The GOP-heavy 114th Congress took its seats with the majority claiming that it wanted to hit the governing road running. The traffic jam wasn’t long in coming. With the Republicans divided among themselves and the Democrats no strangers to playing obstacle tag, polarization and gridlock have yet to leave town. But what if there were a major policy issue ripe for settlement on the merits? It turns out there is one: reforming the Federal role in housing policy, a subject implicated in no small way, let us recall, in the onset of the Great Recession of 2007–08.
A bill introduced in May by the Chairman of the Senate Banking Committee, Richard Shelby (R-AL), illustrates the potential for this issue. Shelby’s Financial Regulation Improvement Bill aims to repair some of the ham-fisted errors of Dodd-Frank by raising the threshold for defining SIFIs (Systematically Important Financial Institutions) from $50 billion to $500 billion. Dodd-Frank slapped regulatory constraints, and costs, onto a host of smaller regional banks and lumped them together with the likes of Goldman Sachs. That made these smaller banks less able to loan out money, in turn harming regional investment and growth.
But Shelby’s bill is 216 pages long, and so obviously is about more than the SIFI threshold. Indeed, tucked in the latter pages of the bill, which passed out of committee in June, are stipulations concerning Fannie Mae and Freddie Mac that really should not be in this bill at all. These two government-sponsored entities (GSEs) have been stuck in conservatorship now for nearly seven years, thanks to the role they played in the real estate meltdown that catalyzed the Great Recession. Remember that, in the waning days of the Bush Administration, Congress passed HERA, the Housing and Economic Recovery Act of 2008, which created the Federal Housing Finance Agency to “preserve and conserve” Fannie Mae and Freddie Mac, who otherwise (and surprisingly to many) did not merit a wholesale bailout to save them from their sins. Then in 2012, the Obama Administration’s Treasury Department unilaterally changed HERA’s terms, taking 100 percent of Freddie and Fannie’s profits and sweeping them into the Treasury’s general fund, without regard to Congressional oversight (and, some would argue, the rights of shareholders). This kept Freddie and Fannie, which certainly qualify as SIFIs (and which is one reason they merited inclusion in Shelby’s bill) in perpetual limbo. It kept them permanently undercapitalized and hence unable to exit conservatorship. Title VII of Shelby’s bill, which would lock in this change, can be seen as an initial step in the road to GSE reform, since Freddie and Fannie cannot now exit conservatorship in the same general arrangement as they entered it.
We would be better off if Shelby’s bill passed without the GSE pieces and Congress were ready for some serious reform initiatives. Unfortunately, Republicans and Democrats are miles apart on reaching consensus on liquidating the GSEs. That distance is illustrated in part by the lack of any action on a bill House Democrats introduced in March, the lesser-known Partnership to Strengthen Homeownership Act. That Act would dramatically expand the role of a different government-owned corporation that has served as a successful guarantor of billions of dollars of mortgage-backed securities for more than forty years—and unlike the GSEs, this government-owned corporation survived the financial crisis unscathed. The name of this Federal guarantor is the Government National Mortgage Association, more commonly known as “Ginnie Mae.”
The success of Ginnie Mae needs to be considered before any reform of the secondary mortgage market. With a little legislative tweaking, Ginnie Mae could guarantee some of the mortgage loans that are now the responsibility of the GSEs—and most likely do a better job of it. Radical Ginnie Mae expansion, as contemplated by the Democrat-sponsored House bill, is not a good idea, at least not yet. It is worth remembering that, prior to legislative re-authorization of the GSEs in 1992, most considered the GSEs to be well-functioning “quasi-agencies.” One lesson of the Great Recession, according to some, was the toxic impact of bad GSE reform on housing finance. Ginnie Mae should not become a casualty of bad legislation after decades of success.
Congress created Ginnie Mae in 1968 to test the model of federally guaranteed mortgage-backed securities. Prior to 1968, the secondary market for mortgage loans was fairly limited, and that in turn limited access to mortgage financing. Ginnie Mae’s creation opened up the mortgage market to individual investors and expanded the base of eligible mortgage-purchasing institutions as well. Even more desirable, the guarantee fee charged by Ginnie Mae covered program costs, so Congress did not have to subvent Ginnie Mae from the Federal budget. The Ginnie Mae model confirmed that the Federal government could support the secondary mortgage market—allowing more Americans to own their own homes—without engaging in purchase and sale activity itself.
