(MCT)—Fannie Mae and Freddie Mac, once the twin kingpins of the home loan market, have been languishing in federal conservatorship since Sept. 6, 2008. While their continued presence is an embarrassment to many on both sides of the political aisle, it is generally understood that the agencies can’t be axed without seriously disrupting the market, and that a phase-out should occur over a period of years — to coincide with a phase-in of the institutions that will replace them. The problem has been the absence of a coherent game plan for developing those institutions.
But now there is at least a preliminary game plan, which is contained in the draft on housing finance reform recently released by leaders of the Senate Banking Committee. The draft has received a positive response in some quarters as evidence that bipartisan cooperation is still possible. The bipartisan consensus, however, is pretty much limited to the view that Fannie Mae and Freddie Mac have to go. The structure proposed to replace the agencies is replete with provisions from the left designed to promote affordability for the disadvantaged, and from the right designed to protect taxpayers.
A lot of ink is being spilled on which side of the aisle is getting the better of the bipartisan deal, but that is a sideshow. The critical question is whether the basic structure proposed as a replacement for Fannie and Freddie would meet the objective of creating effective secondary mortgage markets.
The proposal would eliminate the major structural weakness of the Fannie/Freddie model, which was the blending of private shareholders and political meddlers. Under pressure during the bubble years to meet both the demands of investors for rising earnings and the demands of politicians for rising allocations to disadvantaged groups, the agencies assumed massive risks that did them in when the bubble burst.
The Federal Mortgage Insurance Corp., or FMIC, that would replace Fannie and Freddie would be wholly owned by the federal government, with insurance functions similar to those of the Federal Housing Administration and regulatory functions similar to those of Federal Deposit Insurance Corp. Its weaknesses would be those of government corporations, which are much better understood than those of private/public hybrids.
FMIC would insure the mortgage-backed securities that meet its standards, and would regulate the various participants in the security creation process. These include originators who make the loans for sale in the secondary market, aggregators who pool mortgages and sell insured securities, and guarantors who place their guarantee in front of that of the government and will be subject to a capital requirement of 10 percent. The major objective is to provide the same degree of security to investors in mortgage-backed securities as Fannie/Freddie do now, but with the private sector assuming a major part of the risk exposure.
The model proposed is a new one that has not been tested, and to my knowledge has no antecedents anywhere. Whether or not it will work as desired, therefore, is not clear.
There will be no shortage of loan originators, since we have a large industry of mortgage banks that do this; and there will be no shortage of aggregators, because we have a large industry of investment banks; but whether there will be private guarantors willing to do what the scheme requires is uncertain.
Guarantors play a critical role in the draft proposal because their capital is the buffer against loss by the government. Only when the guarantor’s capital is depleted does the government insurance kick in. And while there are now many firms that guarantee securities, including mortgage insurance companies, these guarantees are always limited. None of them will bet the firm on a single security. To avoid such risk concentration under the draft proposal, the guarantor will need an enormous amount of capital to place at risk.
For example, if a guarantor backs 10 securities of $1 billion each, which provides only limited risk diversification, it would require $1 billion of capital to meet a 10 percent requirement. It is not at all clear that the premiums it could charge would justify an investment of this magnitude.
Of course, the capital requirement could be scaled down, as could the requirement that the guarantor assume 100 percent exposure on every security. But such adjustments would be resisted by those determined to “protect the taxpayer.”
A major omission from the draft proposal is a game plan to create a private secondary market that would be more robust than the one that collapsed during the financial crisis. Indeed, the need for a private secondary market is not even recognized in the draft. I’ll discuss this next week.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
©2014 Jack Guttentag
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