Sensitive/Pre-Decisional DEPARTMENT OF THE TREASURY WASHINGTON, D.C: 20220 pxiare 2010 INFORMATION MEMORANDUM FOR SECRETARY GEITHNE FROM: Jeffrey A. Goldstein Undersecretary for Domestic Finance SUBJECT: Housing Finance Reform Plan The accompanying document contains staff's proposed transition plan and descriptions of three end states as discussed in the December 23 meeting, It also highlights other key policy items that require decisions before the whitepaper release. We look forward to discu: ig this proposal at your convenience. Attachment(s) Tab 1: GSE Transition Plan and End State FrameworkSensitive/Pre-Decisional ‘TRANSITION PLAN ‘Transition will take place gradually over a multi-year phase-in period and be managed in a way so to (@ preserve the current economic recovery, (ii) avoid further dislocation in the housing markets, (iii) protect taxpayers, (iv) attract private capital, and (v) ensure the GSEs honor their obligations. A clear transition path with a well-defined end state will be important to communicate to the market and to all constituencies. End aetivit er have been doing in the first place. lerway): part of the PSPAs, the GSEs have already begun to reduce the size of their retained portfolios by at least 10% per year. We would continue at this pace and look for additional opportunities to accelerate reductions, particularly through disposition of non-performing loans. + Consider managing certain assets of FNM and FRE jointly (REO, etc) to realize economies of scale and outsource any non-core activities. 2, End the preferential capital standards and pricing the GSEs have relied on at taxpayer expense. Establish new capital standards for new guarantees made by GSEs and the mortgage finance market: * The Administration will work with the FHFA and the Fed to establish improved capital requirements that reflect differential risk-weightings across LTV and risk profiles, consistent with Basel III. Based on current estimates, this would increase required capital to 300 - 400 bps. Previously, the GSEs were required to hold 45 bps of capital against guaranteed mortgages. + Within six months of the whitepaper release, FHFA could publish new capital standards with clarity of long-term pricing implications (implying 50-75 bps in higher rates) under conservatorship. Phase in guarantee pricing to reflect higher capital standards: ‘+ Also within six months, FHFA could put forth a pricing phase-in schedule to reflect the higher capital requirements/implied pricing. ‘This could follow a linear path of 10-15 bps per year. FHFA could indicate the specific conditions where the phase-in could be faster or slower. © Different mechanisms/triggers for pricing increases should be considered to account for housing market conditions (such as HPI indices, home sales, primary/secondary spread, etc). + Over the past two years, the GSEs have implemented loan-level pricing adjustments (LLPAs) based on LTV and FICO scores. These pricing adjustments would continue and should further allow pricing to adjust for differences between states to capture differences in market conditions. 3. Create an atmosphere to attract private eapital, while ensuring safety and soundness of the financial system. Return FHA to traditional role as targeted provider of affordable housing eredit: + Lower loan level limits and increase pricing to decrease FHA’s market share of new mortgages. This process should be phased in under similar timelines to the increased GSE pricing, Continue to implement reforms under Dodd-Frank (ongoing) * Reforms under Title IX and XIV, including risk retention, transparency, and credit rating agency changes, help create « more stable and efficient private securitization and mortgage market. + FSOC processes and SIFI designation increase overall supervision of bank and non-bank actors. + The CFPB brings added oversight and important consumer protection standards to the entire mortgage origination process. Strengthen underwriting standards and reduce credit risk in system: + QRM under D-F 941 will exempt high quality underwritten mortgages with lower LTV and debt to income ratios from risk retention (e.g., agencies hiave proposed 80% LTV for new purchases). 2Sensitive/Pre-Decisional Higher capital requirements including Basel ITI standards and explicit loan level pricing adjustments set by private sector will increase costs for higher LTV mortgages. ‘Qualified Mortgage under CFPB will set a minimum ability to pay standards for all mortgages underwritten in system, ‘The conforming credit box for GSE mortgages will be tightened over time to max cap of 90% LTV overtime, 4. Affirm our current obligations. The remaining PSPA capacity must be managed so that market participants are assured GSE obligations will be met, regardless of the outlook for legislation. (This must be clear in the whitepaper and communicated to the market). * Ensure $275 billion of funding capacity available after 2012 is not used to pay dividends. This may require converting preferred stock into common or cutting or deferring payment of the dividend (under legal review). * Potentially accelerate recognition of losses prior to 2012 (there is currently a $180 billion