Mortgage-backed securities guaranteed by Ginnie Mae are structured as securities backed by a pool of government agency mortgage loans, such as FHA-insured or VA-guaranteed loans. Payments under Ginnie Mae securities reflect the scheduled monthly mortgage payments under the pool of loans backing such securities after a deduction for servicing and guarantee fees. The key enhancement is an unconditional commitment of the U.S. government, commonly referred to as a “full faith and credit guarantee”, for payments guaranteed by Ginnie Mae. The full faith and credit guarantee makes the risk of non-payment under Ginnie Mae mortgage-backed securities as low as the risk of non-payment under a Treasury bond. In other words, investors in Ginnie Mae-guaranteed securities need not worry that the default of a pooled mortgage loan will stop or delay payments due under the securities.
The GSEs, by contrast, have no full faith and credit guarantee for their securities. GSE guarantees were understood to constitute an “implicit” Federal guarantee thanks to their credit line to the U.S. Treasury. Exactly how the GSE guarantee was supposed to work if tested was never spelled out in GSE re-authorizing legislation, however. Even before the financial crisis emerged, the bond market recognized that the implicit GSE guarantee was not as valuable as the full faith and credit guarantee made to Ginnie Mae.
The GSE guarantee was finally tested under Federal conservatorship beginning in September 2008. What occurred shocked many bond market participants. The Treasury limited its financial support to GSE debt and guarantees; holders of GSE preferred stock were out of luck. Considering the standing of the GSEs as “quasi-agencies” and the volume of GSE issuances (exceeding Treasury issuances at various times), the implicit GSE guarantee ultimately failed to stabilize the secondary mortgage market. The Ginnie Mae guarantee, in contrast, served as an anchor of stability for an anxious bond market in 2008.
It would be nice to able to show in plain, clear language how the Ginnie Mae model differs from Freddie Mac (which came after it) and Fannie Mae (which came before it). Alas, the missions of all these organizations and the business models of each have changed so many times over the past half-century that no short explanation is possible. Suffice it to say that while Ginnie Mae has maintained a fairly narrow range of functions as a government corporation, Freddie and Fannie broadened their range of activity in what turned out, in due course, to be highly risky ways. Since both are linked in origin to the government, the effect was to drag the Federal government into the mess they created, and force it to face the problems of cleaning it up.
It doesn’t take a financial genius to understand the risks the GSEs took. Any institution that buys an asset like a mortgage loan needs a funding source for the purchase. What are such sources? Well, pension funds have plan contributions for investment. Depository institutions have capital and deposits (subject to regulatory restrictions). The GSEs also had use of some capital from shareholders who invested in their stock. But debt remained Freddie and Fannie’s main source of funds for purchasing mortgage loans. They both borrowed money from America’s bounteous capital markets.
Now, mortgage loans (assets) tend to be long-term instruments, while debt financing (liabilities) for such loans tends to be short-term. So long as the interest rate paid on the mortgage loan is higher than the interest rate charged on the short-term debt that finances it, using short-term borrowings to finance a long-term mortgage—called the “carry trade”—is profitable. The carry trade, essentially arbitraging interest rates, had been a major source of profitability for the GSEs (and much of Wall Street, for that matter).
The risk inherent in the carry trade is that interest rates move in not-always-predictable ways. Should short-term borrowing rates exceed interest rates on mortgage loans, one could be stuck with the much feared “negative carry.” One loses money, in other words. This is exactly what happened to Fannie Mae in the early 1980s, when the cost of financing its low-interest rate mortgage portfolio using short-term debt reached double-digit percentages. A mortgage-backed securities program adopted by Fannie Mae, following the Ginnie Mae guarantee model, helped restore Fannie Mae to financial health from its near-death experience.
