Senate Witnesses Agree on Need for Government MBS Guarantee

The Senate Banking Committee held a hearingrnon Thursday on the preferred structure of any government guarantee ofrnmortgage-backed securities (MBA). rnCommittee Chairman Tim Johnson (D-SD) opened the hearing saying therndetails of how a new guarantee should be structured is paramount to arnwell-functioning national market.  “Therngovernment guarantee in the current system ensures that qualifying mortgagesrnare TBA eligible, which allows borrowers to lock in their interest rates andrnconnects loans and MBS with investors from across the country and around thernglobe. </p

“If the structure of the new guaranteernis not compatible with TBA execution, a wide range of stakeholders havernexpressed concerns that access to credit will tighten for borrowers, makingrnmortgages more expensive – especially in rural and historically underservedrnareas. This outcome is unacceptable. “</p

Johnson also said that if the new systemrnallows a variety of private capital participants Congress must make certain itrnis safeguarded against future boom and bust cycles.  ‘It will be essential to create a system thatrnprotects taxpayers, but also does not create so many inefficient layers thatrnthe mortgage market becomes too expensive for qualified borrowers.” </p

Phillip L. Swagel professorrnat the University of Maryland’s School of Public Policyrntold the Committee it is extraordinary for any private financial activity, asset, or firm to have a government guarantee.rn Where there is one “it should bernstrictly limited and withrnthe terms and conditions that reflect the fact that it shouldrnbe rare to have arrangements in which Americanrntaxpayers come to the rescue of those who made badrninvestments.”</p

Swagel says he sees housing financernas an instance in whichrnhaving an explicitrngovernment guarantee is a better policy than not havingrnone because policymakers would feel obligated to intervene anyway.  If mortgages loans were not available duringrna crisis the intervention would be for social reasons, the special placernhousing holds in America, and for economic reasons that reflect its importance forrninvestment and consumption.rn Government officials would alsornfeel obligated to intervenernif the market for mortgagernsecurities locked up because it represents a vital part of U.S. financialrnmarkets and so not to impair the flow of new mortgage origination.</p

Thusrngovernment intervention is latent, Swagel says, and it would be better tornformalize the guarantee and have it priced appropriately rather than allowing it to remain implicit and unpriced.</p

Doing awayrnwith the implicit housing finance guarantee is not easy.  “Arnhousing finance reform in which the government ostensibly doesrnnotrnguarantee housingrnwould inadvertently recreaternthe implicit guarantee that wasrnonernof the worst aspects of the previous failedrnsystem.” That implicit guaranteernmade it possible forrnthe private sector to receive the upside when Freddie Mac and Fannie Mae (thernGSEs) did well, but left taxpayersrnwith the bailout whenrnthe market collapsed.</p

It is vitalrnto spell out what happens when the government must make good on itsrnguarantee.  It should be designed sorntaxpayer liability is far behind private capital but eventually there will bernanother crisis severe enough to activate the guarantee.  With this in mind, Swagel said, there arernseveral key decisions.</p

First, the guaranteernshould be switched to particular MBS rather than firms.  This would allow for entry and competitionrnwhich would prevent the value of the guarantee going to management andrnstockholders rather than passing through to borrowers.  Entry and competition will also help addressrnthe issue of Too Big to Fail.  Allowingrnmore firms to participate in the activity of securitization and guaranty forrnmortgages will ensure that these firms can fail without a bailout. If multiplernfirms fail the government could shore up only one firm to ensure liquidity andrncontinuity in the crisis.</p

Michael Canter, Senior Vice President and Director of Securitized Assets,rnAllianceBernstein spoke on behalf of SIFMA, the Securities Industry andrnFinancial markets Association.  He toldrnthe committee that the 30-year fixed rate mortgage provides a stable andrnaffordable vehicle for many borrowers but provides risks to lenders and investorsrnbecause the interest income is locked in over a long period.  To manage this risk, lendersrnneed access to a liquid, forwardrnmarket for mortgage loans. </p

The “to-be-announced”rn(TBA) market serves that function today, allowing mortgage originators to sellrnconforming loans before they are originated and thus provide interest raternlocks to borrowers and hedge risk.  The TBA market also providesrnthe necessary liquidity that enables a nationalrnmarket for geographically diverse MBS where buyers andrnsellers agree on arntransaction even though buyers do not knowrnthe specifics of their purchase untilrntwo days beforernthe trade settles.  </p

This isrnpossible because of the standardization of terms and the absence of creditrnrisk.  The GSEs provide thernstandardization and the implied but near explicit government guarantee on thernprincipal and interest of the MBS eliminates the risk.  A structure where private capital would takernfirst loss position ahead of a limited government guarantee would serve torndiminish any credit risk concern, leaving only prepayment risk; a so-called “rates market”, as opposedrnto a “credit market”.  </p

The government guarantee alsornprovides support to the market in times of crisis, allowing investors to fundrnmortgages even at times when other markets become less liquid. No one disagrees that the role ofrnthe government must shrink,rnbut it must also be recognized the critical counter-cyclical role the guarantee plays.</p

When thinking about the privaterncapital that should stand in front ofrnthe guarantee, Canter said that thernpossibility of taxpayer loses should be very remote and behind multiple levelsrnof private capital which include borrower equity, loan- or pool-levelrnmortgage/bond insurance providers, and a well-capitalized insurance reserve funded by fees paid for governmentrnbackstop. </p

Global capital markets are betterrnat pricing mortgage credit risk than the government and capital market participantsrnalso price risk relative to other investment options.  This should help temper risks of arnrace-to-the bottom.</p

Canter said there is a risk that arnmandatory, fixed level of risk sharing would contribute to volatility inrnmortgage markets and credit availability and exacerbate booms and busts.  SIFMA could support an approach where levelsrnof risk sharing fluctuate in relation to the demand for mortgage credit risk.</p

The liquidity of therncurrent $4 trillion GSE MBS markets</bmust flow seamlessly into thernnewrnmarket and not be orphaned in the transition.  Abandoning outstandingrnsecurities would immediately diminish liquidity and valuernin the market for existing MBS, and wouldrnlikely damage the confidence in thernnewrnsecurities. Itrnwould also mean that the market forrnthe MBS would startrnwith zero liquidity and be veryrnvolatile. Therefore, the form ofrnthe conforming MBS in thernfuture needs to be generally compatible with conforming MBSrntoday, or at least not so different that the current MBS couldrnnot be made fungible.</p