difference between the GAAP and Fair Value balance sheets of the GSEs). model: * Credit Enhancement/Mortgage Guarantor entity could be sold/disposed to the private market as new “going-concemn” entities or in parts. + Securitization/reinsurance utility (GNMA-like) backed by PSPA support for guarantee that could be ultimately either be transferred to NMA or wound-down. “Bad Bank” consisting of retained portfolio, legacy guarantee liabilities and 3rd party debt that would also be backed by PSPAS and run down slowly to maximize taxpayer recovery. Crowd-in private capital (these actions could start over the next J-2 years as guarantee fees increase). + FHFA could require higher down payment at borrower level or increase level of credit enhancement at loan level, such as increasing amount of PMI. ‘+ Syndicating pool level risk to markets through cat bonds, CMOs or other method. Higher guarantee fees will increase ability to sell risk back to the market. Consideration: crowding in private capital reduces pace and effectiveness of taxpayer recoupment. Note on the impact of higher capital standards/role of QRM. Higher capital requirements will generally result in lower market shares for the GSEs and any successor entities. Banks will likely originate and hold higher share of ARMs. QRMS and jumbo mortgages would make up the bulk of private securitizations away from GSEs. As guarantee fees increase, investors may determine that the value of the liquidity and credit protection provided by the GSEs is too expensive, and an unguaranteed capital market or portfolio execution is more attractive. The QRM will also provide a basis of standardization. Under the Agencies’ current proposal, approximately 30-40% of current GSE volumes (or 20-25% of total market) would qualify as QRMS (with historical credit loss of largely on the sid ing s ative range of f they begin guaranteeing the new and riskier product, but they also began holding some of these riskier mortgages, in effect creating giant hedge funds with implicit government backing. And they made these moves at the riskiest possible time, when the market, having exhausted much of the prime business in years of aggressive origination and refinancing, was left chasing borrowers it would not have touched only a few years before. They were able make these moves, in part, because of the market’s assumption that taxpayers would shield investors from losses if dangerous bets didn’t pay off ‘When the bubble burst, Fannie and Freddie took billions of dollars in losses on those bad bets, burning quickly through their thin reserves. With the nation’s economy already reeling and the mortgage market at risk of freezing up, the impact of their failure would have been enormous. So in September of 2008, when it had become clear that Fannie and Freddie could no longer function as private entities, the Bush Administration, with the backing of a bipartisan majority in Congress, made the difficult but ultimately necessary decision to step in and protect the housing market from their collapse. Where We Are Now ‘The fall of the housing market has had a devastating effect on millions of families and the nation’s economy. As home prices tumed downward and more and more homeowners began defiulting on mortgages that they couldn't afford, the effect has been widespread and dramatic, Nearly 11 million borrowers are underwater on their mortgages and both mortgage delinquency rates and foreclosure startsDrafi/Sensitive/Pre-Decisional and completions remain at elevated levels. Additionally, inefficiencies in the foreclosure process and differences between state rules have led to extended foreclosure pipelines and increased uncertainty. New and existing home sales also remain near their historic lows. As a result, private capital has not yet returned to the market and the government continues to play an outsized — though unfortunately necessary role ~ in ensuring the availability of mortgage credit. Since September 2008, there has only been one new issue securitization to come to market. Today, Fannie, Freddie, FHA and Ginnie Mae together insure or guarantee more than nine out of every ten loans that are originated in this country, more than double their historical share. Additionally, private capital left in the market has consolidated dramatically around a few larger players, with the top three mortgage originators doing almost two thirds of all originations. In sum, our nation continues to struggle under the weight of the collapsed housing market. Treasury's clear and continued commitment to the GSEs, together with the Federal Reserve's purchases of mortgage- backed securities, has been crucial to restoring stability in the housing market and to maintaining the availability of mortgage credit. Without the continued activity of the GSEs today, mortgage rates would be higher and families would find it harder to get a mortgage or to refinance their existing mortgage. Principles of Reform and the Role of Government As we look ahead and continue the process of healing our broken housing finance system and slowly reducing the level of direct government support, the Administration is guided by four key objectives