”

With Fannie and Freddie dominating the market, that leaves only two companies to compete: a dynamic Dr. Carter took note of: “In my mind, there is no magic number of guarantors for the new system, but I think it is safe to say it is more than two.”

Chairman Hensarling recently announced he would be retiring when his term ends in 2018.

The Housing and Insurance sub-committee is chaired by Sean Duffy, a Republican from the State of Wisconsin.