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April 26, 2017

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com
Twitter: @joshrosner

The MBA’s Plan for GSE Reform – Unsolved Problems & a Dangerous Recipe

The MBA’s plan, like many other proposals, fails to address the question: ‘What
is the problem we should be seeking to solve’. Any changes to the system should seek to
create a stable, cyclically neutral or countercyclical, system for the provisioning of
mortgage credit in economically adverse environments during which banks and market
participants are unwilling to make or hold new mortgage loans. Such is the reason for the
social contract that led to the creation of the GSEs in the first place. The recognition of
the provisioning of societally necessary goods and services is the reason that we charter
electric, water, gas and other utilities. Without the ability to ensure the provisioning of
these goods and services, regardless of economic environments, lights and water would
either fail in economic downturns or become economically inaccessible to all but the few
and wealthiest consumers.
While the MBA’s acknowledgement of the value of a utility model is a step in the
right direction, but what they propose is not a utility model at all. In exchange for
governmentally conferred powers, the utilities chartering body regulates their rates of
return, ensures adequate scale and requires they are overcapitalized and counter-cyclical
entities that compete not on price but efficiencies and service. For reference, see our
paper and PowerPoint “GSE Reform: Something Old, Something New, and Something
Borrowed ” (available at https://tinyurl.com/lfoxkye & https://tinyurl.com/kbctr5n )

The real costs of acquiring the necessary scale and infrastructure (efficient costs
of capital), combined with regulated rates of return would make it impossible for new
entrants to survive without the distortive subsidization of some players to the
disadvantage of others – which is precisely what the MBA proposes.

Importantly, even without addressing the issues we should be trying to solve for, other
key elements of their proposal are unresolvable and problematic.

 Taxpayers are exposed to more risk and uncertainty.

o Foreign holders of U.S. mortgage debt would be more exposed to
incalculable risk due to the MBA plan’s structure.

o MBA’s mechanism for attempting to protect taxpayers works “through
expanded front- and back-end credit enhancements.” However, even in a
stable economic environment, back-end credit enhancements have proven

Please refer to important disclosures at the end of this report.
The Spew April 2017

to be needlessly costly and uneconomic to Fannie and Freddie for the
given risk they are purportedly laying off.

o Unnecessary complexities and inherent inequities are created via an
explicit government subsidy where “new entrants may be allowed greater
flexibility to charge market-based rates.”

o Creates the risks of further skewed government policies via unnatural
incentives, which are not market driven, by providing guarantors with
“incentives to distribute credit risk to private market investors rather than
retaining all of the risk.”

 Housing market liquidity will be significantly reduced.

o Requires “deeper front-end and back-end” single family risk transfers to
the private market. There is no evidence of adequate investor appetite for
this risk and the market remains very illiquid, even in the best of times.
Specific requirements for such sharing also allow issuers to game
guarantors on price.

o Public knowledge that the guarantor can reduce requirements in an
economic downturn introduces pro-cyclical incentives for investors to exit
the market as a herd, and to benefit from higher yields. This is in stark
contrast to a properly capitalized GSE with clear and enforced regulatory
controls that would provide countercyclical support to assist the economy
and dramatically reduce this incentive.

o Articulates the idea that the MIF would ensure “liquidity in the event of a
full-blown systemic crisis,” but this liquidity falls on the shoulders of the
government without a clear ability for repayment post-crisis. Costs of
failed institutions that have no capital reserves for put-backs on loans that
are found to have defects in reps and warranties will cause these exposures
to compete with depositors in FDIC resolutions. This, like the existing
priority of FHLB loans, would take priority over depositors in bank
resolutions. The GSEs sued surviving banks for such put-backs after the
banks had received TARP monies and had begun to recapitalize.

 The MBA’s Mortgage Insurance Fund (“MIF”) concept is dangerous to the
mortgage market’s stability and liquidity.

