The Senate Banking Committee's attempt to bring private capital back into the secondary mortgage market gives high hope that, after five years of political inertia, meaningful government-sponsored enterprise reform is finally within reach.
Unfortunately, we've seen this play out before: plan after plan gains interest, but fails to muster the broad support it needs. Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, now run the risk of proposing a second-rate solution for the market to gain mass support for the new legislation. Their forthcoming bill, however, presents a real opportunity to get housing policy right. As we await the latest version of GSE reform, what should we look for to determine whether it is landmark legislation?
With the Corker-Warner plan serving as the benchmark for any new proposal, the biggest issue at hand is the nature of private-public risk-sharing in mortgage credit risk. Some proposals in the past have penciled out any form of federal insurance on non-Federal Housing Administration mortgages. However, the consensus is that a level of federal support for losses well outside expected levels is a more likely policy outcome. Whether the line is drawn at 5%, 10% or anywhere in between, for the next generation secondary market to thrive, there must be some limited form of government guarantee present to reduce potential investor flight during times of crisis.
In setting the threshold for private-public capital, the designers of any new plan must contemplate it effects on market stability. Say what you like about the GSEs, even an implicit (at the time) federal presence in the conventional conforming secondary market had a calming effect during market flare-ups, such as in 1998 during the Russian debt crisis. If private capital is to absorb the vast majority of losses, that effectively makes the secondary market extremely dependent on the discipline of investors to stay the course when times get tough. We only have to look as far as to what happened to the private-label mortgage-backed securities market to see that when times get tough, investors head south.
Placing a high threshold for when public capital absorbs loss – which would be needed to bring widespread Republican support to the table – is not unreasonable. But if something close to 10% remains in the new plan, then it must clearly establish conditions and the type of market participants that can provide the equivalent of neutral buoyancy for the secondary market. Firms with strong capital buffers, regulatory oversight and deep credit risk expertise must have a prominent role in any post-GSE secondary market in order to provide a countercyclical role through different market conditions. Reliance on highly levered institutional investors without such balance severely limits the market's viability while introducing unnecessary volatility.
Another item of interest is the structural form of the secondary market. That is, assuming some small role, should federal insurance be provided by a government agency, market utility or something else? Morphing the Federal Housing Finance Agency into a combined gatekeeper of securitization, regulator of Federal Home Loan banks and catastrophic insurer is a recipe for disaster down the road if it becomes politicized. One only has to look over at FHA within the Department of Housing and Urban Development to see the direct costs of politics on the integrity of the $1 trillion plus Mutual Mortgage Insurance Fund over multiple administrations.
Proponents of a broad federal structure point to the Federal Deposit Insurance Corp. model and its successes. However, it isn't altogether clear whether that example should be held as the standard by which a new mortgage secondary market should be built. Let's not forget that deposit insurance premiums were priced well below what they should have been before the crisis.
The history of federal insurance pricing hasn't been a success story, whether talking about flood insurance or FHA loans. Measures that would mitigate such a problem affecting the secondary market would include making any GSE replacement a federal corporation at the least and allowing such an organization to have the payroll to recruit top talent with the skills to price complex risks.
Much is at stake in the latest attempt to move a GSE reform bill forward before Congress heads off to campaign. Let's face it, heading into midterm elections, Congress doesn't have much to show for its efforts lately. GSE reform could play well among voters. But in trying to achieve broad-based consensus, lawmakers may let our chance at transformative change in the mortgage market to slip through our grasp.
Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland and and a principal in Chesapeake Risk Advisors LLC.