to achieving a well-functioning and stable housing finance market: © Widely available mortgage credit: Mortgage credit should be available and distributed on an efficient basis to a wide range of borrowers, including those with low and moderate incomes, to support the purchase of homes they can afford. This credit should be available even when ‘markets may be under stress, at rates that are not excessively volatile © Housing affordability: A well-functioning housing market should provide affordable housing options, both ownership and rental, for low- and moderate-income households. The government has a role to promoting the development and occupancy of affordable single- and multi-family residences for these families * Consumer protection: Consumers should have access to mortgage products that are easily understood, such as the 30-year fixed rate mortgage and conventional variable rate mortgages with straightforward terms and pricing. Effective consumer protection should keep unfair, abusive or deceptive practices out of the marketplace and help to ensure that consumers have the information they need about the costs, terms, and conditions, of their mortgages ‘+ Financial stability: the housing finance system should distribute the credit and interest rate risk that results from mortgage lending in an efficient and transparent manner that minimizes risk to the broader financial and economic system and does not generate excess volatility. The mortgage finance system should not contribute to systemic risk or overly inerease intereonnectedness from the failure of any one institution These are the same principles that were first laid out in March 2010 and they remain the standard the Administration believes any proposal should be measured, ‘The Administration believes that in any proposal, it is important to clearly delineate what activities are most appropriate for the private sector and which activities are suitable for government support. While government should clearly play a much more limited role than it has in the past, government can still playJ Draft/Sensitive/Pre-Decisional \ ‘an important role to play to ensure markets remain stable and access to credit to an be assured for the millions of families tha need to refinance a mortgage or take a new loan to buy a new hot Structured properly, government support can help provide the level of standardization and credit certainty in the market which create the liquidity to ensure access to safe products such as 30yr fixed rate mortgage products to all responsible Americans. As the recent crisis has also shown, fluctuations in the supply of mortgages over ‘boom and bust cycles can have a major impact on the economy. By supporting the availability of and access to mortgage credit through standardization, the government can ease the adverse effects in the financial system on the broader economy. Overview of the Administration’s Proposal ‘The Administration's proposal calls for fundamental reform of our entire system of housing finance and the GSEs through a privatization of our nation’s mortgage market. The private sector will bear the vast majority of the mortgage credit risk in future the system. The government role will be limited to ensuring the liquidity, transparency, and standardization needed for widespread access to credit in both normal times and times of stress, including continued access to the 30 year fixed rate mortgage product. The government can help accomplish this by providing reinsurance for a select group of safe mortgage products. Protecting taxpayers is a priority in this proposal. The private sector entities that bear the mortgage credit risk in the system will be subject to bank-like capital requirements and increased prudential regulation and oversight. In sum, there will be a substantial amount of private capital to absorb losses before the reinsurance contracts kick in. Additionally, any reinsurance payouts will be pre-funded through premiums paid by those who directly benefit from the system, not taxpayers. Even if the premiums collected are exhausted during periods of severe and historic economic stress, any funds used to make up this deficit would automatically be recouped through a future assessment on the housing finance industry. ‘Taxpayers will be protected on both the front-end and the back-end, The Administration would envision the provision of goverment mortgage reinsurance in a similar structure as the way the FDIC provides insurance for deposits at banking institutions. . For over 75 years, the FDIC has provided protection important protection for Americans and has preserved and promoted public confidence in the U.S. depository banking system without appropriations from Congress. In the case of the FDIC, the type of rare and potentially damaging event is a bank run or failure. In the case of the government mortgage reinsurance, the rare and damaging event is a severe housing downturn which could endanger the availability of mortgage credit for responsible American families and harm the broader economy. Additionally, the FDIC has allowed small community banks to compete on a more level playing field with larger institutions. The government