WASHINGTON - Thanks very much for giving me an opportunity to continue a conversation that I began at the Structured Finance Industry Group’s conference in January.
As I said then, the Administration is committed to making comprehensive housing finance reform happen as early as possible. The President recently called for a bipartisan bill that protects taxpayers and supports homeownership in his State of the Union Address.
Over the past year, we have been actively engaged with Members of the Senate Banking Committee, including Chairman Johnson and Ranking Member Crapo, and also with Senators Corker and Warner. We are very encouraged by the progress the Committee is making toward reaching a bipartisan agreement on housing finance reform.
We look forward to continuing our work with the Committee and the rest of Congress to achieve a final bill that meets President Obama’s principles to require private capital to play the dominant role in providing mortgage credit; ensure all creditworthy borrowers, including first time homeowners, have broad access to safe and responsible mortgages; put strong safeguards in place to protect taxpayers; and help ensure access to affordable rental options for middle class families and those who are working toward joining the middle class.
Today, I would like to briefly touch upon three related housing finance reform issues. These involve the complementary principles of access and affordability, the price implications of housing finance reform; and a discussion of why two implausible scenarios recently put forward by various stakeholders are not acceptable alternatives to comprehensive housing finance reform.
I will then devote the remainder of my remarks to another matter of great interest to those in this room: the hard work ahead required to rebuild a vibrant private label securities market.
Level Playing Field / Funding Stream for Affordable Uses
I have previously talked about the Administration’s commitment to the principle of a level playing field – where large and small originators have access to the secondary market on comparable terms and where the system serves credit-worthy borrowers wherever they live or wish to live.
In the past the relationship between access and affordability became confusingly interlaced with questionable results.
The legacy GSE system seriously underpriced mortgage credit risk; was severely undercapitalized; had implicit federal guarantees, that did not fully benefit borrowers in the form of lower mortgage costs; and featured a complex set of affordable housing mortgage purchase requirements, the impacts of which remain subject to continuing debate.
The housing finance system envisioned by the Administration would require that the secondary market help provide liquidity to all segments of the primary market. Separately, it must also support affordable housing through its basic design, augmented by an explicit and transparent affordable housing funding mechanism. It is worth noting that the bipartisan bill, sponsored by Senators Corker and Warner, contained a similar approach.
These resources would be used to capitalize the Housing Trust Fund and the Capital Magnet Fund, two affordable housing funds created under the Housing and Economic Recovery Act, which also had broad bipartisan support.
The key here is that these resources would be used clearly and accountably to help those the private market cannot serve without subsidy. The two principles of broad access and affordability are complements, not substitutes, and both must be hallmarks of a reformed housing finance system.
Benefits that Accrue from a Reformed Housing Finance System
There are a number of benefits and cost savings that will accrue to society through pursuing housing finance reform that can potentially more than offset the effort required to complete the transition to a new system. Let me point out just a few:
First, and most importantly, there are substantial gains to society from having a system that can withstand housing cycles without destabilizing the economy.
A system less prone to bubbles and crisis will give private lenders more comfort on the value of the housing stock, which should reduce credit premiums over time. This is of course in addition to the savings that accrue to families by minimizing the frequency and devastating impact that periodic housing crises have on homeowners and their financial well-being.
Second, the improved liquidity and removal of credit risk afforded by a single security with an explicit full faith and credit government guarantee relative to the implicit guarantee in the legacy system will also reduce spreads, thus lowering relative post-reform mortgage costs.
Third, comprehensive housing finance reform that creates a single government insurance entity may reduce operational expenses imposed by the current system for many market participants-- through greater standardization of critical mortgage-related functions, such as for representations and warranties, pooling and servicing agreements, and loss mitigation.
A conversation I recently had with a senior executive in the mortgage origination business suggests that creating a single protocol for loan modifications across execution platforms—rather than requiring separate regimes for Fannie, Freddie, and proprietary loans—would be a significant cost-saver.
As a result, for some players, operational savings from these and related efficiencies will be substantial.
Why Reform Now: Two Implausible Alternatives
We believe that extended conservatorship is not good for the housing market, which is why we are working so hard to help make housing finance reform happen this year. But there are some who say that comprehensive housing finance reform can wait, and their arguments fall into two camps.