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The Spew April 2017

o The MIF would be primarily is funded by interconnected and highly
correlated Too Big to Fail (“TBTF”) guarantors instead of via more
predictable guarantee fees from entities like Fannie and Freddie. The
MBA’s MIF would leave taxpayers exposed to dramatic risks when TBTF
banks inevitably require another bailout in a crisis situation.

o The MIF would create an underpricing of risk, relative to private markets,
and confer a new government subsidy of at least 2% to 5% (and explicit
guarantee) to the industry at the expense of taxpayers. This subsidy exists
with the FHA’s Mortgage Insurance Fund. Big banks win, taxpayers lose.

o The MIF concept creates undue risk if there were another economic
downturn before the fund was adequately capitalized. This would leave
taxpayers exposed with no workable recourse for recovering losses.

o Government deposit insurance schemes effectively price for individual
failures in normal times but are inadequately funded for systemic events
effecting the largest and most interconnected institutions. This required
significant open-market assistance and government expenditures during
crisis without regard to the ability to reclaim those costs.

 Wholly incomplete plan with respect to implementation costs, time, and
property rights.

o The plan does not address the economic cost or risk associated with a
“transfer [of] legacy GSE assets and liabilities to new entities.”

o Does not address property rights associated with the GSEs. Implementing
the MBA’s proposal before resolving those issues would only lead to
further risk and uncertainty.

o Does not address the government’s warrants for 79.9% of each company.

o No cross analysis of impacts on mortgage rates or costs associated with
implementing such a plan were articulated. The cost burden of the MBA
plan will ultimately fall on the government or the GSEs.

 Relies on the Common Securitization Platform (“CSP”) and other unproven
structures, which introduces more liquidity risk and taxpayer exposure than
ever before.

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The Spew April 2017

o The complexity of the various parts (e.g., guarantors, CSP, risk sharing,
single security) will make the Federal Housing Finance Agency the most
complex financial safety and soundness regulator with the broadest
regulatory mandate – a recipe for failure.

o Proposes the creation and use of new, untested, and complex financial
instruments, instead of Tier 1 capital (i.e., capital on the entity balance
sheet) as a means to move, transfer, and hide risk – not dissimilarly from
CDO’s during the financial crisis. Guarantor developed “back-end
structures such as reinsurance and capital markets transactions” will lead
to new and complex structures where the guarantors will be incentivized
to innovate around the regulators.

o Like regulatory failures to oversee MBS & CDOs, this type of risky
development will disadvantage regulators who will either not be able to
keep up with proper oversight, or will be exposed to political pressure and
capture.

o Relies heavily on “issuance of MBS for single-family mortgages through
the CSP.” The CSP has already cost the GSEs over $450 million with no
firm guidance on where the capital has gone or how much more is
required. This has been an enormously costly, failed experiment that
clearly disadvantages Fannie Mae.

o The rationale behind the CSP was to allow guarantors to fail but keep the
securitization platform working in crisis. In actuality, the CSP is just back
office support (e.g., disclosure and fund administration) and doesn’t have
the infrastructure to issue securities in good or bad times. The platform
will not be able to support the market in crisis without acquiring all of the
tools to issue securities.

o The CSP would become a government-owned, systemically important,
central clearing party that would expose the taxpayer to massive
exposures. Is the government capable of keeping it up to date?

 Too Big to Fail banks would control yet another segment of the economy.

o Allowing primary market players to gain control over any aspect of the
secondary market creates the same type of blurring of the lines between
primary and secondary market that created GSE pro-cyclicality and led to
the 2008 economic crisis.

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The Spew April 2017

o Allowing joint ownership of a guarantor by several TBTF banks invites
collusion, increased interconnectedness, and systemic risk. This lesson
was learned with municipal bond bid rigging, the Forex scandal, and the
LIBOR scandal.

o “Charters and functions of the guarantors will be different from those of
the GSEs…” leading to a convoluted and subsidized system where certain
guarantors have certain rights, whereas others have a variation.

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