mortgage reinsurance will ensure that smaller banks have access to capital markets so they can continue to offer their clients safe transparent products such as the 30 year fixed rate mortgage. Pricing and bearing mortgage credit risk is fundamentally a private sector activity, but the goverment is better at providing protection against of rare and potentially damaging events ~ known in economics as “tail risks.” We recently saw evidence of this fact in the mortgage market. The private sector, scarred from the damage of the crisis, almost entirely retreated from the housing finance system. In this new system, the private sector will bear the mortgage eredit risk, and the government will provide protection against tail events to ensure that Americans are able to take out mortgages in times of economic stress. Additionally, the knowledge the simple presence of the government reinsurance will dramatically reduce the probability of a fear-induced, damaging panic in the mortgage market.Draft/Sensitive/Pre-Decisional While the federal government will have a strong role in supporting housing affordability initiatives, it will no longer attempt to achieve policy objectives through the toxic mix of private profit incentives and quota-driven affordability goals that proved to be such a challenge for the prior system. Support will be clearly delineated and structured. ‘The FHA will continue to provide access for lower income and first- time homeowners and to be prepared to step into a more robust, countereyelical role in times of market stress. To make sure that itis healthy and stable enough to play these important roles, we will continue to make changes to improve its risk management and increase its capital reserves. Additionally, the government will continue to provide targeted support for multifamily housing, ensuring a more balanced housing policy through continued development of lower and middle class rental options. ansition ‘The Administration has already begun the process of implementing important reforms of the financial system with the passage of the historic Dodd-Frank Act. The Dodd-Frank Act included reforms that will start address many of the problems in the private residential mortgage credit markets. The provisions under Dodd-Frank Act will promote a more stable and efficient securitization market with enhanced transparency. A key provision of the Dodd-Frank Act is requirement for key actors in the mortgage finance process to retain “skin in the game.” This provision will help ensure that originators and securitizers can no longer pass toxic products through a system without regard for their risk. Additionally, the Consumer Financial Protection Bureau will help bring added transparency and important consumer protection standards to the entire mortgage origination process. ‘While in conservatorship, under the direction of the Federal Housing Finance ‘Agency (FHFA), a new regulator for the GSEs created under HERA, Fannie Mae and Freddie Mac have already started winding down their investment portfolios at a pace no less than 10% per year. This will pput them on pace for complete wind-down of all non-targeted uses over approximately the next ten years, ‘gradually reducing and finally eliminating the taxpayer exposure to these investments. Fannie Mee and Freddie Mac have also significantly improved and strengthened their underwriting standards, Fannie Mee and Freddie Mac will not be allowed to eam private gains at public expense, and any income that the GSEs ear will go towards paying back taxpayers. In addition to the actions under HERA and Dodd Frank, there are several steps that we can begin to take together to continue the efforts to reform our nation’s housing finance system and reduce the exposure of the US taxpayer in a careful and measured way. * WanaeDove and Rescare the dciien ofthe]GSERAF amie Mac and Freddie Mac mst be fundamentally resroctred aad BE icy never pet taxpayer of ca again ‘The business models of Fannie Mae and Freddie Mac historically combined activities which were suited for the private sector and for the government. The guarantee business of the GSEs fundamentally consisted of two parts: () a mortgage credit insurance business that takes first Loss risk, similar to banks or insurance companies and (ii) a reinsurance/securitization business that takes catastrophic risk and sets the standards in the market, Sica ETERS ayes (G@WOUATREMEnities. The mortgage credit insurance business should be wound down or sold in parts to the private sector in such a way as to maximize taxpayer recovery, while minimally impacting the markets. The securitization and reinsurance activities, which previously relied upon the perception of government support, should be run as a “public utility” and be converted into a government corporation, with the retained support of Treasury. In addition to this fundamental restructuring, the GSEs’ investment activities will continue to be wound down at a measured pace. The GSEs should have never been allowed to maintain such large investmentDraft/Sensitive/Pre-Decisional portfolios and conduct the activities of a hedge fund or investment bank with the funding support ofthe