The Great Debate

Last week, I spotlighted three ominous trends in consumer banking. The last one spotlighted a brewing war “between the private bank sector and the government over who exactly controls the allocation of consumer credit in this country.”

By far, the most important front in this battle is over the future of housing finance. Today, the government is underwriting or assuming 100 percent of the credit risk on practically every new mortgage that’s originated. With regard to outstanding mortgages, the government is responsible for 100 percent of the default risk on about $6 trillion of the roughly $10 trillion market.

Thankfully, there is some real hope that a somewhat clandestine reform effort is about to commence that would start to shift a portion of this credit risk back to the private sector. The leader of this effort is the much-maligned regulator of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. After Fannie and Freddie were bailed out and then taken over by the government in 2008, Edward DeMarco was named acting head of the Federal Housing Finance Agency (FHFA) and conservator of the GSEs. He was tasked with a nearly impossible balancing act or mission:

mitigating Enterprise losses, which ultimately accrue to taxpayers; ensuring families have access to mortgages to buy a home or refinance an existing mortgage; and offering borrowers in trouble on their mortgage an opportunity to modify their loan or otherwise avoid foreclosure.

Most of the criticism that DeMarco has received to date has come from those who wish he would prioritize making mortgage refinancing or modifications easier, even if there are questions about whether some of these actions may lead to more taxpayer losses. Taxpayers have already bailed out the GSEs with more than $150 billion.

Democrats and Republicans practically all acknowledge that the government’s role in housing finance must be reduced. Likewise, nearly everyone is concerned about maintaining the availability of credit and making sure the speed of any transition back to the private sector is well thought out, so as not to jeopardize the nascent recovery.

This tension has paralyzed the Obama administration and Congress, which have let more than four years pass without providing DeMarco any clear instructions on how to proceed. In fact, President Obama has not even nominated someone to serve as his permanent conservator of the GSEs, a shocking fact given that there is perhaps no other federal regulatory position that’s more important to taxpayers and the economy, save maybe the top post at the Federal Reserve.

Given all this inaction, DeMarco has decided to advance his own “Strategic Plan for Enterprise Conservatorships: The Next Chapter in a Story that Needs an Ending.” Two of the steps that he lays out deserve way more attention than they’ve received to date: the loan-level disclosure initiative and establishing loss-sharing arrangements. One criticism is that this aptly named strategic plan does not go into enough detail on how loss-sharing arrangements might work. That said, DeMarco did provide some more color on this topic in a speech he gave toward the end of 2011:

Another way to meet the dual goals of reducing the Enterprises’ long-term risk exposure and placing them in a more stable and sound financial condition in line with private market disciplines is to consider methods of sharing risk. FHFA will be considering a number of alternatives, such as expanded use of mortgage insurance and securities structures that allow for private sector risk sharing.

A traditional way that the Enterprises shared risk with the private sector was through the use of private mortgage insurance. The law has long required that the Enterprises obtain some form of credit enhancement on mortgages with loan-to-value ratios greater than 80 percent. Most often the Enterprises meet this requirement through private mortgage insurance, and the Enterprises often require deeper mortgage insurance coverage than strictly required by law. Consideration could be given to requiring greater mortgage insurance coverage, but doing so would need to be weighed against the financial condition of individual mortgage insurers.

Another way to allow for greater private sector risk sharing is to develop security structures that allow for a portion of the credit risk currently undertaken by the Enterprises to be sold off. There are numerous securities structures that could be considered in this space, and we will be evaluating some of those in the coming months.

While both of the options he discusses are promising, the idea of developing new security structures that allow for a portion of the default risk to be shared with a new private investor is the most promising. Why? Well, practically all of the U.S. firms that specialize in providing private insurance against mortgage defaults (a.k.a private mortgage insurers or guarantors) are struggling to make good on their existing liabilities from the pre-crisis years. In fact, many analysts think several of the five or so firms that dominate this space in the U.S. are already insolvent. So, it’s unclear if any of these companies have the capacity to step up and partner with the GSEs on some sort of increased-risk-sharing agreement.

But what about attracting new investors by laying out clear rules — a policy foundation, if you will — such that investors start thinking about creating new private mortgage insurance companies?

This is where DeMarco’s loan-level disclosure initiative comes into play. As he has said, it’s important to “enhance loan-level disclosures on Enterprise MBS, both at the time of origination and throughout a security’s life” as it will “contribute to an environment in which private capital has the information needed to efficiently measure and price mortgage credit risk, thereby facilitating the shifting of this risk away from the government and back into the private sector.”

One of the lessons from the financial crisis is how poor the flow of quality information was between originators of mortgages, securitizers, rating agencies and investors. If a healthy, private housing market is going to sprout back up, loan-level data (i.e., loan-to-value ratios, FICO scores, loan amounts, census tracts, etc.) must be accurately reported and shared throughout the process. (It’s worth noting that Senator Bob Corker and Representative Scott Garrett have introduced separate pieces of legislation on this topic and are leaders in their respective chambers on this issue.)

Earlier this month and with little fanfare, DeMarco announced a deadline of June 30, 2012 for Fannie and Freddie to submit a “template for enhanced loan-level disclosures for single family mortgage-backed securities (MBS) that incorporates market standards.”

The date that this is finalized can’t come soon enough. DeMarco also plans to initiate the first new risk-sharing transactions by September 30, 2012, including a “timeline for continued growth in risk sharing through 2013.

Over the past couple of years, I’ve had many conversations with asset managers and investors who are scouting out this space, but they all plan to stay on the sidelines until more details emerge on how risk sharing is going to work. This is why DeMarco’s efforts are so welcome; he appears to be very close to addressing the key obstacles to folding back into our housing system the private suppliers of capital.

With our current system — dominated by Fannie, Freddie, and the Federal Housing Administration — private lenders and investors get guarantees from the government. Where is the incentive, then, for these (supposedly) private actors to effectively manage mortgage credit risk? What we need is a system where the private sector is making the lending decisions and taking on the incremental credit or default risk on new loans, rather than continuing to let the government micromanage the process.

While the economic landscape bears many scars from the crisis, it’s important not to lose sight of the fact that positioning private capital as the foundation of our future housing system can drive important innovations and benefits for borrowers and homeowners. The transition back to the private sector should occur at a measured pace, but it also needs to start, sometime. DeMarco clearly gets this. Thank goodness someone is leading in Washington.

PHOTO: Acting Director of the Federal Housing Finance Agency Edward DeMarco delivers testimony on robo-signing and foreclosures at a hearing of the Insurance, Housing and Community Opportunity Subcommittee of the House Financial Services Committee, on Capitol Hill in Washington, November 18, 2010. REUTERS/Jonathan Ernst