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10 Steps to Housing Finance Reform

Editor’s note: This feature originally appeared in a recent issue of MReport.

The government-sponsored enterprises (GSEs) have been in conservatorship for more than 10 years. During that time, three presidential administrations, four Federal Housing Finance Agency (FHFA) Directors, and seven different congresses have grappled with the seemingly herculean task of bringing Fannie Mae and Freddie Mac out of conservatorship and completing housing finance reform. 

While the public debate has often envisioned and emphasized the need for legislative action, that avenue has been, and continues to be, an uphill battle in an unprecedented partisan political landscape. Still, stable growth in the housing market, strong employment, and the potential for rising interest rates point to the increasing need to establish a “new normal” for housing finance. 

The Trump administration has tapped regulators to take a fresh look at the options available to get momentum moving in the right direction. Published in March, the White House’s Memorandum on Federal Housing Finance Reform directs the Treasury Department, in consultation with other key housing regulators, including the FHFA, the Department of Housing and Urban Development (HUD), and the Consumer Financial Protection Bureau (CFPB), to develop a blueprint for reform. 

The memo not only outlines broader national housing policy priorities but shines a light on the influential role that regulators can play in driving significant components of housing finance reform in the absence of congressional consensus. The 10 requirements regulators have been tasked with represent a toolbox of policy authority that, when drawn upon, can accomplish significant progress, leaving a final few select measures up to Congress. 

As FHFA Director Mark Calabria said before the Mortgage Bankers Association Secondary Market Conference in May, “The perspective in the past that we must wait on Congress is not one I share. There are a number of things I can’t do, where we need congressional authority, but there are a number of things I can do.” Treasury Secretary Steven Mnuchin expressed a similar sentiment in a CNBC interview in February, saying the administration preferred bipartisan legislative action, but “if that doesn’t work, we have administrative tools that we can [use to] make moves in housing.” 

As President Trump’s memo makes clear, there are at least 10 ways regulators can lay the groundwork for reform. 

The memo mandates the regulatory proposal for housing finance reform end conservatorship, facilitate competition in mortgage lending, establish regulations of the GSEs going forward, and ensure the government is compensated for support of the secondary housing finance market. The memo sets forth the following objectives to advance these priorities: 



  1. Preserve the 30-year Fixed-Rate Mortgage 



Unsurprisingly, maintaining access to the 30-year fixed-rate mortgage—the hallmark of the U.S. housing market and the impetus for chartering the GSEs in the first place—tops the list. Regulators are tasked with preserving this product and other affordable mortgage options that “best serve the financial needs” of qualified homebuyers. 

At times during the decade-long debate on housing finance reform, certain industry stakeholders have disagreed on the need for the government to guarantee the availability of the 30-year mortgage and asserted that private lenders and others who securitize mortgagebacked securities (MBS) could sustain access to this product on their own while also offering competitive interest rates. 

Calabria has argued against the necessity of the 30-year mortgage in the past, but recently has expressed a more open position, saying during his nomination hearing before the Senate Banking Committee, “It is indeed possible for us to have a well-capitalized, strong system that preserves the 30-year mortgage.” 

With Calabria, the Trump administration, and most of the mortgage industry aligned on this objective, the release of the GSEs and/or the design of a new guarantee structure is more than likely to incorporate requirements to sustain securitization of the 30-year mortgage by continuing to match mortgage lenders with investors that can manage the long-term interest rate risks associated with a 30-year product. 


  1. Maintain Equal Access for Lenders


Today the GSEs play a central role in providing liquidity that is accessible to lenders of all sizes, charters, and geographic locations. In 2017 and 2018, Fannie Mae and Freddie Mac originations represented just under 50% of total volume, according to the Urban Institute. Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) originations account for about a quarter of total volume, and portfolio originations make up another 30%. Prior to conservatorship, private-label securities (PLS) accounted for roughly one-third, to as much as half, of all originations. 

Restoring a healthier and more competitive mix of securitizations, one not entirely dependent on GSE and government-backed securitization, would contribute to a more functional mortgage market that meets the needs of all lenders. Before the Mortgage Bankers Association, Calabria said, “I’m a big believer in competition.” 