government and the American taxpayer. Bring private capital to back into the mortgage market and decrease the risk held by the GSEs. The GSEs’ historically low and ultimately insufficient capital standards meant that the GSEs were able to guarantee mortgages at rates which crowded out private capit alternatives form of credit uncompetitive. ‘ast share away fomthesOSEsxoveriie: As the guarente fos increase, the private market will be able to take the first loss p. ion ahead of any GSEs guarantees and move the risk held by the GSEs to a more remote risk position. Return the FHA 10 its role as a targeted provider of credit. The Administration will also gradually rotum the FHA to its traditional role as a targeted provider of access for low-income and first time home buyers through reforming the standards for the loans and borrowers that qualify for FHA insurance. We will start this process by reducing the conforming loan level for FHA loans. It is important that changes at FHA occur in conjunction with the reforms of the GSEs ~ higher capital requirements and increased pricing at the GSEs will simply encourage ‘more business to flow to FHA, leaving the direct exposure of the taxpayer unchanged, It is important, however, that we proceed carefully, ensuring that we do not pull back government support in a way that would undermine the economic recovery. We will be carefal to bring private capital back in to the market and reduce the direct exposure of the government to the guarantee businesses at a pace that is prudent given conditions in the housing market. Home prices have not fully stabilized, a significant portion of homeowners are underwater, and there is great uncertainty surrounding the foreclosure process. Successful and sustainable reform will responsibly account for the current market conditions while still setting clear end-state objectives. All existing guarantee obligations of both entities will continue to be honored and the market should continue to have the certainty that the Treasury stands behind its commitments through this period of transition to a new system. Conclusion / Endstate The end-state will be a private mortgage market with the government supporting standardization, liquidity, efficiency, and transparency. This is a fundamentally different system than what we have had in the past. ‘This new system will ensure that markets are stable, consumers are protected, credit is widely accessible to responsible borrowers, and important housing policy objectives, such as affordable housing for low and moderate income families, are administered effectively and efficiently. The role of government will be clearer with substantially less risk borne by the American taxpayerSENSITIVE/PRE-DECISIONAL DRAFT EXECUTIVE SUMMARY The Obama Administration believes strongly that reforming the nation’s housing finance system is essential to the long term stability of our housing market and to our nation’s sustainable long term growth. In this paper we lay out a plan to provide that reform, beginning with an account of the problems that led to the collapse of our old system, and then laying out the path that we will take to a healthier new one, Introduction In the fall of 2008, President Bush took the dramatic step of putting the two largest guarantors of mortgages, Fannie Mae and Freddie Mac, into conservatorship. With the housing market recling, his administration decided to step in and take over a pair of institutions that had become essential to the functioning of the nation’s housing finance system, but whose structural flaws, finally exposed under the ‘economic stress of the times, had driven them to the verge of collapse. Shareholders were wiped out in the move, with the government stepping in to back the companies’ debt and guarantee obligations. Given their condition and their importance to the housing market, President Bush had little choice. In this white paper the Administration lays out its plan to ensure that this never happens again, Repairing and fundamentally reforming our housing finance system is critical to millions of American homeowners, their communities and our nation’s economy. ‘What Went Wrong Dramatic Expansion of Risk in the Housing Market In the early 2000s, lenders began to expand both the types of borrowers they were willing to lend to and the products they were willing to offer. Borrowers who only a few years before did not have enough income or a high enough credit score to borrow the money needed to buy a house, suddenly had dozens of lenders anxious to make them a loan. Borrowers who could not afford the monthly payments on a 30 year fixed rate mortgage, were suddenly offered the same loan with lower up-front monthly payments, pushing the more significant payments into the future. Lenders were making loans to riskier borrowers, in riskier products. There were a few things driving this expansion of credit and risk: with home prices going up, many borrowers assumed that they would be able to sell their home at a profit if it tumed out that they couldn’t afford their mortgage; and lenders didn’t worry about a borrowers” ability to pay, because securitizers stood by anxious to take the loans