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AmericasNovember 1 2012

Regulatory torpor keeps US housing market in state of paralysis

The housing market in the US appears to have turned a corner since the conservatorship of Fannie Mae and Freddie Mac in 2008. But until the government puts clear regulatory guidelines in place, uncertainty surrounding the precise nature of capital rules on mortgages will remain for market participants.
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Regulatory torpor keeps US housing market in state of paralysis

More than four years have passed since US housing finance giants Fannie Mae and Freddie Mac were placed in government conservatorship, and granted a last-minute reprieve from insolvency via a steady stream of state-supplied cash. It was a critical move, and one that James Lockhart, who headed the Federal Housing Finance Agency (FHFA) at the time and is now vice-chairman of Invesco subsidiary WL Ross, says “prevented a free-fall” in the mortgage market.

Since then, the financial climate has changed dramatically. Huge players have disappeared from view, markets have plunged and staged some semblance of a recovery and a regulatory tsunami of unprecedented proportions has engulfed the industry. Despite the turmoil surrounding them, however, the sibling government-supported enterprises (GSEs) and the housing finance markets they support have held at something of a deadlock.

There have been some recent signs of life, however. Home prices have begun to stabilise while the worst of the troubled loans on Fannie Mae and Freddie Mac’s books have been restructured or written off, and thanks to new issuance, the particularly disadvantageous mortgages issued in the pre-crisis years make up an ever lower proportion of their portfolios.

In fact, both are now turning a rather healthy profit. Fannie Mae made $7.8bn and Freddie Mac generated $3.6bn in the first six months of 2012, versus losses of $16.9bn and $5.3bn, respectively, for 2011. It was quickly made clear that this, along with future income, would be directed to the US Treasury, which says the GSEs will “not be allowed to retain profits, rebuild capital, and return to the market in their prior form”.

Murky future

For now, the status of GSEs as government tools is assured, but the future of a state presence in the US housing finance markets is far less clear. About 90% of the market has government support, and while the current situation is relatively stable, few would argue that this level of concentration is desirable, or indeed sustainable, in the long term.

“I really do think it’s an issue which needs to be addressed. There is $5000bn in mortgages on the balance sheets of Fannie and Freddie,” says Mr Lockhart. “It’s just not healthy to have that all on the government so we really need to start thinking about alternatives.”

It is hardly a controversial view. Both sides of the political spectrum envisage a future where the roles of GSEs are wound down, and private capital plays a greater role. Some hard-line Republicans – among them Paul Ryan, Mitt Romney's running mate in the 2012 presidential election – have even advocated ridding mortgage markets of any or all state influence.

GSE reform

The US Treasury, in a white paper released two years ago, also proposed plans to reform the GSEs. Meanwhile, the FHFA has been taking some steps designed to decrease market reliance on the two agencies, including slowly increasing guarantee fees, a move designed to make pricing seem more attractive to private sector firms, and one welcomed by Mr Lockhart.

He also advocates lowering the conforming loan limit – which, following the crisis, reached as high as $729,750, or 125% of the median home value within a metropolitan statistical area. This should also encourage private sector involvement.

The FHFA has also moved to clarify rules for what prompts a loan repurchase request, which should help free up credit beyond the highest quality borrowers, says Mahesh Swaminathan, a managing director and head of residential mortgage strategy within the securitised products research group at Credit Suisse.

The government is too involved in housing, but we’re still very much in recovery mode… part of the issue at the moment is that no one can compete with them [the GSEs] because they can borrow at very attractive rates

James Lockhart

So far, so incremental. However, larger changes will be required to make a real difference to levels of private capital, warns Mr Lockhart. “The government is too involved in housing, but we’re still very much in recovery mode… part of the issue at the moment is that no one can compete with them [the GSEs] because they can borrow at very attractive rates,” he says.