The first argues that FHFA Director Watt, now confirmed as regulator and conservator of the GSEs, will be able to achieve many reforms that are consistent with the president’s principles without legislation. The second camp, while recognizing that conservatorship augments the Director’s regulatory authority, thinks that the GSEs’ charters need to be “tweaked” to eliminate their most egregious failings, and call for what might be referred to as “housing finance reform lite”. Neither of these options are in the best interest of borrowers, taxpayers, or the economy.
Keep Them in Conservatorship
Among other things, those who believe that perpetual conservatorship is a viable and sustainable option discount the risks to taxpayers of the government continuing to support the majority of mortgage credit risk. More than that, the status quo leaves government with a dominant role in influencing the majority of mortgage credit decisions.
While this is appropriate for FHA and other government programs that provide support to areas of the market that the private sector does not serve especially well, it should not be the case for the majority of the mortgage market. Despite deep differences in opinion about the proper course of housing finance reform legislation in Congress, there is broad consensus that government should not be the primary driver of mortgage credit decisions.
Just Tweak Them
The second camp advocates for a reform-lite approach to housing finance, which ignores the fact that legislation is needed to make even small changes to the GSEs’ charters to fix their failed business models. And as we begin to address these issues, it is unclear where to draw the line between minor tweaks and fundamental reform. The tweaks start to add up and pretty soon, we’re looking at comprehensive reform.
For example, there is broad consensus that the implicit federal guarantee and the Preferred Stock Purchase Agreement must be replaced in the reformed system with an explicit federal guarantee. However, this measure is insufficient on its own.
It also requires a strong regulatory regime to govern the scope and application of the guarantee, stipulations for private first loss capital, and creation of an insurance fund. These require detailed legislation to assign regulatory oversight and enforcement authorities.
Transforming the current mortgage finance system into one rooted in private capital also requires us to reconsider the roles and interactions of key players. Maintaining a deep and liquid TBA market lends itself to the creation of a single security and accordingly, a single securitizer.
Critical securitization and issuance infrastructure should be separate from those who take credit risk. It also helps to lower barriers to entry for originators and those who take credit risk. This, too, requires bipartisan legislation.
And since a cessation of the GSEs’ doing new business would leave the fate of legacy securities in limbo, legislation would also be required to apply the same full faith and credit guarantee as the new securities.
And finally, since the government is putting itself at risk, we need to address the issue of fairness. There needs to be some certainty that the benefits of the government guarantee will be available broadly to lenders in all geographies and to creditworthy borrowers of all backgrounds and characteristics.
And to make sure that there are ample affordable options for those who choose to rent, we need to bring similar reforms to the multifamily housing finance market; which again requires legislation.
Because each of these elements are intertwined, they should be considered as part of a package. This is our definition of comprehensive housing finance reform.
Reviving the Private Label Securities Market
I have said before that the lack of GSE reform is an impediment to growing a vibrant non-agency private label securitization market; but it is not the only impediment (nor is it the most significant impediment). We understand why it is important for market participants to have greater clarity around the future government’s role in the mortgage market. But my message today is that the lack of housing finance reform should not become an excuse for not making progress in the PLS space. Many investors have told us that they can and want to take mortgage credit risk.
Since my remarks on this topic in January, Treasury has engaged with a variety of market participants who pretty much all agreed that lack of trust among parties involved in PLS transactions is keeping the market at a virtual stand-still.
Losses sustained on investments are still fresh in everyone’s mind. The new issue market today is unnecessarily thin and un-scalable because rather than rebuilding from the ground up, putting in place a solid, sustainable foundation for future growth, issuers continue to structure their offerings using varied terms, requirements, and documentation that have failed to instill investor confidence.
A principle reason for this lingering distrust is that the pre-crisis PLS market, by design or default, favored opacity over clarity. Under the mantra of “best execution” and market efficiency, mortgage products, deal structures, and documentation took on greater and greater complexity. This complexity masked a variety of conflicts of interest among participating parties. In hindsight, we can see why a system rooted in complexity and opacity was likely to fail.
Sophistication, bespoke terms, and yes, even a degree of complexity, can increase market efficiency and accordingly lower borrowing rates if they incorporate mutually respected contractual relationships and business practices.
The point I want to make this morning is more basic: We believe that to get back to an efficient, responsible, and sustainable level of complexity, and to rebuild trust, the new issue non-agency market must first follow a path of greater standardization and transparency.