off their hands, as they could sell to investors ready to put money into what had long been a relatively risk-free investment. In shor, those creating and selling the mortgage products that eventually made their way into the hands of investors had very little reason not to loosen credit standards and push as much through the pipeline as they could manage. So that’s precisely what they did. ‘Though Fannie and Freddie were largely on the sidelines during the inital expansion, they eventually followed the market down this dangerous path. The conservative underwriting standards and the ‘conservative range of products that they traditionally offered had made it impossible for them to compete as the market moved into increasingly risky terrain, cutting their market share almost in half during the boom, from 70% in 2003, to just 40% in 2006. In an effort to regain that share, Fannic and Freddie made the fateful decision to lower their own underwriting standards and chase the market. Not only did they begin guaranteeing the new and riskier product, but they also began holding some of these riskier mortgages, in effect creating giant hedge funds with implicit government backing. And they made theseSENSITIVE/PRE-DECISIONAL, ‘moves at the riskiest possible time, when the market, having exhausted much of the prime business in years of aggressive origination and refinancing, was left chasing borrowers it would not have touched only a few years before. Structurally Flawed Entit that made them uniquely ill-suited to take on the extra risk. First, the perception that these private, shareholder-owned companies enjoyed the implicit backing of the government allowed them to hold mucl in reserve to protect against losses than was being held by other large financial institutions, which in turn allowed them t/Gidemprige thejfeestliat they changed,for their guarantee. Fannie and Freddie thus had a considerable and unnatural advantage | co tompetg ‘were left woefully unprepared for a downtum in the market- the capital they held turne even one-ienth of the amount they would have needed to endure the downturn. Put differently, the perception of implicit support from the government allowed their shareholders to gain enormous profits by pushing off much of their risk on the US taxpayer- in essence allowing for a model of “heads I win, tails you lose.” ‘The second factor that left Fannie and Fredidic in « poor position to chase the increasingly risky market ‘yaspoor oversight by regulators and policymakers Not only was the oversight by regulators weak, allowing Fannie and Freddie to take on increasing levels of risk at the expense of the taxpayer, but the oversight provided by policymakers was poorly conceived. Rather than focusing on their increasingly dangerous levels of risk, policymakers instead focused on a series of quota-driven affordability goals that actually increased that risk further. It was not thatthe goals weren't laudable, or even that the GSEs couldn’t be advan But because the they actually pushed Fannie and Freddie into riskier segments of the market, particularly as their volumes grew. ‘These serious weaknesses in how the GSEs were allowed to operate put them in a particularly vulnerable position as they chased the rest of the private market into the increasingly dangerous terrain, The Collapse Ultimately, the GSEs took a gamble in chasing market share and shareholder profits, encouraged by the assumption that taxpayers would shield them from losses if those dangerous bets didn’t pay off. As the housing bubble that Fannie and Freddie helped expand finally burst, these bets failed and failed dramatically, with the companies taking billions of dollars in losses and burning quickly through their thin reserves. With the nation’s economy already reeling and the mortgage market at risk of freezing up, the impact of their failure would have been enormous. So in September of 2008, when it had become clear that Fannie and Freddie could no longer function as private entities, the Bush Administration, with the backing of a bipartisan majority in Congress, made the difficult but ultimately necessary decision to step in and protect the housing market from their collapse.SENSITIVE/PRE-DECISIONAL Where we are now The fall of the housing market has had a devastating effect on millions of families and the nation’s economy. As home prices tuned downward and more and more homeowners began defaulting on mortgages that they couldn’t afford, the impact has been widespread and dramatic. Millions of families have been foreclosed upon, millions more find themselves owing more on their homes than their homes are worth, and entire communities are feeling the strain. To make matters more difficult, private capital has all but disappeared from the market, forcing the government to step in to ensure that Americans have some access to credit during these strained times. Today, Fannie, Freddie, FHA and Ginnie Mae together insure or guarantee more than nine out of every ten loans that are originated in this country, more than double their historical share, And the private capital left in the market has consolidated dramatically around a few larger players, with