Explaining the 2008 GSE train wreck, however, requires more than the observation that Fannie Mae failed to learn the lesson of the 1980s. It more than merely failed to learn that lesson; it magnified its error instead by borrowing very heavily to buy mortgage assets. The GSE’s ratio of assets to capital (its leverage ratio) was frighteningly high compared to that of other financial institutions. According to some, the GSE leverage ratio was nearly twice that of investment banks that failed during the financial crisis. It was easy—much too easy—for the GSEs to issue so much debt in the bond markets given their credit line to the Treasury.
Despite the increasing use of leverage in the run-up to the financial crisis, capital has always been an important cash cushion for most businesses, including mortgage lenders. In plain English, this means that if businesses get in trouble they still have their own non-borrowed money to withstand losses. By 2008, however, each GSE had engaged in so many risky purchases that it triggered an increase in the default rate of its mortgage portfolio, an increase so steep that the GSEs’ razor-thin capital margin could not cover all the losses. We all know what happened next: The Treasury covered GSE losses through a conservatorship authorized by Congress in July 2008 only weeks before the point of collapse was about to arrive. What had been an implicit but presumably expansive guarantee suddenly became an explicit but much narrower guarantee.
Meanwhile, as this nerve-wracking drama played out, Ginnie Mae avoided the GSE meltdown. Unlike the GSEs, Ginnie Mae does not raise funds to buy mortgage loans. As a result, Ginnie Mae does not issue debt or stock. Navigation of the bond markets and the management of loan interest-rate risk—complex functions that usually accompany institutional purchases of mortgage assets using borrowed funds—were never part of Ginnie Mae’s playbook.
By sticking to its knitting as a guarantor (rather than a buyer of mortgage assets) over the past four decades, Ginnie Mae has been able to develop and refine its guarantee model. As the volume of Ginnie Mae securities has increased (in 2014, the total balance outstanding reached $1.5 trillion), the familiar Ginnie Mae model has had the indirect effect of promoting a chain of related business activity conducted by the private sector. For a mortgage loan included in a Ginnie Mae pool, the private sector performs the role of loan originator; loan servicer; document custodian; securities issuer; warehouse lender and other types of secured lender; and securities purchasers and sellers, an umbrella term that includes trading and repo desks with a niche in Ginnie Mae product.
The narrow role performed by Ginnie Mae in creating a secondary mortgage market for Federal agency loans (mainly FHA and VA still), with fewer moving parts to master, contrasts with the many hats worn by the GSEs. Not only do the GSEs price and fund loans directly, they often bought and sold their own guaranteed mortgage-backed securities to exploit trading opportunities and the carry trade. In the quest for profit growth, the GSEs engaged in mortgage transactions that, given the inherent advantage as quasi-agencies, could eat the lunch of mortgage bankers, investment bankers, and other industry participants along the way.
Another way of comparing the Ginnie Mae model to the much criticized “social losses, privatized profits” model of the GSEs is that Ginnie Mae doesn’t compete with its own program participants for business; the GSEs did, and typically won, given the advantages of its implicit Treasury guarantee. Ginnie Mae’s goal is to operate a self-sustaining guarantee program that supports the secondary mortgage market for agency loans; the GSEs undertook the additional task of finding profitable opportunities for their shareholders in the mortgage markets. In view of the GSE conservatorship, few would disagree that the simpler Ginnie Mae guarantee model is superior as a means to support the secondary mortgage market.
Another strength of Ginnie Mae’s guarantee model concerns the two major players that are likely to be the source of payments under the securities if a pooled mortgage loan is in default. First, the lenders who originate mortgage loans eligible for Ginnie Mae securitization typically “issue” the mortgage-backed securities and are the first line of defense in advancing scheduled payments under the guaranteed securities. Second, agencies such as FHA and VA, with mortgage loans eligible for Ginnie Mae securitization, provide loan-level insurance or guarantee coverage in the event of a default. The investor who buys Ginnie Mae securities sees only scheduled payments, without knowing (or needing to know) the source of the payments when a pooled mortgage loan is in default. In other words, Ginnie Mae offerings are pre-insured by other agencies; GSE offerings mostly are not.
