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Reform of the secondary mortgage markets in the United States must start with consideration of the public purposes that the housing finance system should serve. U.S. housing finance policy has historically rested on three longstanding core principles:
- Broad and constant liquidity
- Systemic stability achieved through responsible risk oversight
- Wide and fair availability of affordable mortgage credit
We believe these goals should constitute the foundation of any reforms. This draft white paper is meant to provide a framework for addressing these goals, incorporating the lessons we have learned from the recent crisis.
Our paper differs from proposals offered by others in at least two fundamental ways.1 First, we offer a more comprehensive vision of the housing finance system of the future, one that goes beyond only “GSE reform” (revising the government-sponsored enterprises Fannie Mae and Freddie Mac). The structural flaws exposed by the current mortgage crisis were largely—albeit not exclusively—found in the private-label mortgage securitization markets. Thus, any proposal that seeks to resolve the problems in our mortgage system must address the entire secondary mortgage market.
Second, while other proposals primarily aim to address the objective of liquidity—attracting investment capital sufficient to meet the housing finance needs of U.S. housing—our ideas are designed to fulfill a broader set of public purposes, including systemic stability and affordable housing finance.
Federal support for the secondary mortgage markets is not, and never has been, simply about providing liquidity. Rather, liquidity is sought in order to achieve other priorities, including the wide availability of housing credit that expands access to sustainable homeownership and affordable rental housing over time. These broader goals are part of the legacy of more than a half-century of housing finance policy.
This white paper offers a new framework in which Chartered Mortgage Issuers, or CMIs, would enjoy some limited governmental backing for their mortgage-backed securities and take on concomitant obligations to serve public purposes. But a key feature of this white paper is that it is concerned with the relationship between the market served by these new CMIs and the rest of the market. As a result, this white paper also suggests establishing a system of consistent oversight for all other mortgage-backed securities, or MBS issuers.
The existing system of loans insured by the federal government through the Federal Housing Administration, the Veterans Administration, and Rural Housing Administration and bundled into securities enjoying a federal Ginnie Mae guarantee would not be affected by this framework, except as described in the discussion of loan limits. The framework imagines an ongoing role for wholly public housing finance agencies providing an essential backstop and economic stabilizer as during the current crisis.
Chartered Mortgage Issuers
Under this framework, privately owned and capitalized monoline Chartered Mortgage Issuers would be given exclusive charters to issue government-guaranteed MBS in order to ensure that a deep and liquid secondary market provides capital for favored mortgages. Key features of CMIs would include:
Explicit government guarantee on MBS to ensure liquidity. The federal government would provide an explicit guarantee of the timely payment of interest and principal on MBS issued by the CMIs. Specifically:
- The federal government would stand behind the MBS. The federal government would ensure the timely payment of principal and interest on MBS issued by the CMIs, making MBS investors whole if the CMI’s assets and a new Taxpayer Protection Insurance Fund were ever insufficient to cover MBS losses.
- CMIs would absorb all ordinary losses on MBS. The government guarantee would only apply if a CMI’s capital were inadequate to meet its obligations to make timely payments. To reduce the likelihood of this happening, capital and reserve requirements would be established and monitored by appropriate regulatory authorities.
- Resolution authority. Regulators would have authority to place a CMI in conservatorship or receivership to facilitate an orderly reorganization or winding down of their assets to minimize costs to taxpayers. This authority would be modeled on the Federal Deposit Insurance Corporation’s resolution authority for depository institutions. Any MBS losses would be paid first out of the failed CMI’s assets at the expense of shareholders and creditors, with additional costs to be paid from our proposed Taxpayer Protection Insurance Fund.
- Taxpayer Protection Insurance Fund. Taxpayers would be further protected by an insurance fund, financed by a small fee levied on each guaranteed MBS transaction. Should a CMI become insolvent and unable to meet its obligations to make timely payment of interest and principal to MBS holders, this insurance fund would be tapped, providing a buffer against taxpayer exposure. The size of the fee would be determined by regulators, and designed to provide taxpayers yet greater assurance that they are shielded from losses.