the top three mortgage originators doing almost two thirds of all originations. In short, our nation continues to struggle under the weight of the collapsed housing market. Path Forward But this is a tale with a clear lesson: the housing finance system that has led to this collapse needs dramatic reform. It has been plagued by a number of flaws that together have come at great cost to homeowners, communities, and the broader economy. We as a nation cannot continue to have so important a system built on so flawed a foundation. Fundamental Reform is Needed ‘There are = SLATE VCR 2 the coming months to continue the effort begun under Dodd-Fr ‘0 put our housing finance system on more sound footing. Together these steps will reduce the exposure of the US taxpayer, bring more private capital back into the mortgage market and ensure that the system into which that private capital flows is a stronger and healthier one. 1 ‘The GSEs were allowed to behave like government-backed hedge funds, managing large investment portfolios for the profit of their shareholders with the risk ultimately falling on the US taxpayer. ‘The Administration will end this, winding down these retained portfolios at an annual pace of no less than 10%, exploring opportunities to increase that pace as is prudent. Future investments by these companies will be limited to a narrow range uses, such as providing liquidity for small lenders, ‘Shin og BREA Ea EPPS The Administration will also take the steps necessary to reduce significantly the new guarantee business being done by both Fannie and Freddie, creating space for private capital to return to the market and further reducing risk to the taxpayer. The Administration will use two primary levers to scale this ‘business back, increasing the prices charged for their guarantee and decreasing the maximum size ‘of loans that will qualify for the guarantee. ‘The path to winding down these businesses will be as, follows: a. First, we will increase the capital that these companies are required to hold against any new business, finally aligning their capital standards with those of private financial institutions and bringing their pricing in line with the private market. Second, we will let the present extension of their loan limits expire on October 1, 2011, bringing them back to their historic levels. Larger loans for more expensive homes will once again retum to the private market,SENSITIVE/PRE-DECISIONAL, ©. And finally, we will continue to use both of these levers- decreasing loan limits and inereasing pricing through increased capital requirements- to pull both companies gradually out of the guarantee market altogether. The decreasing loan limits will limit them to increasingly smaller loans, and the increasing capital standards will gradually price them out of the market more broadly. Given the large footprint of the companies in today’s finance market, we will proceed carefully with these steps, ensuring that we do not pull them back in a way that would undermine the economic recovery. All of the existing and ongoing guarantee and debt obligations of both entities will continue to be honored through this transition. Whether in the end the guarantee businesses is scaled back to a much smaller footprint and then fundamentally restructured to provide the form of catastrophic risk insurance later described in this paper, or scaled back altogether, presents a remaining critical choice to be made. The pace and means of the scaling back of the guarantee business will also be impacted by that decision. Return the FHA to its role as a targeted provider of credit. The Administration will also gradually return the FHA to its traditionally more targeted role of providing access for low- income and first time home buyers. The Administration will do this by decreasing the maximum Joan size that can qualify for FHA insurance. We will first allow the present increase of loan limits to expire on October 1, 2011, and then decrease the limits further as needed to return to @ size and focus more narrowly tailored to its core mission. Similar to the care we will apply to changes to the GSEs, we will ensure that the pace of these changes is steady but prudent given. conditions in the housing market. Better align incentives and increase oversight in the broader housing market. And finally, the Administration will work to address two significant structural flaws in the broader housing finance system: the misalignment of risk and lack of adequate oversight. ‘The break-down in incentives in the housing finance system contributed to @ significant increase and mismanagement of risk in the system. The first and most important step in addressing this ‘will be making sure that the risk retention provisions in Dodd-Frank are fully and appropriately implemented. This requirement that key actors in the mortgage finance process have “skin in the ‘game” will finally ensure that they no longer pass toxic products through a system without regard for their risk. [The second step will be to work to repair misaligned incentives elsewhere in the system, such as the servicing sector, where servicers” lack of appropriate incentives has contributed