House of cards

At some point in the next 30 days both political parties will gather on Capitol Hill to vote on what might be the most important piece of financial legislation since the Great Depression. This bill will attempt to prevent forces facing the US housing market from developing into a path of destruction impacting every American.  If the bill doesn’t pass or is not constructed in just the right way, it will cause irreparable damage to the US economy.   

What’s the downside? 

Higher taxes? Another US credit downgrade from the ratings agencies? Higher mortgage rates? Or lower housing prices? A bipartisan group of US senators is putting the final touches on a bill that would liquidate Fannie Mae and Freddie Mac and replace them with a government reinsurer of mortgage securities behind private capital. 

The legislation, written by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner, with input from other senators, is likely to be the first detailed blueprint reflecting a growing consensus in Washington. An increasing number of Democrats and Republicans feel the government’s role in mortgage finance should be limited to assuming risk only in catastrophic circumstances. The bill reflects the prevailing view among lawmakers that the two government-sponsored enterprises (GSEs) should cease to exist in their current form.

Named the Secondary Mortgage Market Reform and Taxpayer Protection Act of 2013, it seeks to enhance the liquidity and availability of mortgage credit in the secondary mortgage market.  This would be accomplished by winding down Fannie Mae and Freddie Mac, and establishing in their place the Federal Mortgage Insurance Corporation (FMIC).  

The FMIC will then encourage private market participants to assume first-loss risk by developing standard form credit risk-sharing mechanisms, but they will also provide insurance for covered securities so that private market holders don’t assume a first-loss position.  In other words, Uncle Sam acts like a super, back-up reinsurer. The FMIC hopes to be for mortgage issuers what the Federal Deposit Insurance Corporation (FDIC) is for banks. The Act establishes an umbrella-like structure where the FMIC approves various entities to issue covered securities and purchase insurance offered by it. 

The FMIC assumes losses only when the loss exceeds the capabilities of the first-loss private market holders.  The Mortgage Insurance Fund (MIF) is modelled on the FDIC’s Deposit Insurance Fund (DIF) and it earns money through insurance premiums, guarantee fees and amounts earned on investments. This establishes a safety net to cover losses.  

The MIF must maintain a balance equal to 2.5% of the sum of all outstanding principal balances insured under the Act. How this amount is maintained is at the discretion of the FMIC. The FMIC sets standards for private mortgage insurers (PMIs), including financial history, capital adequacy, character and fitness of management of an insurer, risk, insurance adequacy, requirements to submit audited financial statements, and any other standards the FMIC deems necessary.

We are shocked this took five years since the collapse of Lehman Brothers but for the first time, there is new regulation for approving issuers of mortgage securities. The FMIC is to set new standards for approving issuers, which must include information regarding an issuer’s ability to aggregate and securitise eligible loans, transfer investment risk and credit to private market participants. They’ll ensure equitable access to secondary markets and create mechanisms for multi-lender pools.

The bottomline

The bill is a clear articulation of a far larger role for private capital, compared with today’s dangerous market conditions.  It will liquidate the current government-sponsored enterprise model, while retaining a clear role for federal support in the secondary marketplace. Our partners, ACG Analytics, believe this draft bill will garner a great deal of attention over the coming weeks and months.  Likewise, further hearings on housing finance reform will be held in the Senate Banking Committee. The bill is also likely to help move these hearings toward discussions of far more specific ways to increase the role of private capital, rather than the generalisations that have been more typical thus far.

As a catalyst for ratcheting up discussions and focusing attention on one particular vision of a post-GSE world, the bill will be successful, but as a legislative vehicle, we believe that it will not be passed into law this year.  This puts all Americans at risk, and here’s why: It’s amazing that after $3.4 trillion of Federal QE, mortgage rates are at their highest level in 22 months (see: Mercury rising).  

The road ahead

Five years ago this September, two events took place that dramatically changed the financial face of America. On September 7, 2008, the Housing Economic Recovery Act passed through the Congress, plunging the American taxpayer into a 21st century real estate commune, where the price tag and risk have been rising every day since. Then, on September 15, Lehman Brothers collapsed in the largest corporate bankruptcy in history.

The Act established the Federal Housing Finance Agency (FHFA). Through the powers granted to FHFA, the GSEs Fannie Mae and Freddie Mac were placed under the conservatorship of the FHFA.  This was a super-sized step in America’s march toward socialism and a devastating blow to free market capitalism.  

