Reforming, privatizing or replacing the government-sponsored enterprises is the next big legislative issue for reform of the financial system, with the Treasury Department saying it will issue a proposal for "comprehensive reform" in January. Meanwhile, market participants and other interested parties are weighing in on the future of GSEs — many producing recommendations in response to the request for comment by the Treasury and HUD. Although the various proposals differ on whether the government should have any role and, if so, what that role should be, most call for at least a limited guarantee for securities backed by conventional mortgages.

The debate takes place in the context of major change in the primary market. The Dodd-Frank legislation and other regulatory changes are already shrinking the range of mortgage products and the pool of eligible borrowers. Therefore, adopting a secondary market structure without a government guarantee — which would shrink those even further — faces an uphill battle.

The framework underlying proposals from major participants in the banking and securities industries is designed to capture the benefits of the government guarantee while substantially reducing the risk of taxpayer bailouts. The benefits include greater liquidity, a sustainable supply of mortgage credit during credit crunches and the ability for originators to lock in rates ahead of settlement through the TBA market.

Under these proposals, private companies would serve as guarantors and conduits, issuing securities and insuring the mortgages that back them. The securities, but not the private companies, would have further credit enhancement in the form of government reinsurance. The private conduits would be regulated and supervised by a federal agency, hold capital based on the risk characteristics of their mortgages and pay a risk-based premium for the government guarantee. The federal agency supervising these conduits would also serve as a chartering authority, adjusting the number of such entities to accommodate demand without requiring intervention from Congress.

A back-of-the-envelope calculation puts the amount the conduits would have to charge at about 50 basis points above the amount charged by Freddie Mac and Fannie Mae. This number, of course, depends on many assumptions and may be an understatement in today's belt-and-suspenders environment.

While consensus is building for a government-backed secondary market for conventional mortgages, the proposals vary on a number of important questions. One key difference among the proposals is whether access to the federally backed securities should be confined to certain classes of borrowers or loans. Most favor limiting access, either to specific types of loans, particularly fixed-rate mortgages and "prudently underwritten" adjustable-rate mortgages, or to middle-market borrowers, leaving out the wealthy or high-income borrowers.

Recommendations to restrict access to federally backed securities are not consistent with the spirit of most proposals overall, i.e. that borrowers will not be getting a budgetary subsidy. According to most proposals, both the regulatory oversight and the government guarantee are to be fully priced. Thus, the call for limits appears to be a concession that, in reality, the government guarantee will be underpriced. As Wells Fargo noted in response to the request for comment, "as long as the guarantee is appropriately priced and the risk to the government is consistently measured and properly managed, there is no reason to sacrifice liquidity in some parts of the housing market in an effort to concentrate the government's support somewhere else."

Despite the apparent concession that the government guarantee will be underpriced, all of the proposals are very deferential to the interests of fixed-income investors. The philosophy that everyone should have some "skin in the game" seems to apply to everyone but them. If there is concern that the government reinsurance will be underpriced, at least part of the response should be to expose traders and investors to at least some credit risk, perhaps by narrowing the guarantee so that it covers not quite all of the principal and interest owed on the securities of a failed conduit.

Another question is whether the new secondary market institutions should include support for affordable housing. Instead of goals for the number of units supported, advocates recommend that some percentage of the conduits' premium income be diverted to a fund to assist with affordable housing finance. This, too, is inconsistent with the way the proposed system is promoted. If it works as advertised, the number of federally chartered conduits will be adjusted to constrain excess profits available for redirection. Support for affordable housing should be obtained from general revenues, not from a tax on mortgage payments of homeowners.

There will be many other issues to address in the months to come, and it is important that they are quickly resolved. Failure to establish a framework for reform soon will increase the difficulty in addressing long-term problems in the mortgage market.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.