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Wednesday, 10/09/2019 1:15:41 PM

Wednesday, October 09, 2019 1:15:41 PM

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GSE reform: How the plans could play out for the world of ABS

By John Hintze Published - October 08 2019, 9:06pm EDT




https://asreport.americanbanker.com/news/gse-reform-how-the-plans-could-play-out-for-the-world-of-abs

One of the provisions included when the Consumer Financial Protection Bureau finalized its mortgage underwriting rules in 2014 provided a temporary exemption for Fannie Mae and Freddie Mac from meeting the stricter qualified mortgage standards applied to private lenders.

The so-called “QM patch” expanded the definition of qualified mortgages to include certain loans eligible for purchase or guarantee by Fannie and Freddie and provided safe harbor provisions for lenders who originated those loans.

This special treatment was introduced with the intention of supporting a housing market still recovering the fallout of the financial crisis.

But critics have argued for some time that the GSE exception distorted the market, resulting in nearly one-third of all Freddie/Fannie-backed loans gaining an exemption from QM rules, a factor that has contributed to and deepened the market’s dependence on thinly capitalized GSEs that put taxpayer money at risk.

From a public policy perspective, critics say, the patch forestalled the goal of pushing Freddie and Fannie out of conservatorship, and maintained a steep barrier to the industry’s (and government’s) goal of boosting non-agency loan volume in the market, opponents contend.

“There is the feeling that there’s ample capital that has been relegated to the sidelines of the business because the GSEs have been so dominant,” said Charles Krawitz, vice president of commercial lending at Alliant Credit Union.

“Don’t get me wrong, they played a crucial role to create liquidity in the marketplace during the Great Recession. But in a healthy environment, in a more normalized environment, there are ample lenders hungry to step in to meet market demands.”

The market may be poised to test that idea given recent signaling from the Trump administration. To be sure, the administration has had reform of some kind in its crosshairs for years. The U.S. Treasury argued in a report published back in June 2017 that the QM patch and other federal guarantee programs create “an asymmetry, and regulatory burden, for privately originated mortgages.”

The debate returned this summer as the CFPB – now under the direction of Trump-appointed leaders – began soliciting public comments about plans to allow the QM patch to end with its statutory expiration in January 2021. And the idea was among the recommendations in the Treasury’s recently proposed blueprint for reforming the GSE market.

While it is not yet clear what changes in that blueprint will be adopted, any reform could have a far-reaching impact on securitization and see a considerable shift of risk to private-label securitization investors from agency ABS buyers.

Steps to reform

The 50-page Treasury report offers up a number of proposals to goose the non-agency loan market. The report called on policymakers to address regulatory gaps between the GSEs and private-market competitors, such as aligning the GSEs’ credit risk capital charges with those of regulated lenders.

The Financial Stability Oversight Council would also have a role in aligning the GSEs’ and private banks’ regulatory regimes on an interagency basis. The report also recommends expanding capital relief to private lenders engaged in credit-risk transfer arrangements, and even expanding guarantees into the private space.

In a report issued shortly after the Treasury’s published recommendations, Moody’s Investors Service stated the most obvious outcome affecting ABS investors would be the a drop in market share for GSEs, and the “reduced systemic importance” of government support underlying much of the investor faith in GSE securitization bonds.

“The Treasury’s proposals could materially reduce the GSE market share (making them less central to the U.S. housing finance market) from the mid 40% level to 35% or less,” the Moody’s report stated. But the recommendations, “if implemented, would create a larger and more diverse private-label securitization (PLS) market and generally improve the credit quality of GSE credit-risk (CRT) transactions.”

Freddie and Fannie CRT pools - under each agency’s unique platform - are credit-linked notes that provide principal-and-interest cash flow of single-family and multfamily development mortgages to investors, but are unsecured notes requiring holders to share in potential loss risks. Prior to 2013, both agencies sold interest-only certificates to investors that retained the loan risk on the books of Fannie or Freddie. This year, both agencies have sold a combined $14.6 billion in CRT assets in 16 deals through September, according to online data from Finsight).

Restricting the shopping list

Paul Norris, managing director and head of structured products at Conning, with $145.5 billion of assets under management, said enacting the proposals could “see securitization increase there in terms of the private market, where private lenders could get back into those markets because they’ve been priced out by the GSEs.”

Private-label MBS issuers could benefit not just from the Treasury proposal’s restrictions on GSE activity and product offerings (including cash-out refinancings and investor loans), but also some form of federal guarantees applied to their own transactions.

“So we could see securitization increase there in terms of the private market, where private lenders could get back into those markets because they’ve been priced out by the GSEs,” Norris said.

The weight that the GSE-reform proposal gives to reducing the GSEs’ purchasing of multifamily loans was one of its more surprising aspects, said Brendan Doucette, senior securitized analyst and government bond portfolio manager at $39-billion asset GW&K Investment Management. Such a development ultimately could increase activity in the commercial mortgage-based securities (CMBS) market.

