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Opinion, commentary, and analysis on everything that makes the U.S. housing economy tick -- not to mention the ghosts in the machine, too. Written by HW's team of editors and reporters each business day.
Lending

Is this any way to run a mortgage market?

Here's the right solution

April 20, 2015

Fannie Mae and Freddie Mac are especially vulnerable to losses from financial market volatility today because their existing capital cushions are extremely low. These Government Sponsored Enterprises or GSEs were the focus of the largest housing Federal bailout in history. Ironically, their lack of capital is a direct result of the Federal bailout deal and leaves them – yet, again – at risk for needing a second government bailout.

Let us first recall that each GSE reported disappointing fourth quarter 2014 financials. That alarming financial performance resulted from significant losses in the financial derivatives the GSEs use to hedge exposure to interest rate risk. It also highlighted the fact that the bailout agreement with the U.S. Treasury (codified in a Preferred Stock Purchase Agreement or PSPA) requires each GSE to remit all quarterly profits to the Treasury. Critically, it requires them to reduce existing capital cushions each quarter until they reach zero in 2018.

Yes, it is hard to believe that this shaky financial situation is the deliberate design of Federal policy, but it is. What is even more difficult to accept is the fact that acceptable capital levels could be restored easily and quickly. Yet, both Congress and the Administration appear content to pursue instead a long-term – with no imminent action even on the table – legislative reform strategy.

Here's my perspective:

The U.S. single-family mortgage market is one of the largest markets in the world. There were $9.8 trillion in mortgages outstanding as of March 15, 2015.The GSEs, in spite of the 2008 crisis, continue to be the axis of this market. As of March 2015, they owned or guaranteed nearly half - $4.5 trillion – of all outstanding single-family mortgages. The GSE underwriting guidelines, documents and practices continue to set the standard for the U.S. mortgage market as a whole. In fact, if a loan qualifies under GSE underwriting guidelines that loan merits a “qualified mortgage” classification of the CFPB regulations.

The GSEs are still pivotal to all market players – homebuyers, lenders and realtors, as well as a multitude of related venders -- and yet, we allow them conduct their massive businesses on nearly non-existent amounts of capital. For the combined $4.5 trillion in outstanding mortgages that the GSEs own or guaranty in securities, they hold a grand total of $6.4 billion in capital. That is billion with a “B” of capital today; zero, that is “0” with a “Z” by 2018.

In spite of their Achilles heel status in the U.S. housing market, the GSEs have been intentionally left vulnerable to the slightest hiccup in either the market or their financial performance and/or the most insignificant miscalculation in their hedging strategy.

And here's the right solution:

In addition to the sharp drop in income, a report recently issued by the FHFA Inspector General points out that the future profitability of the GSEs is by no means assured. “The enterprises have acknowledged in their public disclosures that adverse market and other changes could lead to additional losses and that their financial results are subject to significant variability from period-to-period.”

Managing my own mortgage banking company, I am well aware of the impact market volatility can have on income from quarter to quarter for even the most well managed and conservatively run company. That is the precise reason having a well-capitalized company is so important – to give you a cushion to absorb unexpected losses. Thus, you can have some bad quarters financially and still be able to carry on with your business.

That same common sense approach is true for the GSEs at the very heart of our modern secondary mortgage market. It is easy to remember the grim times of 2008, when the financial world seemed to be imploding with bankruptcies and receiverships.

Do we really want to risk a repeat of those times by allowing such shortsighted policies to continue?

We should all be demanding an amendment to the PSPA that would:

1.    Stop the forced depletion of GSE capital cushions; and

2.    Allow the GSEs to retain a portion of their earnings to build a sufficient capital to absorb future losses from unexpected market volatility and do without the need for a second Federal government bailout.

This is a sensible and necessary solution to the health and soundness of the linchpins of our mortgage finance system.