Among the specific components required to maintain access for smaller lenders is the preservation of the TBA market model and the cash window for loan sales. In releasing Fannie Mae and Freddie Mac, the ability for smaller lenders to continue to deliver into the TBA market, bypassing the volume requirements for “specified pool” markets, should remain unchanged. Maintaining the GSEs respective cash windows for the outright purchase of single loans is extremely important for the stability of small and even mid-sized lenders. When delivering loans through an aggregator are added to allowing direct investor delivery 

without incurring the pricing and product impairments, the cash window creates securitization access in an environment that minimizes market risk for smaller market participants. 


  1. Establish New Capital Standards


Calabria has been vocal about the importance of setting and achieving appropriate levels of capital and liquidity, saying in May, “It was insufficient capital that triggered the conservatorship, and it’s going to be sufficient capital that triggers an exit.” 

FHFA is in the process of once again reviewing the GSEs’ current capitalization, but Calabria has said that “step one” will be to end the current net worth sweep of Fannie Mae and Freddie Mac’s earnings. 

This measure alone, however, is not expected to build capital fast enough to align with the administration’s timeline. FHFA is considering other options, including raising capital through initial public offerings (IPOs) and hopes to begin implementing new capital building measures by January 2020. 

Although no specific levels have been established, a suitable capital requirement threshold has been the source of industry, regulatory, and congressional debate for years. “With a leverage ratio of nearly one thousand to one, the GSEs’ balance sheet capital cushion is razor-thin relative to their huge amount of assets,” Calabria said at the Secondary Market Conference. “As a regulator, my primary concern is that the GSEs maintain capital levels commensurate with their risk profiles,” he added and suggested Fannie Mae and Freddie Mac should be subject to the same capital requirements as large financial institutions. 

Congress has occasionally weighed in on the issue. Senators Mark Warner (D-Virginia) and Bob Corker (R-Tennessee) proposed the Housing Finance Reform and Taxpayer Protection Act, one of the first major bipartisan legislative proposals for housing finance reform, envisioned a 10% capital requirement. The Urban Institute estimates that a level of 4-5% would have adequately sustained the GSEs through incurred losses from the financial crisis. 

Regulators need to agree on the appropriate capital level in order to finalize a risk-based capital rulemaking. This critical step “needs to be finished before there’s an exit,” Calabria told Politico earlier this year. 


  1. Charter New Guarantors


Several proposals for housing finance reform, including Senate Banking Committee Chairman Mike Crapo’s (R-Idaho) outline and the Mortgage Bankers Association’s white paper, have suggested privatizing the GSEs and allowing new additional private guarantors to compete with them. 

The inclusion of this priority in the White House’s memo reflects a shared interest in pursuing an expansion of the number of mortgage guarantors. Legislation would be required to provide FHFA with the authority to issue charters to new guarantors. A new chartering authority would allow FHFA to move away from Fannie Mae and Freddie Mac’s current duopoly. Calabria said, “When it comes to housing, competition would make the system more stable. If there were 10 GSEs instead of two, it’s unlikely any of them would be ‘too big to fail.’” 


  1. Curtail the GSE Footprint


Right-sizing Fannie Mae and Freddie Mac’s collective footprint in the housing market has been one of FHFA’s primary objectives since conservatorship. This is also one of the only lingering reforms not addressed by the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (Dodd-Frank) mandate to end “too big to fail.” Reigning in the GSEs’ market share is contingent on the successful execution of some of the other objectives laid out by the White House, including reevaluating multifamily market participation, the Qualified Mortgage (QM) patch, and affordable housing. 

There are several avenues that FHFA could pursue to reduce the GSEs’ current origination volume directly. Eliminating or reducing participation with certain products, including larger loan sizes, investor or second homes, and cash-out refinances, is a commonly discussed option to cut down market share tactically. Some of these products arguably do not serve the GSEs original mandate and make up nearly one-third of their total volume (cash-out refinances accounting for 20% and second homes accounting for 10%). 