However, such changes are beyond the scope and power of the FHFA. The decision to take Fannie and Freddie into conservatorship made them creatures of Congress and, as such, reform must inevitably come from policy-makers. The best that the FHFA can do, says Mr Swaminathan, is to prepare market infrastructure for common pooling and servicing agreements, standardised contracts and data acquisition and disclosure formats and anything else that any outcome with whatever degree of government involvement would require.

Weighing the options

So what might the end result of such a move actually look like? First, even if the 2012 US presidential election does result in a Republican victory, all state influence from housing markets is unlikely to be eradicated, according to Karen Petrou, co-founder and managing partner at legislative advisory Federal Financial Analytics. “I think there are many practical obstacles to full privatisation, which will quickly be made apparent to a Romney administration, although their predisposition may be to more aggressively privatise than if Barack Obama remains in power,” she says.

A more likely outcome might be the third of three possible options published in the aforementioned Treasury white paper, which would see the government leave the mortgage market to private operators outside of programmes put in place by the Federal Housing Authority (FHA) and other such entities, but at the same time offering reinsurance services to some market operators, with private capital taking first loss piece and sharing risk.

Reinsurance arrangements could go both ways, however, says Michael Canter, director of structured assets at $420bn US asset manager AllianceBernstein Investments. “Fannie and Freddie currently take the whole capital structure of credit risk when they wrap or guarantee mortgage securitisations. We think the next step for them is in essence to buy reinsurance from the capital markets for the first 5% or 10% of risk that they assume. Given how low yields are, I think they would find the capital markets extremely receptive to taking on that risk, and it helps achieve the FHFA and Treasury’s goal of getting Fannie and Freddie further removed from taking mortgage credit risk.”

He adds that FHFA might also look to combine the resources and knowledge of the two GSEs, improving infrastructure and cutting costs. “The idea is to create the idealised platform for mortgage securitisation going forward, and to give private label access to that platform,” adds Mr Canter. “So really to become the standard and the logistics for mortgage securitisation.”

Numbered days

It seems likely that the GSEs’ days are numbered. However, Laurie Goodman, who heads residential mortgage-backed securities (RMBS) strategy with Amherst Securities Group, a broker/dealer specialising in residential and commercial mortgage-backed securities trading, is far from optimistic about the possibility of any swiftly enacted restructuring.

“The earliest we could conceivably get reform is 2014, because there won’t be major legislation the year after an election… Then it would take at least two years to write the rules, and another one to implement them,” she says. “Even then, legislation is unlikely because everyone has a different version of what GSE reform should look like. My guess is that in five years things will look exactly the same as they do now. There might be some nibbling around the edges, such as higher guarantee fees or some sort of risk sharing, but they will not be too different.”

It is certainly a view supported by Mr Lockhart’s experiences in the FHFA. “I worked for the Obama administration for about seven months, so I was there when we created the Home Affordable Modification Programme, and I was the one who suggested the Home Affordable Refinance Programme,” he says. “Implementing them became big and bureaucratic… The government was a little slow in reacting, and with all the oversight and inspector generals, and Congress all over the place, the response was slower than we would have hoped.”

Ms Petrou adds whatever the election outcome, reform is unlikely to be of major concern to either side. In the meantime she warns that the risks of inaction may be slowly increasing. “What to me remains really troubling is the significant risks overhanging the market as policy continues to muddle along.“

In particular, she highlights the potential impact on market stability that would be caused by the predicted fiscal cliff at the end of 2012 (when the terms of the Budget Control Act of 2011 go into effect), as well as other macroeconomic issues, such as significant declines in housing prices or a drop in mortgage market liquidity, any of which could have a destructive effect on the GSEs, particularly Freddie Mac, the weaker of the two. “I don’t think the impact of a market event of even systemic consequences should be ruled out if the US Congress proves as incapable as I would expect with fiscal policy,” she says.

Deep freeze

Ms Petrou's concerns are numerous. Not least of these is that conservatorship has not just imposed a deep freeze on the markets, but also for the GSEs as entities, making it very difficult for them to operate as recovering enterprises. “The policy strains put on them – such as how much they owe borrowers facing foreclosure because as taxpayer-owned companies they are wards of the state – force them to operate in a very different manner from how they would if they were focused more on recovery,” she says. “That has exacerbated the situation and made them more vulnerable to macroeconomic shocks than one would think.”

