GSE Reform: No proof in the pudding

Worse than too-quick, unsatisfying sex

Last Friday the Obama Administration and the Department of Treasury released their long awaited and overdue plan for housing reform. They delivered a whole lot of nothing: No plan, No future of mortgage secondary market, No future mortgage buyer of last resort, and No substance. The kids at the Department of Treasury must have written this paper during their senior economics policy class at their Ivy League school. (At my alma mater they would have received a mid “C” for this crap if the professor were in a generous mood.)

Too harsh? No. The Department of Treasury promised to present a path forward for housing policy and the resolution to the Government Sponsor Entities (GSEs) in conservatorship by January 31st, 2009. Thirteen months later, Treasury’s plan entitled “REFORMING AMERICA’S HOUSING FINANCE MARKET A REPORT TO CONGRESS” is nothing more a rehashing of facts everyone knows, requiring the wind down of the GSEs (repeated 16 times!) with no or unknown replacement, and three lobbyist driven options.

The report promotes the politically easy recommendation of unwinding of the GSEs, increased focus on affordable multifamily housing units, and re-starting the private label securities market through the implementation of the Dodd-Frank Act (DFA). Of course, many really important rules of the DFA aren’t even available for comment yet. For example, section 941 requires securitizers to retain five percent of the credit risk in securities they issue unless 100% of the assets are qualified assets. Ne Running true to form, the guidelines for risk retention and the definition of qualified assets are “in process”.

Inexplicably, nowhere in the entire treatise does the Treasury doesn’t discuss the futures mortgage market (known as TBA) and its critical importance in providing liquidity to the US Mortgage market. Fannie Mae and Freddie Mac’s tight underwriting guidelines and US-backed guarantee allow investors to purchase mortgage-backed securities in size and in the futures markets. It’s a huge market. In fact, it’s the ONLY mortgage market at the moment. If it didn’t exist, then mortgages would exist only for top credits with 40% down. For historical reference, look up what the typical mortgage prior to the Great Depression. (40% down with 5-7 year balloons).

Conspiracy Theory “R” Us

Why did the Treasury leave out such an important piece of the mortgage market? I don’t know for sure but I’ll lay out my theory. The GOP’s sound byte machine (E.g. Fox News) claims the whole housing mess is Fannie Mae’s and Freddie Mac’s fault (not true) and got their base to believe it. Wall Street contributed a ton of money to the GOP in the 2010 elections to mute the Dodd Frank Act. The political honchos in the White House know this and decided to make Wall Street lobby for a government guarantee solution (options 2 or 3) and undercut the power of the tea party types.

I also believe in Area 51 and we all know the Queen of England runs the international illuminati.

Failure is always an option – Adam Savage

The report outlines three options (starting on page 27 of 30):

  1. Privatized system of housing finance with the government insurance role limited to FHA, USDA and Department of Veterans’ Affairs’ assistance for narrowly targeted groups of borrowers.
  2. Privatized system of housing finance with assistance from FHA, USDA and Department of Veterans’ Affairs for narrowly targeted groups of borrowers and a guarantee mechanism to scale up during times of crisis.
  3. Privatized system of housing finance with FHA, USDA and Department of Veterans’ Affairs assistance for low- and moderate-income borrowers and catastrophic reinsurance behind significant private capita

All the ideological think tanks and their minions discussed these options ad nauseam since the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac into conservatorship in September 2008.  As it says in the book of Kohelet 1:9 (Ecclesiastes for the goyim), “There is nothing new under the sun.”

Option one keeps FHA/VA (i.e. Ginnie Mae securities) while the rest of the market relies on private capital. In this model (like in the U.K. and Australia), the thirty year fixed rate mortgage will give way to adjustable rate mortgages tied to either the three month or six month treasury.  Investors will not take both credit risk and interest rate risk simultaneously without significant returns. Despite assurances from Rep. Garrett, the TBA market will not exist without stringent underwriting guidelines and a government backstop.

Moreover, rates will go up significantly as liquidity and mortgage futures provided by the government guarantee and GSE underwriting standards leave the market.  Liquidity comes from very large investors including foreign central banks, pension funds, insurance companies and other investors buy Agency backed mortgages because of the guarantee and the higher yield compared to treasuries. These investors have been purchasing these securities for several decades. They don’t like change. Further compounding the reduction in liquidity will be the loss of the enormous collateralized mortgage obligation (CMO or REMIC) market. Many investors use CMOs to help hedge duration and convexity without buying swaps. (I’ll miss PACs, TACs, VADMs and, my favorite, Rocket Zs).

Conservative pundits expect rates to go up 37.5 bps while liberals expect an increase of 300 bps.  They are both wrong. Rates will have a new benchmark and the borrower, who is SO expert in asset valuation, will now have to do deal with Interest Rate Risk as they do in the UK and Australia.

Lastly, does anyone really expect private capital to fund mortgages if there is a credit crisis? Anyone? Garrett? Palin? Bueller? (If you don’t believe me look-up David Askin’s Askin Capital Mortgage fund on their reliance of Agency Inverse IOs)

Option two allows some company/government agency to be named later to insure mortgages, which fit into a very tight credit box and buy mortgages during credit crises. The down side of this option is the American Taxpayer is on the hook for supporting housing when private capital doesn’t.  The pros of this option allow a futures mortgage market (known as TBA) to continue (though in a smaller form) and creates a buyer of last resort.

During the 1998 Russian currency crisis where credit became nonexistent, Fannie Mae and Freddie Mac purchased billions of dollars worth of mortgages and kept rates low. With Fannie Mae and Freddie Mac in conservatorship and under orders to lower their portfolios, the Federal Reserve Board (hated by Tea Partiers worldwide) over bought mortgages, which kept rates low.

Option three is a very minor tweak to the current system. Fannie Mae and Freddie Mac were privatized to create public capital with the government having an implicit (government speak for explicit) guarantee. The system worked until Fannie Mae & Freddie Mac got greedy as the private mortgage market got away from them and they had 40% combined market share down from 60% earlier in the decade. Like in Option 2, Tiny Tim (Geithner) and his kids don’t explain how this new entity will be structured.

Screaming Therapy

The Treasury wasted 13-months without giving the Dems direction on this issue and the GOP a plan to attack. It is so bad that both Rep. Garrett and Rep. Frank claim this report states what they want. Expect nothing of any substance to happen until after the 2012 elections at the earliest. If I were to hibernate until real reform happens you wouldn’t here from me until the Cubs win the World Series.

2 thoughts on “GSE Reform: No proof in the pudding

  1. The current administration thinks that private capital will re-enter the marketplace and eventually replace Fannie and Feddie. They are wrong. Without a working secondary market and standardized underwriting guidelines (via FNMA + FHLMC), securitization is going to be very difficult. The alternative is Savings and Loan institutions picking up the slack but there is no current incentive whatsoever for institutions to change to a balance sheet model.

    $HCBK is one of the only banks that understands how to profitably run a mortgage bank. America needs more S&L institutions to enter the marketplace, but with the restrictive regulatory reforms of H.R. 4173 being implemented April 1, I fear thats not going to happen.

    Homebuyers of America are going to be screwed once again by the officials they elected.

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