Limitations on conforming mortgages. A primary regulator would determine the specific characteristics of mortgages eligible for CMI securitization and be expressly charged with ensuring these mortgages were safe and sustainable for the homeowner, advance the goal of ensuring access to homeownership for credit-worthy borrowers or the availability of affordable rental housing, have known risk characteristics, and would not otherwise be offered consistently by private markets. An additional goal of such regulation would be to promote standardization in the interest of both transparency to mortgage borrowers and liquidity through deeper markets for MBS investors.
Regulators would determine, within parameters set by Congress, the maximum size of mortgages eligible for CMI securitization. We anticipate that loan limits on mortgages eligible for CMI securitization would decline over time as a more robust housing finance market is reestablished, so that taxpayer backing is not used to support liquidity in segments of the market that the private market can well serve alone, given the purchasing power of homebuyers at those home prices. But to the extent that housing market disruptions occur from time to time and liquidity once again is limited for mortgages for homes in higher cost areas, the regulator would have the ability to temporarily increase loan limits to address the shortage of credit.
Appropriate standards and oversight. CMIs would be subject to oversight on a range of issues in order to minimize the risks of taxpayer exposure and ensure that these entities receiving the benefits of government-backed enhancement of their obligations were acting in the public interest. Specifically:
- Monoline institutions. CMIs could only issue government-backed MBS and would be prohibited from issuing MBS backed by mortgages not deemed eligible for the government guarantee in order to ensure that the nature of taxpayer exposure is transparent and the benefit of public backing is in fact limited to those preferred products.
- Risk oversight. CMIs would be regulated for risk in a manner roughly analogous to the regulation of commercial banks, including requirements to hold significant levels of risk capital and to pay into a taxpayer protection insurance fund meant to protect against catastrophic losses.
- Managed returns. The profits earned by CMIs would be established through both market mechanisms and regulatory oversight. The goal would be to achieve sufficient and durable private capital investment to support socially important housing markets without allowing private investors to unduly capture the value provided by the public backing of MBS obligations or encouraging risky behavior.
Public purpose obligations. CMIs would enjoy exclusive access to a market facilitated by government backing. In return, they would be required to serve the public good, including by providing:
- Countercylical liquidity. CMIs would be chartered expressly with the goal of providing mortgage liquidity during credit downturns, with reserves and other mechanisms established to they can continue to play essential functions in times of market disruption.
- Affordable multifamily rental housing. CMIs would be required to support affordable multifamily rental housing, through securitization activities, credit enhancements, direct investment, or a combination thereof.
- Broad access to affordable credit. CMIs would have an affirmative responsibility to provide affordable credit broadly and equitably and in accord with all applicable fair lending laws.
- Affordable Housing Trust and Capital Magnet Funds. To the extent that market pricing on the MBS issued by CMIs would allow—while still providing sufficient returns to attract private investment capital for the CMIs—the regulator would require the CMIs, like other MBS issuers,to pay a small fee on each MBS issue that would be used to finance the proposed Affordable Housing Trust and Capital Market Funds—and perhaps other vehicles—for financing affordable housing production and preservation.
Limited direct investment activities. CMI direct investment or so-called “portfolio” activities—loan or investment assets held in portfolio and not securitized—would be limited to serving certain public purposes only as approved by their primary regulator. Approved activities would include multifamily housing finance and direct investment and other activities to the extent determined necessary to allow for the provision of countercyclical liquidity.
Comprehensive and uniform oversight of other MBS issuers
Under our proposed regulatory framework, all financial institutions seeking to issue securities substantially based on U.S. residential mortgages would be subject to comprehensive regulation of risk in order to create a level playing field between CMIs and all other MBS issuers and to prevent regulatory arbitrage. This risk regulation would be designed to supplement and work in concert with any securities regulation applicable to MBS under requirements of the Securities and Exchange Commission, the Commodity Futures Trading Commission, and other regulators of securities issuers. Further analysis is required to understand the relationship between the framework approach here and those requirements in current law and as they may emerge from financial regulatory reform legislation currently pending.