Moreover, Ms Petrou argues, the smaller changes implemented by the FHFA – particularly increases in guarantee fees and loan level pricing adjustments – may, in fact, prove counterproductive, making Fannie and Freddie less attractive in the high loan-to-value ratio part of the market than the FHA. “That part of the market is vital to recovery, because that’s where first-time buyers, or other borrowers who have low equity in their houses and can’t take much cash out, go. The pricing increases which the FHFA argues will bring back private capital really just move more risk over to the FHA’s credit book, and the US government."

In addition, adds Mr Lockhart, so long as the hulks of Fannie and Freddie remain relatively directionless, crew may start to abandon ship. “Because this has lasted so long they’re starting to have personnel issues at the two firms and they’re losing good people,” he says. “It’s hard to work in an organisation not knowing its future and having been told it will be eliminated but not knowing what will replace it.”

Market impact

The net result of all of these uncertainties is that non-government involvement in housing markets has essentially ground to a halt, with private investors standing on the sidelines, paralysed by uncertainties. Things are further complicated, especially for banks, by the post-crisis regulatory deluge, says Chandrajit Bhattacharya, a director in the US asset-backed securities (ABS) strategy team with Credit Suisse’s structured products research group, and head of the bank’s non-agency RMBS and consumer ABS sectors.

Indeed, even while the private level, legacy part of the market is coming back and securitisation on new loans appears to be economically viable, major challenges in terms of regulations need to be addressed before banks can come in and securitise on a private platform without involving the government, he says.

For example, the precise nature of capital rules if a mortgage is held on portfolio under the US version of the Basel III standards is unclear, with the only certainty being that requirements will increase drastically. Similarly, banks wishing to securitise are not yet sure what the capital treatment of a mortgage servicing right would be, except that it will likely be more onerous. The Dodd-Frank Act’s risk retention rule, which will force firms to hold securitisation tranches, adds yet further complexity, he says.

If Congress is as slow to act as almost everyone seems to expect in clarifying these issues, then getting private capital back into the market will not be easy. Indeed, Mr Swaminathan describes regulatory uncertainty as the biggest barrier to doing so. “Each of these [regulatory uncertainties] is a strategic factor for whether or not you as a bank or a non-bank would originate or securitise a residential mortgage and none of them are close to clarity.”

New participants

These issues could ultimately lead to greater involvement from non-banks in the markets. In particular, the real estate investment trusts (REITs) stand to benefit, suggests Mr Bhattacharya. “Right now it seems that from an economic point of view the banks are at a disadvantage compared with other entities such as REITs, who are not necessarily bound by the same kinds of rules.” As a result, securitisation, except through the FHA and the GSEs, becomes uneconomic and even the largest banks will continue to sit on their money.

Certainly, Mr Bhattacharya adds, whatever private level securitisation has been seen in recent years has been almost exclusively originated by non-bank entities. “Banks have to retain some of the risk if they do the securitisation, and as a result, we have seen more involvement from the REITs.” This, of course, has some major implications for the banking sector, but it is unlikely to offer a complete solution for financing the markets, says Mr Bhattacharya, especially given unanswered questions over how much capital the REITs can put in.

Answers here also depend on lawmakers. “All of these rules have to be defined and uncertainty is the biggest problem for our marketplace. If you don’t know the rules of the game, how do you know what game you’re trying to play,” adds Mr Bhattacharya.

Here then, as with seemingly every component of US housing financing markets, things are murky at best, and slave to political whims. The one thing that does seem certain is that the advantages and/or risks of different proposals to kick-start the markets and reform the GSEs will remain completely academic while there remains no real governmental will to act. It appears that the only thing market participants can truly agree on, is the fact that the status quo is likely to remain in place for some time yet to come.

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