He added that in terms of the MBS market, the GSE-reform proposal’s recommendation to restrict the agencies from purchasing high debt-to-income (DTI) and loan-to-value (LTV) loans would likely migrate those loans to the Federal Housing Administration (FHA), which insures mortgages to low-income and first-time borrowers. Supply in the FHA market would therefore increase while falling in the conventional QM market.

“And ultimately, if there was an explicit guarantee, you could see Ginnie Mae securities potentially sell off and conventional pools rally,” Doucette said. That would in effect erase some or all of the discount at which GSE pools currently trade relative to Ginnie Mae. “If the GSEs were to get the same explicit guarantee as Ginnie Mae, and high DTI and high LTV lending migrated to the FHA, supply would worsen for Ginnie Mae while improving for GSEs.”

A key goal of the Treasury proposal to open opportunities for non-agency lenders is to have the GSEs return to their core mission of supporting the low- and moderate-income home loan market.

Norris said an easy place to start would be to restrict the GSEs from purchasing mortgages for second homes and investment properties.

He called those steps the “low hanging fruit” and he would expect them to be among the first, with jumbo loans following. In high-cost housing markets, GSEs today guarantee jumbos over $600,000.

“Second homes and investment properties are areas that really do not apply to low and moderate income housing,” Norris said.

“If I were Calabria I would start by cutting those back, then I would look into jumbo loans, maybe by increasing pricing or reducing the loan limits. This would help create pathways for private capital to enter the mortgage market, a stated goal of Calabria’s,” he added.

Further down the road, he said, the FHFA could tackle cash-out refis, increasing pricing by some measure on a mortgage-loan market that isn’t a part of the GSE’s core mission. (In 2014, the FHFA announced it would begin restricting Fannie and Freddie from buying certain loans that are classified as non-QM for reasons besides DTI - for example, interest-only or 40-year term loans).

Were the reforms to permit more private lending, private-label ABS issuance is sure to follow.

And Moody’s believes that will lead to one certain outcome: higher risk pushed into the private sector. “The influx of additional loans into the PLS market is likely to introduce some riskier pools and shelves,” Moody’s September report stated.


But those pools would deflect the number of higher-risk loans in Freddie and Fannie pools, since the GSEs would be restricted from buying riskier loans under the Treasury’s plans, according to Moody’s. The result would be an improved credit standing for credit-risk transfer deals despite the perceived diminished government support the Treasury reforms would bring to the GSEs.

When...and how ?

“What makes this proposal more likely is that earlier ones relied on a more legislative approach to get done, and many parts of this plan do not,” said Jack Kahan, senior managing director responsible for residential MBS at Kroll Bond Rating Agency.

The Treasury’s GSE reform proposal states a preference for a more permanent legislative solution, although Treasury secretary Steven Mnuchin signaled in September that the administration could take action on housing finance reform even before the year’s out if Congress does not make progress on overhauling Fannie Mae and Freddie Mac.

Indeed, Mark Calabria, Federal Housing Finance Agency director since April, announced a revision allowing Freddie and Fannie to keep $45 billion of their combined earnings publicly (compared to a prior cap of $3 billion), in a first major effort wind down the GSEs’ conservatorship status.

Ed Reardon, a research analyst at Deutsche Bank Securities, can also be counted among the doubters.

While he described the document’s support for letting the QM patch expire as “probably its most important” element, he called recommendations such as bringing in more private capital and ending the GSEs’ conservatorships as “thematic” issues that are very difficult to get through Congress.

“My honest assessment is we could have the GSE reform conversation over the next decade,” Reardon said.

A managing director and portfolio manager at a major investment management firm (who declined to be named) said he sees the administration more likely to wait for a second term before acting, and before then sticking to laying out plans.

“Maybe the FHFA would like to make some progress and chip away at it,” he said, referring to potentially restricting the GSEs investments in loans supporting second homes, investment properties and other loans outside their core mandate. But “[t]hose loans are a tiny subset of the MBS market, so why bother? Why not try to roll out something that’s more sweeping” later on, he said.

In addition, the manager stated, the non-QM has been growing steadily regardless of the agency trends. He said the market is likely to top $20 billion this year. He anticipates more shorter-term and adjustable rate loans being securitized anyway, with the expiration of the QM patch to increase non-QM private-label volume even more.

“I anticipate growth in private-label continuing regardless of GSE reform, but I think it could accelerate growth at some point,” the manager said, noting the market reached in excess of $350 billion in 2003 and over $1 trillion by 2006, and today it remains in very early-stage growth. “We think the opportunity set is growing for these private-label markets.”

Conning’s Norris sees some likelihood of near-term administrative changes as likely, regardless of current market actvity. He noted the FHFA’s change of leadership. Mel Watt was the FHFA’s director between 2013 and the start of 2019, and the Democrat had publicly said he wouldn’t reform the GSEs without Congressional approval. Calabria, who assumed the position in April, has been promoting GSE reform for years.

“No one has ever attacked the issue from an administrative standpoint like he has, taken the tact that he has,” Norris said.

“He has the power to do it, and no one can stop him. So I’m giving him the benefit of the doubt that he’ll do something.” ASR

(This story includes reporting from Hannah Lang and Brad Finkelstein)