Our analysis of the U.S. mortgage crisis finds that the irrational pricing in the privatelabel security market had a distorting and devastating effect on the conforming market. Competition for market share contributed to poor choices made by the governmentsponsored enterprises Fannie Mae and Freddie Mac, which in the end have proven costly to taxpayers, well beyond even the dramatic losses one would otherwise expect from monoline housing finance firms serving the conforming market during the worst housing downturn in 80 years. Our framework, therefore, would harmonize the regulation of similar activities performed by different financial institutions in the U.S. mortgage marketplace, level the regulatory playing field, avoid a race to the bottom, and stabilize the mortgage finance system by imposing risk oversight at the secondary market level.
This comprehensive regulatory regime for other MBS issuers would be similar in key respects to the way banks and thrifts are currently regulated and would apply to all issuers of securities substantially based on U.S. residential mortgages. As in the mortgage markets of other countries, there would be far greater oversight of the form of MBS that could be issued and the types of mortgages that could be securitized, with an emphasis on ensuring the “safety” of mortgages that could be financed through the secondary market. We believe it is insufficient to rely upon origination-level consumer protection measures as the sole means of overseeing systemic risk posed by the safety of products—although clearly it is important to have coordination with origination-level regulators, such as the proposed Consumer Financial Protection Agency and state regulators.
Importantly, however, we do not contemplate that loans securitized by other MBS issuers would be subject to the specific requirements to be imposed upon the CMIs—that the loans they securitize advance public objectives of affordability and broad access to credit. More exotic product types not found to be “safe” to the consumer and for the system would nonetheless be available—unless barred by primary market regulation—to the extent that mortgage lenders or investors were prepared to maintain these loans in their portfolios. Innovation could thus proceed and new products could be tested before gaining wider market acceptance.
Providing access to affordable homeownership and rental housing
Under our proposed framework, liquidity for mortgages that would expand access to affordable housing would be provided in a number of different ways. Among them are:
- FHA and Ginnie Mae. Ginnie Mae would continue to securitize loans insured by the Federal Housing Administration, the Veterans Administration, and other agencies that are designed to promote affordable homeownership and mortgage financing for multifamily rental housing.
- Affordable Housing Trust and Capital Magnet Funds. A fee levied on all MBS issues—unless found to unduly restrict the availability of investment capital for CMIs, which already would bear heavy public purpose and liquidity requirements—would support these funds created by legislation in 2008 to provide direct and credit subsidies for affordable housing.
- Basic duty of broad access for all MBS issuers. CMIs and other MBS issuers would be required to provide broad access to affordable credit in all markets they served. A combination of quantitative and qualitative factors would be assessed to determine whether the duty to serve has been fulfilled.
- Direct investment or “portfolio” activities of CMIs. As aforementioned, CMIs would be limited in the direct investments they could make to hold in portfolio and not securitize. But to fulfill their affirmative obligations to serve public purposes, including the provision of multifamily housing finance and other efforts to provide liquidity to underserved markets, certain investments which served a public purpose would be permissible for the CMIs—with the specific parameters and total amounts of these direct investments being articulated by the CMIs’ primary regulator.
Better protection of taxpayers against loss
Under our proposed framework, taxpayers would be far better protected against risk of loss than in the past. Specifically:
- Limited government guarantee. The government guarantee would be explicit and only apply to MBS issued by the CMIs. There would be no guarantee of the CMIs’ debt or equity.
- Government backing would be offered only for securities backed by loans that are deemed to be safe and sustainable. Eligible loans must have known risk characteristics, and be safe and sustainable.
- New Taxpayer Protection Insurance Fund. A small fee would be levied on each new MBS offering made by the CMIs to fund a reserve held by the Treasury that would buttress the capital reserve requirements of the CMIs.
- Robust risk oversight of both CMIs and other MBS issuers. The level playing field also reduces risk of taxpayer exposure. With competitors also subject to a consistent regime of risk regulation, the CMIs and their regulator would not be pressured to allow them to assume higher risks to chase market share.
- Limited portfolio activities. A substantial portion of the losses currently being borne by the GSEs result from loans and MBS they purchased for their own portfolios, which until the onset of the current financial crisis served as major profit centers. Limiting the direct investment activities of the CMIs to those that serve public purposes would rein in their potential losses accordingly.
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