In the coming days, Congress will have an opportunity to undo much of the financial danger facing the American taxpayer.  If Congress doesn’t act soon, they put us all at great risk. Since Lehman’s failure, the US housing market has been over 90% supported by the US government.  Five years, over 1,800 days later, the private sector is now the Invisible Man in a place where it used to be the Incredible Hulk.  Too much time has passed, Congress has blown opportunity after opportunity to bring the private sector back to housing finance.

We understand during the financial crisis we all needed the government to become the lender of last resort, but Uncle Sam has become that obdurate guest that won’t leave.  Right before our eyes, temporary Keynesian fixes are transforming into permanent Stalinesque anchors holding back the US economy.  

It’s like we are all living in fantasy land, where housing is doing better, the market is ripping higher, some jobs are coming back, but it is time to get real.  Just take 10 minutes and look at what’s behind the latest run in American housing.  It looks much more like 1970s Soviet Union than 1950s America.  The US was not built on the principles of planned economics and with the government controlling over 30% of our economic output.

How big is the problem?

GSE corporate and mortgage debt is now approaching $6 trillion. If this is added to the $16.6 trillion of US government debt, you achieve a total debt to GDP nearing 150%. The private sector has pulled away and stayed away.  Most of the mortgage insurance industry was pushed to the brink of collapse.  The Federal Housing Administration and the Department of Veteran Affairs have seen their footprints in the US mortgage market jump up over 300% since Lehman’s failure.  At the height of the crisis, they insured more than 85% of the US mortgage market, and even today that number is 64% … not totally dissimilar to our Communist friends in China.

Private mortgage insurers once represented 77% of the market pre-Lehman. Today, they represent a paltry 32%.Private investors and US banks have yanked over $1.5 trillion of investments away from this space, creating an over crowded trade in corporate bonds and loans, income producing stocks and REITs.  Savings and Loans withdrew another $100 billion from mortgage-backed securities in 2012. Private label mortgage security issuance in 2006 was $740 billion vs $6 billion last year.

The pendulum has swung to the left as far as the eye can see, and it’s costing America millions of jobs.  Sure, the Dow Jones Industrial Average is 3,000 points higher than it was in January of 2008, but close to 2 million Americans are still looking for work.  This is the number of jobs we must create to get back to the 2008 pre-Lehman high. We need private capital once more to ignite our economic engine.

The Fed and United States Treasury are now the largest owners of mortgage-backed securities on earth, holding $6.5 trillion of the $10 trillion US residential mortgage-backed securities. In 2012, over 90% of the $1.9 trillion mortgage issuance was supported by the US government.

Housing is 20% of US GDP

The Case Shiller index is up 10.5% from last year’s all-time low, but it’s still down nearly 30% from 2006 levels. In the next 12 months, an additional $1 to $1.5 trillion mortgage risk will be backed by the US government.  There is a Ponzi flavour to the whole buildup, which in the end has the taxpayer holding the bag.

The GSEs have an open credit line in the casino named “US Treasury”.  Most people are oblivious to the iceberg ahead, and Congress must act decisively.  America cannot borrow from China to support our housing market forever.  If they do nothing, as has been done since 2008, the problem gets bigger and bigger every day.  Another notch downgrade from the rating agencies is on the line, which could cost America billions in higher interest rates. Now is the time to restructure Fannie Mae and Freddie Mac, and taking our economy to the next level depends on it. We’ve thrown out the baby with the bath water.  We must bring back the good parts of private investment that will help bring our economy back to sustainable growth level, above 3%.  The conservatorship of the GSEs is the single greatest impediment to the return of private capital in the mortgage market.   

The solution

The solution would be to restructure Fannie Mae and Freddie Mac into entities that preserve their core market function of guaranteeing credit risk while preventing any future harm to the taxpayer.

The new company would only be able to borrow money for liquidity proposes and thus there would be no “implicit US government guarantee” of the company’s debt and no large portfolios on their books. They would have to have lots of private capital to absorb losses. They would be systemically important and regulated by the Federal Reserve. It’s important to limit new government-sponsored enterprises to prime lending only, let private market deal with sub-prime.

The US is the envy of most of the world in its protection of private capital and shareholder rights; let’s not destroy a national treasure.

Well-run and regulated companies providing a vital service to consumers and do not need future government intervention. In summary, the GSEs are the entire market for mortgage-backed securities.  We must create incentives and revitalise private capital back into the market to take risks off the back of American taxpayers.