Getting ready to move

Mortgage industry experts know the nature of home finance is set to change, but no one is certain what the new system will look like, how much more costly home buying will become, and how the changes will affect the Federal Home Loan Bank system. Matt Feldman, president and CEO of the Federal Home Loan Bank of Chicago, expects the emergence of mortgage aggregators and guarantors with an explicit government guarantee, that the Federal Home Loan Banks will continue to be a source of liquidity to community banks, and that it will be years before a new housing finance system is finally in place.. Feldman said Fannie Mae and Freddie Mac were doomed from the start. "Using an implied government guarantee to support a mortgage market, and then making money off that market to pay shareholders… was an inherent conflict that was probably meant to fail the day it started," he told some 200 bankers last month meeting in Milwaukee for a conference hosted by the Wisconsin Bankers Association. Since the Federal Housing Finance Agency took Fannie and Freddie into conservatorship in 2008, the twins have wracked up loses exceeding $134 billion. . For decades, Fannie and Freddie served the mortgage markets, bringing improved standards to the mortgage origination process, stabilizing the availability of mortgages, and increasing transparency in housing finance. But as private-label securitization of mortgages flourished in the early 2000s, the twins saw their combined market share decline from about 70 percent in 2003 to 40 percent in 2006. In response to shareholder pressure, they began accepting riskier mortgages. The move came at a time when the number of risky borrowers getting credit was at an all-time high. Now the agency that is supposed to be regulating Fannie and Freddie is in the untenable position of managing them.. Today, the private label market has gone dormant and nine in 10 mortgages – albeit with tighter underwriting standards than five years ago – are sold to Fannie and Freddie. The only other option for a mortgage originator is to hold the credit in its own loan portfolio. Reinvigorating the $11 trillion mortgage market is going to require change. .Three options. President Obama would like to direct that change, and on Feb. 11 his administration released a report to Congress that calls for the gradual phase-out of Fannie and Freddie. Many industry experts are calling for a mortgage securitization system less dependent on tax-payer guarantees and more dependent on private capital. The Obama administration offered three separate paths:. • Encourage the development of a largely private housing finance sector, with an extremely limited government role in insuring or guaranteeing mortgages. Positives: Allows market forces to direct flow of capital, and gets taxpayers off the hook. Negatives: Would increase the cost of obtaining a mortgage and likely discourage community banks from participating in the mortgage business.. • Privatize mortgage finance system, as in the first option, although give the government a backstop role that would allow it to preserve the availability of mortgages should the markets crash. Positives: The approach solves a major problem, which is assuring mortgage credit in times of crisis, without all the taxpayer liability of the current system. Negatives: No one is clear how effectively the government could actually ramp up in times of crisis, plus, like the first option, the general cost of obtaining a mortgage would likely climb and community banks would be unlikely to remain in the market.. • Privatization would be encouraged but the government would offer reinsurance for the securities of a targeted range of mortgages. Positives: This option offers the lowest-cost mortgage credit of the three options and offers a framework that could keep community banks in the system. Negatives: Appropriate pricing of the reinsurance will be challenging, and the taxpayer is back on the hook for a significant portion of mortgages. . All three options vastly increase the role of the private sector in the securitization process, a vision consistent with the American Bankers Association. "The end goal we envision is a housing finance market in which more than half of mortgage finance occurs without federal secondary market guarantees of any type," ABA President/CEO Frank Keating wrote in a Feb. 9 letter to Obama administration officials. "Perhaps the mix eventually might be 10 percent in direct government guarantees like FHA and VA, 30 percent in well-regulated and mission-directed businesses that are privately owned and operated with government backstop, and 60 percent that is without government guarantees.". The Independent Community Bankers of America stress the need for options. A Feb. 11 ICBA press statement warns "completely privatizing the secondary mortgage market would have ruinous effects both on community banks and the customers they serve." Jim MacPhee, ICBA chairman and CEO of Kalamazoo County State Bank in Schoolcraft, Mich., said the government should maintain a role in housing finance. "While reform should focus on preventing future crises in the housing market and embracing the common-sense underwriting standards long practiced by community banks, it should not eliminate all government involvement in the secondary market while turning it over to Wall Street," he said.. The administration report notes that the United States is one of the few countries in the world where the majority of mortgages are pre-payable 30-year fixed-rate mortgages. This financing approach demands a secondary market as no U.S. lender is in position to hold such debt in its own portfolio. "The U.S. is also the only high-income country in which securitization plays a major role in housing finance," the administration report notes. Feldman said there will be debate about our nation's commitment to the 30-year fixed-rate pre-payable mortgage. Europe employs a popular rent-to-own program and as government alternatives emerge in the United States with the phase-out of Fannie and Freddie, other financing arrangements could gain favor. .Improving the system. But for now, most people are betting the 30-year fixed remains the housing finance product of choice and in the near term, steps are being taken to reduce credit risk. The Fannie and Freddie mortgage limit will drop to $625,500 on Oct. 1 from the current $729,750. Also, the FHA's annual mortgage insurance premium is set to go up 25 basis points. Longer term, the administration would like to see further steps taken to shore up the quality of mortgage loans. "To further protect taxpayers, we recommend…gradually increasing required down payments so that any mortgage that Fannie and Freddie guarantee eventually has at least a 10 percent down payment," the administration says in its report to Congress.. The idea is that as government-guaranteed aggregators tighten underwriting standards, private