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Summary and Analysis: Obama Administration Report to Congress on GSE Reform: “Reforming America’s Housing Finance Market”
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From: Patton Boggs Financial Services Public Policy Practice Group
Date: February 15, 2011
Subject: Summary and Analysis: Obama Administration Report to Congress on
GSE Reform: “Reforming America’s Housing Finance Market”
Following is an executive summary and some analysis of the Obama Administration’s Report,
“Reforming America’s Housing Finance Market,” (the “Report”) delivered to Congress on
February 11, 2011 as required by the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the “Act”).
Background
Section 1074 of the Act expressly required the Secretary of the Treasury to submit to Congress
by January 31, 2011 a study that both (i) evaluated the various options for bringing Fannie Mae
and Freddie Mac out of conservatorship and (ii) recommended reforms to their role in the
broader U.S. housing finance markets. The Treasury Department and the Department of
Housing & Urban development jointly released the required Report on February 10th, ten days
after the anticipated release. While the Act called for the Report to focus on possible future
roles of Fannie Mae and Freddie Mac, including their possible dissolution, it also specifically
required the Obama Administration to analyze: (i) the Federal Government support for a stable,
well-functioning housing finance system and (ii) whether, and to what extent, it is appropriate
for the U.S. Government (and thus indirectly all U.S. taxpayers) to take on the risk of having to
rescue Fannie Mae, Freddie Mac and the Federal Home Loan Banks (together the “GSEs”) in
order to achieve the broader policy objective of promoting home ownership, economic stability
and the availability of affordable housing in general.
While the Report is long on analysis and short on specific action items, the Report will be the
starting point for numerous Congressional hearings and eventual legislation on this major issue
left unaddressed by the Act.
Highlights
• As opposed to making one specific recommendation as to how to restructure the
Federal Government’s role in the mortgage finance system, the Report lays out four key
factors that the Obama Administration believes should be taken into consideration in
formulating any GSE reform legislation:
o Preserving access to mortgage credit.
o Creating incentives for private investment in housing.
o Ensuring that taxpayers are protected from a future bailout.
o Preserving the financial and economic stability of the U.S.
2. • The centerpiece of the Report is that it offers three viable alternatives for the long term
restructuring of the U.S. Government’s direct and indirect role in the housing finance
markets.
o A privatized market with FHA/VA/USDA the only government role.
o A system that has a very limited government role but provides the ability for
government’s role to scale up in times of crisis in addition to FHA/VA/USDA
continuing their roles.
o A system where the government is fully involved by providing a reinsurance
backstop for insurance of MBS created and insured by the private sector in
addition to FHA/VA/USDA continuing their roles.
• The Report focuses in particular on the need to incentivize private capital to re-enter the
mortgage finance arena thereby enabling the Federal Government to steadily reduce its
role during normal market conditions.
• The Report also makes recommendations regarding how pools of guaranteed residential
mortgages should be serviced once they are packaged, securitized and the resulting cash
flows guaranteed by HUD, Fannie Mae and Freddie Mac.
• The Report makes recommendations regarding the origination process, loan servicing,
and loan standards.
• The Report also (i) summarizes the history of the Federal Government’s involvement in
the mortgage finance markets; (ii) examines what caused the severe losses at both Fannie
Mae and Freddie Mac; and (iii) describes the current state of the broader U.S. mortgage
finance system.
Summary
Discussion of the Failure of Fannie Mae and Freddie Mac
The Report states that for many years, both Fannie Mae and Freddie Mac held true to their
original missions of promoting home ownership. It notes that year after year of economic
stability and steadily increasing valuations led to the flawed expectation that national home prices
could only increase. This phenomenon led to borrowers and lenders alike becoming increasingly
desensitized to the risk of a collapse in home prices, including senior management at the GSEs.
Therefore, in 2006, when housing prices began to turn, participants in the housing finance
markets were unprepared for the ensuing spike in defaults and resulting foreclosures, and no
one, including the GSEs, had enough capital supporting their investments to absorb the
resulting losses. Fannie Mae and Freddie Mac experienced catastrophic losses as a result of their
guarantees to investors regarding the repayment of principal on large pools of conforming home
mortgages, which eventually led to the Federal Housing Finance Agency (“FHFA”) placing them
into conservatorship in the Summer of 2008, under supervisory powers the newly formed
agency was granted earlier that year.