Lenders who originate FHA/VA mortgage loans usually find that issuing a Ginnie Mae pool to place such loans ensures the lowest interest rates available due to the full faith and credit guarantee. The lender or its successor, approved by Ginnie Mae as an issuer, initiates the needed activities to assemble a pool of mortgage loans that Ginnie Mae will guarantee. The lender issuing guaranteed mortgage-backed securities will typically service the pooled loans and perform pool administrative functions under agreement with Ginnie Mae. The lender performs in this manner in consideration of Ginnie Mae’s agreement to guarantee the securities, and for the compensation associated with servicing the pooled loans.
A look at a few servicing scenarios shows how the lender is ultimately responsible to Ginnie Mae for the pass-through of mortgage payments or payoff amounts of a pooled mortgage loan. If a mortgage payment is paid on time, the lender remits the payment in the manner required by Ginnie Mae. If a borrower fails to make a payment in a timely manner, it is the lender’s obligation to advance the payment. If the borrower is having problems making the monthly mortgage payment, the lender determines whether the default can be resolved through an available workout or modification program.
If the severity of the borrower’s default results in the lender filing a claim with the FHA, the VA, or some other agency providing loan level insurance or guarantee coverage, the lender is obligated to continue to advance payments under the securities even though no payments are made under the mortgage loan. Ginnie Mae allows the lender to buy out a seriously delinquent loan from the securities pool. Absent such a buy-out, claim proceeds paid to the lender by the FHA, the VA, or other agency are passed through to investors under the Ginnie Mae securities. If the proceeds from the agency insurer or guarantor are insufficient to cover the amount due under the guaranteed securities for such a loan, the lender is responsible for covering the deficiency.
If the lender fails to pay amounts due under the securities, the lender is in default of its obligations to Ginnie Mae. When an “issuer default” arises, Ginnie Mae makes good on its guarantee to investors and arranges for another Ginnie Mae issuer to take over the servicing portfolio of the defaulting lender. The lender who defaults invariably loses the ability to issue Ginnie Mae mortgage-backed securities. An issuer default thus has serious consequences for a lender, and tends to be rare.
For Ginnie Mae, the costs of its guarantee include the costs of making scheduled payments under the securities when a lender defaults as an issuer and the costs of resolving such default. Ginnie Mae’s self-interested goal is to minimize the dollar amount paid under its guarantee program arising from an “issuer default.” It should not be surprising, therefore, that Ginnie Mae, as guarantor, monitors the financial ratios and business conditions of its lenders with the goal of preventing issuer defaults. To be licensed as a Ginnie Mae issuer, the lender must not only show expertise in servicing its agency loans; it must also have the financial ability to make any needed advances required by Ginnie Mae regardless of the number of mortgage loan defaults or claim payment delays or reductions that might arise.
Underneath the full faith and credit guarantee Ginnie Mae provides to investors is a program structure that requires the issuing lender in most cases to advance scheduled payments and cover losses not otherwise reimbursed by loan-level coverage. Also underneath the Ginnie Mae guarantee are mortgage loans with agency insurance or guarantees. Claim proceeds from a government agency may be reduced or disputed, but the source of the problem is never the credit risk of a government agency itself. Contrast this to the private mortgage insurance approved by the GSEs for decades to meet statutory requirements for credit enhancement when the unpaid principal balance of a loan purchased exceeds 80 percent of the value of the underlying property. Certain private mortgage insurance companies insuring loans held by the GSEs lacked the financial resources to pay claims during the financial crisis, creating even more red ink for the GSEs. In response to this credit failure, the GSE regulator Federal Housing Finance Agency, with GSE involvement, performed some heavy lifting last year by issuing detailed rules on private mortgage insurance eligibility.
A recurring theme in reform of the mortgage markets since the financial crisis has been the need for lenders to retain a “first loss piece” or at least to keep some “skin in the game.” The aim is to make it difficult, if not impossible, for product originators to mask risks and sell them without any attached liability. The “skin in the game” needed by a lender that issues Ginnie Mae securities is relatively minor if agency claim benefits are paid in the amount anticipated for a mortgage default and liquidation. For whatever reason, if benefits are reduced or not paid by the agency receiving the claim, the lender continues to be responsible for payments under the Ginnie Mae securities.
