A Blueprint for GSE and Secondary Mortgage Market Transition

Yesterday marked an important milestone in the mortgage market with the announcement by FHFA of what may lie ahead for the GSEs.  For the first time, government officials outlined a coherent strategy for a successful transition of the two mortgage giants Fannie Mae and Freddie Mac which indicates that the state of limbo that secondary markets have been in ever since the two entities entered conservatorship in 2008 may be approaching an important turning point.  Don’t expect vast changes to occur in the next year certainly with a Presidential election heating up.  But the fact that the FHFA put this plan forward marks a critical time for the mortgage market as facilitating a transition to a sustainable mortgage finance system is no easy task.

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The plan cites a set of core objectives that FHFA has used to guide the conservatorship process including mitigating losses to the taxpayer, enhancing access to mortgage finance for homeowners and assisting struggling borrowers per the various Administration and other foreclosure prevention programs.   Now FHFA states the time has come to move forward with the next phase of the process which includes building the next generation secondary market infrastructure, reduce the GSE’s market presence, and maintain focus on foreclosure prevention activities.  While the plan is not specific on the exact manner in which transition of the GSEs to another form takes place, a workable approach should entail a well-choreographed set of activities that ultimately leads to a complete wind-down of both GSEs with them being replaced by one of the three options laid out by Treasury and widely supported in the market.

FHFA in its plan lays out some of the progress it has made in aligning important aspects of the GSEs’ business including its Servicing Alignment Initiative, the Uniform Mortgage Data Program and aligning the GSEs’ rep and warrant policies, among others.  So clearly FHFA believes that consistency and alignment of practices and activities between Fannie and Freddie is worthwhile.  Other aspects of the current state of conservatorship highlighted by FHFA include the need to recognize economies of scale in technology and the importance of standardization while recognizing challenges in maintaining focus on the core objectives mentioned by FHFA above.   With these core principles it is possible to offer a blueprint for an effective transition from conservatorship today into a vibrant replacement for the GSEs that meets all of the objectives laid out in FHFA’s plan.

Although a number of possible transition models exist, to get a glimpse into what could take place consider the following plan that could have a timeframe of 2-3 years.  Other than historical legacy, one could argue that maintaining both GSEs in their current form does not meet FHFA’s objectives for mortgage markets.  There is a great deal of complexity in managing both enterprises in their current form that poses a challenge to FHFA’s desired outcome of alignment and consistency of practices and activities of the GSEs despite the progress made by FHFA on this front to this point.  Thus, a possible step forward would be to merge one of the GSEs in with the other, consolidating the various businesses in the process and restructuring them into a logical set of activities lined up against FHFA’s plan objectives.  This approach has the clear advantage of creating improvements in execution of specific strategies such as winding down the retained portfolios, foreclosure prevention and maintaining a stable liquid market for mortgage finance.  It doesn’t hurt either that both companies are in need of new leadership, thus reducing management frictions that can accompany such consolidations.  Further, the FHFA has cited a number of challenges in retaining sufficient talent at both companies to ensure adequate focus on important initiatives that could be improved through consolidation.  By leaving one GSE in place to absorb the other it also helps maintain market stability since the “acquiring” GSE would honor the outstanding debt of the other GSE.  GSE consolidation would facilitate further streamlining among GSE activities, promote greater transparency for lender partners and vendors, and otherwise establish a structure better suited for FHFA’s long-term plan.

Once the consolidation has been completed, the second step in the process would be to reconfigure the entities’ businesses to allow for single point accountability for each strategic initiative outlined by FHFA earlier.  This could be done by creating effectively four business lines; legacy business; current state single-family securitization business; multifamily, and future state infrastructure.  The legacy business would be comprised of two parts; one would house the retained portfolios of both GSEs; the second being a group focused on foreclosure prevention efforts of legacy assets.  The legacy portfolio group would focus entirely on least cost asset disposition strategies and interest rate risk management activities.  The aggregate single-family securitization activity of the consolidated GSE would continue as today until the future state infrastructure was available along with the replacement securitization conduit structures.  However, a single security would be issued, either a MBS or PC.  This would allow for FHFA’s goal of realizing a single mortgage-backed security sooner than they anticipate in their plan.  The securitization entity would house all of the associated processes consolidated from both enterprises including debt issuance, credit and counterparty risk management, credit guarantee pricing, quality control and sourcing, among others.  Given duplication at both enterprises across these activities, some efficiencies will be gained in addition to attaining complete alignment of policies, procedures and strategy.  A consolidated multifamily guarantee business would be created focusing on replacing government with private guarantees.  The fourth group would be tasked with development of the next generation secondary market loan systems and infrastructure.   This would include design and deployment of the new servicing platform, pooling and servicing agreements, data and loan documentation requirements, among other activities.  Elements from other areas deemed to be duplicative could be reassigned to this group along with other resources dedicated to such efforts today.  Two other important support functions; legacy IT and Operations/Administration would round out the structure of the consolidated GSE.  The existing IT systems of both entities would be used in the legacy group since they would need to manage assets from both GSEs while the securitization activity in theory could be conducted from a single GSE platform.

Once the new securitization infrastructure has been developed and tested, the new replacement conduits based on one of the three options laid out by Treasury would be established and capitalized.  This might over time be facilitated by efforts to reduce GSE market presence by raising Gfees, establishing loss-sharing arrangements and revitalizing mortgage insurance contracts as mentioned by FHFA.  Greater use of MI, however, it is important to note is not without a set of financial and policy challenges; namely the extreme weakness of the MI industry and Qualified Residential Mortgage (QRM )proposed rules under Dodd-Frank Act risk retention provisions that are overly restrictive for non-GSE loans.  With this new infrastructure and capitalized replacement conduits in place, the consolidated GSE could be placed into receivership and wound down.  Having consolidated both GSEs first and restructuring the organizations would make this somewhat easier.  Some parts of the company could conceivably be merged in with Ginnie Mae or FHA if deemed to have value for these agencies.  This might include the remnants from the legacy foreclosure prevention group, for example.

This hypothetical framework is not without its challenges from an implementation and policy perspective, and it would be up to FHFA to methodically analyze what sequence of restructuring activities is needed and what it would look like before it could be undertaken.  Nevertheless, the example above provides a clear way out of the mortgage financing morass that has enveloped the entire housing market since the crisis.  The FHFA’s plan signals that change is needed, and the prospect for revitalizing the secondary market now seems for the first time a real possibility.