Some might argue that non-agency deals are being done today without fundamental market reforms. It is no secret though that the collateral backing those relatively few deals is as pristine as it gets. And while there seems to be sufficient interest in the first loss piece of these deals, the pool of traditional senior bond investors is unnecessarily shallow. It’s not the pricing of subordinate bonds that is making private label execution unattractive; it’s the lack of investors interested in purchasing the senior tranches.
One of the factors keeping new issue non-agency securitization at all-time lows is lack of product; that delivering loans into GSE or Ginnie Mae securities or retaining them on balance sheet result in better execution. But this will not always be the case.
The day will come when the government’s footprint in the mortgage market shrinks and when commercial and industrial loans crowd out jumbos on bank balance sheets.
Just as the best time to do housing finance reform is now because the housing market is recovering, the best time to do the heavy lifting required to re-start the PLS market is when other channels provide more favorable execution. So that when the tide turns, the PLS market will be ready to intermediate between the originators of mortgage credit and those who want to invest in mortgage credit. Without accelerating the work that has begun to promote greater investor sponsorship today, the PLS market will be too thin to build liquidity and ensure access to mortgage credit when the economic incentives justify a robust PLS channel.
A necessary first step should be to cultivate greater simplicity and transparency. We need to start with a clear, uniform framework for reps and warranties, servicing and loss mitigation best practices, and transparent disclosure. Just as important is a solid mechanism for their enforcement.
Standardization can create benchmarks, improve liquidity, and allow investors to focus on evaluating credit risk instead of contractual terms. We are not advocating a one-size-fits-all solution.
We recognize that mandating a single standard may discourage innovation down the road. The entire market would not need to follow such a standard – but we would envision a large number of market participants choosing to use it, to build confidence and liquidity, and only using bespoke terms when necessary.
Today, for example, we devote hundreds and even thousands of pages to detailing deviations in rep and warranty provisions. That level of analysis is simply not scalable. Although some investors are comfortable buying into new issue deals without thoroughly reading the documents because of the quality of the collateral, other investors will never again invest in a bond without doing thorough due diligence because their confidence has been destroyed.
Until institutional investors return at scale particularly to purchase senior bonds, we believe it will be challenging to develop a thriving, liquid non-agency market.
With respect to rebuilding trust, a framework for enforcement is just as important as standardizing the deal architecture. The market has started to address this concern by developing new mechanisms designed to give investors greater protections.
These include loan file review and due diligence performed before securitization, third-party credit risk managers, and binding arbitration processes triggered by loan delinquency. We think these provisions merit serious consideration.
Front-end loan file review can be a valuable preventive measure. Likewise, a review and arbitration process subsequent to a credit event can help ensure accountability to the trust. However, from what we’ve been told, the front-end due diligence process today is subjective. It is challenging to scale. And enforcement mechanisms need clarity to engender investor confidence.
Although an active third party that represents investors may come at an incremental cost to the trust, they may be recouped through improved investor confidence. Additionally, if investors are given more affirmative representation within the trust, they are more likely to compromise with issuers on other terms, such as reasonable sunsets.
As I said earlier, investors can and want to take mortgage credit risk. We see it happening today in a variety of forms such as the capital raises by mortgage insurers in the past year and the success of the GSE risk-sharing transactions. What investors do not want is to expose themselves to the other risks that have multiplied in the new regime.
Dealers make regular markets in the GSE risk syndication securities, and investors know they can expect ongoing issuance over time. Is there something that the non-agency market can learn from these deals?
From the feedback I have received from the investor community, there is a high degree of comfort in the standardized nature of these transactions. Investors have told us that these offerings allow them to focus just on mortgage credit risk and not on other extraneous factors such as representation and warranty terms and servicer oversight that might impact the economics of other mortgage-related securities.
Given this, we believe more standardized and transparent terms in future PLS offerings, as well as confidence in their enforcement, should help broaden sponsorship of the sector.
In closing, I want to reiterate that we look forward to continuing our work with Congress to achieve comprehensive housing finance reform and with the issuer and investor communities to help instill trust and confidence in the private label securities market. The economy and the housing market have made great strides since the depths of the financial crisis. But more can be done to cement the recovery. President Obama, Secretary Lew, and Secretary Donovan, are committed to working with all participants who share that goal.