With a modest legislative change, Ginnie Mae could begin to guarantee securities backed by qualifying privately insured mortgage loans. Any expansion to private mortgage insurance would force Ginnie Mae to address, for the first time, the potential for a default by a loan-level insurer or guarantor that results in a failure to pay a claim. To manage this risk, Ginnie Mae could prescribe standards for private mortgage insurers and require special thresholds for lenders that issue securities backed by privately insured mortgage loans. Just like Ginnie Mae securities backed by agency loans, Ginnie Mae could require a lender issuing Ginnie Mae securities backed by privately insured mortgage loans to assume the responsibility for payments under the Ginnie Mae securities, notwithstanding any failure of the private mortgage insurer to pay a claim in whole or in part. A measured expansion by Ginnie Mae into privately insured conventional loans is not a difficult stretch, and draws upon its many years of expertise. Ginnie Mae also has the benefit of past GSE experience in issuing securities backed by privately insured mortgage loans.
To wind down the GSEs, House Democrats want to use the Ginnie Mae guarantee as a wrapper for an unchartered expansion of program operations by Ginnie Mae. The centerpiece of the expansion is a mortgage insurance program administered by Ginnie Mae in which 5 percent of the “first loss” is held by lenders while the remaining 95 percent of the risk is shared by government and a private reinsurer. Ginnie Mae is also given the authority to design, study, and implement two different types of re-insurance. While Ginnie Mae has decades of success in administering a guarantee program for mortgage-backed securities, it has never functioned as a loan-level insurer or re-insurer.
In other words, the Democratic model that has emerged to replace the GSEs first expands the Ginnie Mae mortgage-backed securities guarantee program beyond FHA/VA and other existing agency loan-level coverage by creating a new Federal mortgage insurance and re-insurance program that is also administered by Ginnie Mae. When the Democrats held the majority in the Senate, the Republicans objected to a similar approach found in the Johnson-Crapo housing reform bill. It is unlikely that the Republicans, now in the majority in both Senate and House, will warm up to this Democratic model.
Included in Title VII of the Shelby bill is a method of reform the Republicans want to adopt: risk sharing, or the sharing of losses by the investor in the event of a mortgage loan default. Starting in 2013, after some financial engineering, the GSEs began to experiment in selling debt that did not assure the pass-through of 100 percent of principal to buyers in the event of defaults from a specified mortgage portfolio. Through the first quarter of 2015, the GSEs have sold more than $20 billion in risk-sharing debt involving some $688 billion in mortgage pool balances. Part of the enthusiasm for this new debt instrument may be attributable to the hunger for yield in the current interest rate environment, and the current stage of the residential real estate cycle. Moreover, the mortgage loans tagged for risk sharing transactions tend to be the highest quality loans held by the GSEs.
The gulf between Republicans and Democrats is wide in their approaches to GSE reform, but Ginnie Mae can play a role in bridging that gulf. An incremental addition of privately insured conventional mortgage loans as eligible for the Ginnie Mae guarantee is a first logical step that would tap into decades of expertise acquired by Ginnie Mae. For privately insured mortgage loans that do not meet a conservative eligibility standard appropriate for program expansion by Ginnie Mae, it is worth studying whether FHA insurance is available as an alternative placement source; and if not, whether FHA insurance could be made available without adversely impacting the FHA insurance fund. Expanding the FHA to fill in eligibility gaps is a more sensible approach to reform than creating a new insurance or re-insurance program out of whole cloth for administration by Ginnie Mae, as now contemplated by the Democrats. And for the highest quality conventional mortgages that could become subject to a risk-sharing arrangement favored by the Republicans, it is unknown who will administer that program once the GSEs have been liquidated. Ginnie Mae could grow into this position. Congress needs to consider these options in winding down, partially or entirely, the GSEs. It can do that in a relatively bipartisan way, for a change, and it can do it now.