The Report also concludes that several fundamental flaws in the U.S. housing market system
contributed to the crisis and recommends that each of the following flaws must be corrected in
order to protect American families: (i) the existence of poor consumer protections that allow
risky, low-quality mortgage products and predatory lending to proliferate; (ii) an inadequate and
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3. outdated regulatory regime that failed to keep the GSE’s role in the broader system in check; (iii)
the proliferation of a complex chain of transactions whereby home mortgages were sold,
serviced, and securitized in a manner that lacked transparency, standardization, and
accountability; (iv) the prevalence of inadequate capital levels by key participants in the system
that left insured banks, financial guarantors and other financial institutions unable to adequately
absorb the resulting losses; and (v) the growth of a mortgage servicing industry that was ill-
equipped to promptly and reasonably address the needs of borrowers, lenders, and investors
once housing prices fell and borrower defaults accelerated.
Actions to Manage GSEs Post-Crisis and Going Forward During Conservatorship
In regards to the past two years of conservatorship, the Report states that the Obama
Administration has worked with Congress to help stabilize the housing market, provide support
for struggling homeowners, and provide ongoing financial support for Fannie and Freddie,
policies which have helped avert a deeper economic collapse. The Report goes on to also
acknowledge that the U.S. housing market and private sources of housing financing remain
fragile and will take years to fully recover.
The Report discusses several initiatives that the Obama Administration and previous
administrations have already taken to reform the housing market, including: (i) passage of the
securitization and mortgage lending provisions of the Act; (ii) aggressively moving to place
Fannie Mae and Freddie Mac into conservatorship; (iii) strengthening underwriting and credit
standards at all the GSEs; (iv) raising premiums on FHA mortgage insurance; and (v) placing the
Federal Home Loan Banks (“Home Loan Banks”) under stricter regulatory oversight.
Going forward, the Obama Administration endorsed a number of ideas to address pre-crisis
flaws in the housing market. The Report claims that “taken together, these reforms will improve
consumer protection, support the creation of safe, high-quality mortgage products with strong
underwriting standards, restore the integrity of the securitization market, restructure the
servicing industry, and establish clear and consolidated regulatory oversight.”
According to the Report, the Administration’s goals are to (i) responsibly and gradually reduce
Fannie Mae and Freddie Mac’s overall role and size in the housing finance system, including the
eventual winding down and dissolution of both entities; (ii) increase private capital’s role in the
housing markets, and (iii) refine the government’s appropriate role in this sector of the debt
capital markets. The Report identifies a number of reforms to the current system that the
Administration is willing to support. It also asserts that the Obama Administration is prepared
to work proactively with Congress and the GSEs to adopt all necessary changes as quickly as is
practicable, recognizing the sensitivity of the markets to reform efforts.
Among the specific key reforms to the existing system called for in the Report are:
• Requiring the FHFA to price their guarantees as if they had to meet private
bank capital requirements.
• Decreasing the maximum loan size eligible for FHA insurance.
• Increasing private capital’s role by requiring larger down payments for Fannie
Mae and Freddie Mac mortgages, eventually getting them up to 10% of purchase
price.
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4. • Reducing the Federal Home Loan Banks portfolio investments to better serve
their mission of providing liquidity and access to capital for insured depository
institutions.
• Reducing Fannie Mae and Freddie Mac’s conforming loan size.
• Continuing to wind down Fannie Mae and Freddie Mac’s investment portfolios
by at least 10% each year.
• Requiring securitizers or originators to retain some “skin in the game” by
requiring them to retain five percent of a securities’ credit risk when sold to
investors.
• Improving mortgage servicing and foreclosure processing by establishing
national standards, creating alternative servicing compensation structures, and
better disclosure of second liens.
• Reforming mortgage originations by, among other things, prohibiting
origination of high-cost loans with certain abusive features, establishing
consistent rules for all financial services providers to follow, and requiring
lenders to make a reasonable and good faith effort to ascertain a borrower’s
ability to repay the mortgage.
• Maintaining the availability of affordable rental housing by exploring ways to
secure capital and liquidity for low and middle-income rental options as Fannie
Mae and Freddie Mac are wound down and exit this space.
Discussion of Long Term Policy Options for Government Support of Mortgage Finance
Looking forward, beyond the existing system, the Report does not make one individual
recommendation as to how to restructure the government’s role in the mortgage finance system.
Rather, it outlines three (3) options that fall between what they call the “extremes”, fully
privatized model and a fully government backed model. They also lay out the advantages and
disadvantages of each option, which we have summarized and paraphrased below:
Option 1: What could be called “The FHA/USDA/VA Only” option: Privatized system of
housing finance with the government insurance role limited to FHA, USDA and the
Department of Veterans' Affairs' assistance for narrowly targeted groups of borrowers.