FHFA also can reduce GSE loan limits to curb the concentration of larger balance mortgages, but this step would likely require amendments to the Housing and Economic Recovery Act (HERA). Raising g-fees or tightening credit underwriting requirements is another viable alternative for motivating new competition from PLS securitizers and curtailing GSE volume. 


  1. Choose the Appropriate Size of Retained Portfolios


The retained portfolios of Fannie Mae and Freddie Mac have been gradually reduced under the direction of FHFA since conservatorship. The senior preferred stock purchase agreements (PSPAs) between Treasury and the GSEs established a schedule for 15% annual reductions in retained portfolios. The PSPAs also instituted a $250 billion cap that became effective this year. Both Fannie Mae and Freddie Mac are working on executing FHFA’s approved retained portfolio plans to maintain the cap, even under adverse conditions. Through these actions, FHFA has reduced the volume of mortgage purchases for investment while maintaining securitization volume. 

Under conservatorship, FHFA has specifically focused on the reduction of riskier retained mortgage portfolios, which were down to $484 billion by the end of 2017, compared to $1.6 trillion in 2008. FHFA will continue to maintain restrictions on the GSEs’ retained mortgage and investment portfolios and propose reasonable standards for the GSEs post-conservatorship as part of the regulatory framework for housing finance reform. 


  1. Define the Role of GSEs in Multifamily


In addition to a substantial market share in single-family mortgage originations, the GSEs have grown their footprint in multifamily mortgage lending since the financial crisis. Multifamily mortgage originations have increased as a whole, from around $150 billion in 2007 to a projected $324 billion in 2019, according to Freddie Mac. Before the financial crisis, the GSEs only accounted for about a quarter of multifamily mortgage originations. However, they now represent nearly half of the market’s volume. 

Lawmakers, including Sen. Crapo, have been eager to revisit the scope of the GSEs’ involvement in this area as well. Crapo’s outline proposes selling Fannie Mae and Freddie Mac’s multifamily businesses to be operated as independent guarantors. The multifamily industry has pushed back against a dramatic wind down in the GSEs’ role in the market, arguing they play an essential role in supporting the unique needs of rising apartment lending. 

FHFA’s 2018 Scorecard Progress Report, released in April, outlines a $35 billion cap to be placed on the volume of new multifamily business that each GSE can take on. Importantly, FHFA has chosen to exclude affordable and underserved market segments from the cap requirements.


  1. Evaluate the QM Patch


The original GSE patch for QM requirements will end in January 2021 or when Fannie Mae and Freddie Mac come out of conservatorship—whichever comes first. The CFPB is working in consultation with other regulators to determine whether to allow the patch to expire, temporarily extend its provisions, or revisit the Ability-to-Repay/QM rulemaking altogether. How the CFPB decides to proceed with the patch, which extends safe harbor protections for GSE loans even though they do not meet the regulatory QM requirements, will likely align with the path of housing finance reform. 

The CFPB’s Spring 2019 Rulemaking Agenda explains that the GSE patch is currently under review. “After further policy analysis,” the CFPB said it will “determine whether rulemaking or follow up activity is appropriate.” Bob Broeksmit, President and CEO of the Mortgage Bankers Association, told American Banker, “Not doing something to extend the patch would be highly disruptive.” 

The GSE patch, however, has been linked to the growth of the GSEs’ footprint, in conflict with other objectives from the White House memo. The CFPB recently conducted an assessment of the Ability-to-Repay/QM rule saying, the “continued prominence” of originations covered by the GSE patch “is contrary to the Bureau’s expectations at the time of the rulemaking.” The CFPB continued, “The scope of GSE-eligible loans is broad and grew broader for a period of time after the rule became effective as the GSEs loosened the credit eligibility.” Investors have also gravitated to GSE loans with QM protections in lieu of non-QM originations. As a result, the CFPB said, the PLS market “remains quite small,” which “limits the funding available” for non-QM loans. 

Further extending the GSE patch would allow Fannie Mae and Freddie Mac to continue these trends and risks further disincentivizing PLS growth in non-QM originations. Eliminating the GSE 

patch—assuming the Fannie Mae and Freddie Mac would slow or halt their purchase of non-QM loans without safe harbor protections—would have a significant impact on GSE origination volume. Redwood Trust estimates that between 25-30% of mortgages purchased by the GSEs would be considered non-QM in the absence of the patch. 