secondary markets for mortgages will re-emerge. In theory, a move toward private markets takes pressure off taxpayers. But, as poorly as Fannie and Freddie mortgage portfolios have performed recently, private markets did worse. Nearly 45 percent of private-label loans originated in 2006 had been 90 days due at least once, compared with 13 percent of loans sold to Fannie and Freddie.. The number and kinds of private sector mortgage aggregators that emerge to fill in where Fannie and Freddie withdraw will depend on the rules Congress eventually writes. "I actually think we will end up with several of them," Feldman said. "The taste people have from having dealt with two is so negative, that there will be an impetus to have a number of them, particularly when you are looking at community financial institutions who may not find it beneficial to latch onto the largest mortgage originators.". A key part of the debate will center on the capital requirement of participants in the mortgage system. The favored idea at present requires participants to have "skin in the game" – that is, capital. But Feldman said unrealistic standards will make the mortgage business uneconomic for many of the historic players. "I think the mortgage broker is going to be an interesting artifact of the history of mortgages," he commented.. Furthermore, Feldman said that capital is not the only determinant of success. He noted that both large and small institution members of the Federal Home Loan Bank system that participate in the Mortgage Partnership Program have capital at risk, yet "the large originators perform less well than the smaller originators…People who had the right approach to lending ended up with loans that perform better. Skin in the game is an important component, but it is not the only component.". Historically, government involvement in the housing finance arena has been part of an effort to boost home ownership rates. Some even blame the financial collapse on those goals, noting that Fannie and Freddie relaxed their lending rules as early as 1999 in response to CRA advocates. (See Jan. 17, 2009 blog post atwww.NorthWesternFinancialReview.com) "Direct government support of housing goals does distort private sector incentives," Feldman said. "The presence of large amounts of CRA-related activities in Fannie and Freddie drove enormously illogical loans in the communities." Although most government officials today discount the connection between the financial crisis and CRA, the administration plan backs away from the goal of boosting home ownership rates, and even notes the benefits of rental housing for some people.. Nonetheless, helping low-income people is cited as one of three objectives for housing finance reform by the Obama administration. "The government's primary role should be limited to robust oversight and consumer protection, targeted assistance for low- and moderate-income homeowners and renters, and carefully designed support for market stability and crisis response" is how the Administration put it. "The new norm on affordable housing," Feldman said, "is going to be support for qualified borrowers, that is, borrowers who put some money down and have steady income. I don't think you can get away with the completely subsidized house anymore." .FHLBs and the future. Although the Federal Home Loan Banks held up relatively well during the financial crisis, they have been drawn into the reform discussion, causing angst among some community bank advocates who note smaller banks rely on the Federal Home Loan Banks as an important source of liquidity.. "The financial crisis also exacerbated fundamental flaws in the FHLBs," notes the administration report. "Prior to the crisis, the FHLBs suffered from inadequate regulatory oversight, and were allowed to build large investment portfolios that subjected them to excess risk, while providing concentrated funding to banks engaging in unsound business practices. Today, eight of the 12 banks are under regulatory orders with respect to their capital or have voluntarily suspended dividends or the repurchase of excess stock." The Federal Home Loan Bank of Chicago is one of the eight banks, working through a written agreement with regulators.. "Reforms to the FHLB system are necessary to restore its important primary role of providing a stable source of mortgage credit for financial institutions of all sizes," the report states.. But what kind of reforms? The administration's report doesn't make any suggestions. Feldman believes two questions need to be answered before serious reform discussions can proceed: Should the FHLBs limit membership to community institutions? And, should its debt be explicitly guaranteed?. While the nation's largest banks – the too-big-to-fail banks – can go to the capital markets directly and therefore don't need the Federal Home Loan Banks to raise capital, their membership gives the Federal Home Loan Bank system the capacity to access the debt markets every day. In addition, the largest banks lower the cost of operation of the 12-bank system for the community bank members. Feldman said that he expects the debate to conclude on the side of limited membership for too-big-to-fail banks. Basel III requires the largest banks to have the kind of access to capital that the Federal Home Loan Banks provide, and that will be part of the reason the system remains open to the largest banks.. Federal Home Loan Bank debt has never carried a government guarantee, but many people believe the guarantee is implied. "I was at a session not long ago where a member of Congress said, 'We love the Home Loan Banks; we think you guys are terrific. Now if we could just get rid of your implied guarantee.' Well, how do you get rid of something that doesn't exist?" asked Feldman, who noted that every FHLB prospectus carries a disclaimer stating the debt is not government guaranteed.. The answer is related to Fannie and Freddie and any successor enterprise which may emerge. If they get an explicit guarantee, it will drive up the cost of FHLB debt. The Federal Home Loan Banks would need an explicit guarantee to remain competitive. That guarantee won't come for free and Feldman predicted that money currently being used to repay the Refinance Corporation, or REFCORP, debt, will be redirected to fund the increased costs associated with the guarantee. "GSE doesn't come about for free," Feldman said. "The minute you have an explicit guarantee, you can assume we are going to have more government involvement.". The ABA and ICBA encourage bankers to engage in the housing finance debate, as it is far from settled. The administration, however, made it clear that in the short term, it will take steps to reduce the government's role in housing finance. Long range, it says any solution must provide Americans with broad access to housing finance, manage the risk to taxpayers, and maintain a stable and healthy mortgage market.