GSE Reform Real and Imagined
The ersatz common shares of Fannie Mae and Freddie Mac lost about half of their value this week after news reports indicated that the Senate had agreed on a bipartisan proposal to eliminate the housing GSEs. Senate Banking Committee Chairman Tim Johnson (D-SD), and the panel's top Republican, Mike Crapo of Idaho, said they reached agreement on how to overhaul the complex housing system and reduce the role of the federal government in backing home loans.
And there is good news: Matt Levine at Bloomberg View has finally come to the correct conclusion that the common of shares of Fannie and Freddie must have zero value until the preferred is first paid in full. Somebody break the news to Ralph Nader and Bill Ackman.
First and foremost, the news reports about the likelihood of passage of this “bipartisan” legislation are overly optimistic. The odds of the House adopting the Senate proposal are small to none. But more important, the deteriorating situation in the housing sector makes it unlikely that Congress is going to mess with either GSE anytime soon.
Even though Fannie and Freddie are mostly underwriting prime mortgages, while the FHA and Ginnie Mae are picking up the slack on below-prime loans, the falling volumes in the mortgage market generally are going to start seriously affecting effecting the debate over the GSEs. Once home prices start to visibly fall in many parts of the nation later this year, any discussion of GSE reform will be put aside. This is a shame because the only way to fix the mortgage market and stabilize home prices is via legislation. But the Johnson-Crapo proposal still lacks some essential elements.
As we noted in a recent post on ZH, the roots of the subprime crisis and the subsequent boom and bust in the housing sector can be traced back to 1998, when the SEC under Arthur Levitt amended Rule 2a-7 and thereby handed the world of housing finance to the big banks and the GSEs on a silver platter. See “Zombie Dance Party: It’s Only a Monopoly, But I Like It.”
Under the current regulatory regime in the US, banks are not generally underwriting below-prime mortgages. Non-banks want to do this business, but they cannot fund the warehouse or end investor component of the lending process efficiently because they cannot place paper with money market funds. Under Basel III, keep in mind, a piece of non-agency mortgage debt has a risk weight above 100% vs. 20% for agency debt.
As a result, the largest commercial banks have a monopoly on writing mortgages directly and indirectly providing funding to the non-bank mortgage sector. The commercial banks exercise direct monopoly as the providers of funding, while the GSEs have a monopoly on the long end of the yield curve. This is just one reason why the housing sector is in big trouble. See my comment in American Banker:
What the SEC did with the changes to Rule 2a-7 was to give the big Wall Street banks an effective monopoly on creating paper for purchase by money market funds. The change effectively cut non-bank issuers of mortgage paper and other long-duration securitizations out of the business of selling assets directly to money market funds and created an odious monopoly for the TBTF banks and GSEs.
By handing the market for creating assets for money market funds to the commercial banks and broker dealers, the SEC unwittingly created the very circumstances that led to the near failure of The Reserve Primary Fund in 2008. The monopoly also led to the eventual collapse of Lehman Brothers, Bear, Stearns & Co and even Citigroup later in the crisis. All of these issuers of commercial paper and asset backed securities sponsored paper that was inferior in terms of credit characteristics to that originated by other banks and the GSEs. Eventually they failed. Remember, no private company can compete with a GSE.
If Congress wants to reduce the role of the government in the US mortgage sector, then we must do more than merely extinguish Fannie Mae and Freddie Mac. Congress must allow non-banks to issue transparent, conservatively underwritten and really boring paper for sale directly to money market funds. Congress should also revisit Basel III and allow banks to purchase such assets with less than 100% capital risk weights. Such changes would include paper for residential mortgages, multi-family loans and other types of investment quality debt packaged in asset backed securities.
But until we end the monopoly created by Rule 2a-7, the private sector cannot compete with the banks and GSEs. Simply ending the corporate lives of Fannie and Freddie as the Johnson-Crapo proposal envisions is not sufficient because the TBTF banks will just go on to form a new monopoly with their successor.
The other aspect of mortgage lending that we touched on in that earlier ZH post is the role of the Real Estate Mortgage Conduit or “REMIC” in supporting the Big Bank/GSE monopoly in housing finance. By making the REMIC structure the only type of securitization vehicle that qualifies for pass-through status for tax purposes, the IRS and SEC have essentially handed the securitization market to the largest banks.
More, since in a REMIC trust both sides of the balance sheet are considered “debt” for tax purposes, a REMIC cannot restructure itself in bankruptcy. This is why the 10-15 million home mortgage loans that are owned by a REMIC trust and are currently underwater cannot be fixed. Again, the exclusivity of the REMIC for tax purposes is a major reason why millions of underwater mortgages cannot be restructured. This is a major problem for the US housing market.
When home builders in the 1980s issued their own collateralized mortgage obligations (CMOs), the issuer was actually a “C” corporation and not a REMIC trust. When a calamity hit Texas in the 1980s, the separately incorporated subsidiaries of these builders that issued mortgage bonds could file bankruptcy and restructure their underwater mortgages (which were fully taxable and thus defined as assets) so they could maximize the value of the restructured MBSs.
As trusts, REMIC entities cannot be debtors in a bankruptcy because the mortgages they own are seen as “liabilities” for tax purposes. REMIC's exclusivity is not only a monopoly creator in terms of the advantage they have in terms of funding costs but also acts to inhibit a restructuring of underwater mortgages. You can bet Tim Johnson and Mike Crapo probably don’t have a clue about any of this.
The REMIC's exclusivity for asset backed securities is both a facilitator of monopoly and a resolution problem. The housing market overhang problem caused by the inability of REMICs (or anybody else) to restructure first lien mortgages on primary homes pulls home values down and also inhibits the attraction of capital to support a really robust private mortgage insurance market.
Two points: 1) If Senators Johnson and Crapo really want to see private capital in the mortgage market, we must end the exclusivity of REMICs for tax purposes. 2) The inability of non-banks to access funding via sales of short-term commercial paper secured by conduits to money market funds to support warehousing of loans before creating CMOs is an illegal restraint of trade and places non-bank seller/servicers of mortgages in a subordinate position to the TBTF banks. Again, no private enterprise can compete with a GSE and the TBTF banks are GSEs as much as Fannie and Freddie.
Until we see members of Congress talking about a repeal of the SEC’s amendments to Rule 2a-7, all of this talk about “housing reform” is just going to be a pretense. Unless we allow non-bank issuers of mortgage paper to compete directly with the monopoly commercial banks and GSEs, there is no practical way to attract private capital back into the mortgage market – except as free-riders on a governmental guarantee, explicit or otherwise.
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