This reduction would certainly contribute to curtailing the GSE footprint. According to Redwood Trust’s analysis, the private market could absorb as much as 70% of the GSEs current non-QM volume. This transition would also help the mortgage market achieve a healthier blend of non-QM and legitimate QM products, fulfilling the original intention of the CFPB’s rule.


  1. Direct the GSEs; Role in Affordable Housing


FHFA, in coordination with other regulators, including HUD and Treasury, will need to define what measures, if any, will be used to quantify the GSEs’ role in promoting affordable housing. The White House has asked regulators to define the role for the GSEs “without duplicating support provided by the FHA and other federal programs.” To this end, it is important that HUD is involved in mapping out the placement of multiple federal programs, in addition to the GSEs’ post-conservatorship space in affordable housing. 

Crapo’s outline envisions replacing the current affordable housing goals and duty-to-serve requirements with a Market Access Fund. This fund would extend grants, loans, and rental assistance to advance affordable options for low-income households and communities. 

The affordable housing mission, mandated by Congress in 1992, was one approach to engaging the GSEs in the extension of affordable mortgage credit. Reinvigorating competition and longer-term predictability to the mortgage market may also help achieve a better balance of credit availability. As discussed with other objectives, limiting certain products, such as larger balance loans and investor and second homes may narrow the GSEs’ focus on more low- and moderate-income households. 


  1. Set Conditions for Ending Conservatorship 


While FHFA has arguably been working on setting the conditions to end conservatorship for 10 years, finally actualizing the release of Fannie Mae and Freddie Mac will require agreement on the appropriate measures of success. Calabria said that achieving “an excess of capital” will be the ultimate threshold for release. “The path out of conservatorship that we will establish for Fannie and Freddie is not going to be calendar dependent. It will be driven, first and foremost, by their ability to raise capital,” he said. If one GSE becomes ready for privatization before another, FHFA will consider releasing them out of conservatorship at different times. 

Regardless of the timing, the White House has stipulated that upon the termination of conservatorship, Treasury and FHFA need to develop a mechanism that ensures the federal government is compensated for any explicit and implicit guarantee provided to the GSEs or their successors, specifically “in the form of an ongoing payment” to the U.S. The White House has also called on regulators to ensure that, incorporating many of the priorities listed above, the GSEs’ post-conservatorship missions and portfolios are appropriate. Regulators must additionally outline a vision for heightened prudential and safety and soundness requirements for the next generation GSEs, “designed to prevent future taxpayer bailout and minimize risks to financial stability.” 


Great Expectations


As a host of new housing leaders, including Calabria, Mnuchin, Kathy Kraninger, Director, CFPB, Ben Carson, Secretary, HUD, and Brian Montgomery, FHA Commissioner, coalesce around the tools at their disposable, the mortgage industry should finally expect to see gradual steps taken towards housing finance reform. Calabria has tellingly promised, “If there’s one thing I know for sure it’s that Fannie and Freddie will look much different at the end of my five-year term than they do today.” 

More than ten years after the financial crisis, the mortgage industry certainly understands Calabria’s sentiment, “The status quo is no longer an option.” After executing the objectives set forth by the Trump administration, regulators have assured that Congress will be provided ample time to consider the housing finance reform framework and take any remaining necessary legislative steps to conclude their efforts. Between now and Congress’ eventual action, regulators have a long runway to get housing finance reform off the ground—once and for all. 

About Author: Brian O'Reilly

Brian O'Reilly is Managing Director and Head of the SitusAMC Advisory and Consulting business. Previously, O’Reilly was President of The Collingwood Group, which he co-founded in 2007. The Collingwood Group was acquired by Situs in 2017. Earlier, he was Fannie Mae’s Director of Automated Underwriting and Risk Management Solutions, where he managed several customer-facing, risk management technology platforms. Before joining Fannie Mae, O’Reilly served as EVP and General Counsel of a large regional mortgage originator and practiced law with several international law firms.

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