The Federal Housing Finance Agency's plan to design a new mortgage securitization platform sets in motion one the largest and most ambitious infrastructure projects to affect the mortgage industry in decades.
And while the FHFA's grand vision is generally well thought out, as always, the devil's in the details.
The platform's design is intended to anticipate virtually any future structural replacement for Fannie Mae and Freddie Mac as well as structured credit enhancements. The benefits from providing significant design flexibility are clearly apparent. Establishing a foundation that can accommodate any conceivable mortgage secondary market structure and financing arrangements can proceed without being held hostage to political bickering over the eventual form of the secondary market.
However, real dangers lie ahead in this process that the FHFA must heed for it to be successful.
Large-scale infrastructure projects, particularly those of ubiquitous scope, can fall victim to the sheer complexity of the vision. The F-35 Joint Strike Fighter program provides a cautionary tale.
The F-35 fighter was designed to be everything to every military branch, able to provide each service with its own uniquely adapted version of the plane to fulfill its mission. But in the years spent to design that flexibility, the project encountered a number of technical and financial challenges that have made it one of the defense industry's largest white elephants from a military and budgetary perspective.
For the government-sponsored enterprises, large technology projects have had mixed results at best. Fannie and Freddie during the latter part of the 1990s were able to move quickly to develop their automated underwriting systems, which radically transformed the primary and secondary markets. Sometime later, Freddie Mac embarked on an enterprise-wide project to overhaul its loan selling and delivery system, which had become a bit outdated. The project had buy-in from senior management early on and with it a significant investment of resources including a large interdisciplinary team of Freddie personnel.
The project's scope originally was quite ambitious, envisioned to provide much of the same functionality as described in the FHFA proposal. But over time the implementation of the original vision was scaled back as the reality of execution versus design sunk in around the company.
In this case, the reality is that combining the technology efforts of both GSEs is laudable for efficiency reasons but does not guarantee successful implementation of the FHFA's vision.
The FHFA is correct in pursuing a single platform as a logical next step toward further winding down the current GSE model and providing a seamless transition to a new structure with the new securitization platform. However, a number of practical considerations for such a capability come to mind.
First is ownership and management of the resulting platform. Clearly, the FHFA's plans for this technology imply that it would become a financial market utility, which has all sorts of potential market and regulatory connotations. Without knowing exactly what shape the new secondary market takes, the FHFA should at least be building into their plans the possibility that the ownership and administration of the new platform is spun off and what that would entail.
Beyond this structural issue, the FHFA must insure that it integrates this project with other activities such as the Legal Entity Identifier initiative. Moreover, the FHFA will need to address privacy and disclosure issues surrounding sensitive borrower information.
One of the more difficult issues the FHFA will face in development of the platform is in designing sufficient flexibility in the system to handle an array of different credit enhancement structures. Such tools have existed in the market for years, allowing customized credit structuring of mortgage cash flows. These tools would need to be enhanced beyond current functionality to encompass a wide range of possible credit enhancement structures, at the scale of operations such a platform would be expected to handle.
For example, beyond structures that allocate credit losses by priority position, some investors might prefer to allocate loss based on time since loan origination or other trigger of interest. (For example, an investor might agree to absorb the losses on a pools of mortgages for, say, the first three years, after which a counterparty steps in and covers losses from years 3-5, and then the risk reverts back to the investor thereafter.)
As a result, the framework needs to be built with the lowest common denominator of cash flow in mind – namely at the individual loan level, so cash flows can then be sliced and diced according to default and prepayment parameters designated by the prospective investor. This is not a trivial exercise but it is manageable if designed from the bottom up.
While the a new mortgage securitization platform might not at first glance seem all that exciting, it moves the discussion of the future structure of the secondary mortgage market in a more tangible direction than has yet occurred. Whether or not the platform becomes the mortgage industry's version of the U.S. Interstate Highway System or is ultimately consigned to oblivion with the F-35 and the Concorde will be determined by the balance achieved between manageable project scope and essential platform flexibility.
Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.