”Advantages”: Minimizes distortions in capital allocation across sectors, reduces moral hazard in
mortgage lending and drastically reduces direct taxpayer exposure to private lenders’ losses.”
“Disadvantages”: Acute costs on access to credit. The cost of mortgage credit for those who do
not qualify for an FHA-insured loan – the majority of borrowers – would likely increase. May
be more difficult for many Americans to afford the traditional pre-payable, 30-year fixed-rate
mortgage. Smaller lenders and community banks could have a difficult time competing for
business outside of the FHA segment of the market. Decreases ability of the government to
effectively step in to ensure access to capital during a crisis. Absent sufficient government
support to mitigate a credit crisis, there would be greater risk of a more severe downturn, and
thus the risk of greater cost to the taxpayer. Potentially fails to eliminate the risk of moral
hazard.
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5. Option 2: What could be called “The National Guard” option: Privatized system of housing
finance with assistance from FHA, USDA and Department of Veterans' Affairs for narrowly
targeted groups of borrowers and a guarantee mechanism to scale up during times of crisis.
”Advantages”: Designed to address inability of the government to soften a contraction of credit
during crisis – without taking on costs associated with a broad government guarantee during
normal times. During normal times would avoid the distortions in housing market associated
with a broad-based guarantee and reduce both moral hazard and taxpayer risk. Private capital
would be more likely to flow to the most productive assets in the economy, private actors would
be on the hook for their own risky decisions and the government would not be putting taxpayers
at direct risk in backing the nation’s mortgage market. Government would be in a better
position than under Option One to manage another downturn in the housing market. As
private capital pulls back, government could better step in to ensure the availability of credit and
help to stabilize declining market.
“Disadvantages”: Significant operational challenge in designing and managing an organization
that can remain small during normal economic times, yet has the capacity to take on much more
business quickly during these times of need. Potential issues with access to credit, particularly
the pre-payable, 30-year fixed-rate mortgage, would likely be more expensive under this option
than under the following one.
Option 3: What could be called “The Reinsurance Option”: The FHA, USDA and Department
of Veterans' Affairs would continue to play their roles. In addition, the US Government would
create a private corporation to offer “catastrophic” reinsurance for privately created mortgages
or mortgage backed securities. This government reinsurance would only pay out to the investor
once the shareholders of private mortgage guarantors are wiped out. The report does not limit
this option to either individual mortgages or MBS.
“Advantages”: Provides lowest-cost access to mortgage credit of the three options. “While
mortgage rates would be increased by the cost of the premium and the first-loss position of
private capital, this reinsurance will likely attract a larger pool of investors to the mortgage
market, increasing liquidity.” Could help to lower the prices and pricing volatility of mortgages
and increase the availability of the pre-payable, 30-year fixed-rate mortgage. Government
reinsurer’s broad presence in the market could put it in a position to scale up to provide credit
during a time of stress in the market more effectively.
“Disadvantages”: Increased flow of capital into the mortgage market could draw capital away
from potentially more productive sectors of the economy and could artificially inflate the value
of housing assets. Reinsurance of private-lending activity, by its nature, exposes the government
to risk and moral hazard. If the oversight of the private mortgage guarantors is inadequate or
the pricing of the reinsurance too low or recoupment of costs too politically difficult, then
private actors in the market may take on excessive risk and the taxpayer could again bear the
cost.
Conclusion, Political Analysis and Recommendation for Stakeholders
Again, the report should not be seen as an architectural plan for fundamental GSE reform, but
as the starting point for fundamental bi-partisan discussions with Congress and stakeholders
over the short and medium term.
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6. In the days since the report was released there has been marked opposition from some
stakeholders across the political spectrum. There has also been some positive reaction from
both sides of the aisle. With a U.S. mortgage market roughly valued at $11 trillion and the reality
that any potential solution will fundamentally change the system for all participants, we expect a
difficult path to any agreement. Coming to such an agreement in Congress and forming a
legislative product will most likely take up all of 2011 and 2012. We believe that even if the
House of Representatives passes a GSE reform bill in this Congress, the Senate will likely not
pass a bill until 2013.
While legislative action will be in the deliberative phase, it will be important for stakeholders to
engage policy makers at all levels during the next 12-24 months of this debate as they wade
through the pros and cons of this proposal as well as other proposals from voices on GSE
reform. Effective engagement with policy makers and key staff are critical, as an inevitable
reform plan will have significant effects on all participants.
A copy of the Administration’s Report may be found here:
http://www.treasury.gov/initiatives/Pages/housing.aspx
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