to their failure to meet their obligations to borrowers struggling to stay in their homes.] ‘The Administration will also ensure that there is sufficient regulatory oversight, not just of Fannie and Freddie, but of the housing finance system generally. The lack of robust oversight allowed ‘market participants to take advantage of consumers and take on a level of risk that eventually brought down the entire system, The newly formed Consumer Financial Protection Bureau will play a key role in making sure that the interests of consumers are being protected in the systern, and the banking regulators will ensure sufficient oversight of the financial institutions under their supervision in the broader housing finance system.SENSITIVE/PRE-DECISIONAL Principles that will characterize the future system As we take these steps, we will move to a more stable, healthy housing finance system that no longer suffers from the central flaws that plagued the prior one. The new system will be characterized by a few core principles to ensure that it remains sound, healthy and consistent with our policy objectives. 1. Privatization of the Mortgage Market: The private sector will bear the vast majority of the mortgage credit risk in the system. This will reduce taxpayer exposure and create a more vibrant, competitive market for Americans borrowing money to purchase homes. Level Playing Field in the Mortgage System: Smaller lenders will have access to capital markets, ensuring that they remain a vital link for their communities to mortgage credit. We must, avoid the kind of consolidation in the mortgage industry that would force these community lenders out of the market, as historically they have proven much better at providing access to credit for their communities than have larger institutions. More Clearly Defined Goverament Role in Supporting Affordability: While the federal government will have a strong role in supporting housing affordability initiatives, it will no longer attempt to achieve policy objectives through the toxic mix of private profit incentives and quota-driven affordability goals that proved to be such a challenge for the prior system. Support for Targeted Multifamily Financing: The govemment will continue to provide targeted support for multifamily housing, ensuring a more balanced housing policy through continued development of lower and middle class rental options. This support will come either in the form of insurance or a guarantee for qualifying projects, ensuring that there is sufficient liquidity in the market for the development of lower and middle class rental options Continued Role of FHA. The FHA will continue to provide access for lower income and first- time homeowners and to be prepared to step into a more robust, countercyclical role in times of market stress. To make sure that it is healthy and stable enough to play these important roles, we will continue to make changes to improve its risk management and increase its capital reserves. The Choice Ahead ‘While we will press ahead on this path aggressively and deliberately, a fundamental choice remains to be made about the future of our housing finance system. As we take the steps above to scale back the government's role in the market and bring private capital into a healthier, more stable system, we could take the additional step of providing government-backed catastrophic risk insurance for certain mortgage- backed securities, to promote the liquidity and standardization needed for widespread access to credit. Or we could instead withdraw the government from the market altogether, with the exception of the more targeted support provided through FHA, VA, USDA and Ginnie Mae. ‘These options are described in more detail later in this paper, but the basic choice comes to this: is widespread access to mortgage credit worth the risk to the American taxpayer? Providing catastrophic risk insurance through entities that are well-capitalized and have significant private capital ahead of them to take all but the catastrophic risk would put the American taxpayer in en extremely remote position of risk. In exchange for this risk, we would maintain a steady flow of affordable credit for Americans who have low or moderate credit risk and are looking to purchase a home. This is the choice that remains, and we believe it to be too important to make behind closed doors. We thus hope to engage the public and Members of Congress in a dialogue to determine the best choice for the American people,SENSITIVE/PRE-DECISIONAL Conclusion The housing finance system must be reformed. It is the vital link to homeownership for millions of Americans and it is central to the economy as a whole. We allowed its flaws to go unchecked for too long, leading to a collapse that has strained families, decimated communities and pushed the economy . into the worst recession since the great Depression. What we provide here is a path of reform, which will lead to a future system with more private capital, better aligned incentives, more oversight and less risk to the taxpayer- in short, to a healthier, more stable system of housing finance.SENSITIVE / PRE-DECISIONAL, DEPARTMENT OF THE TREASURY WASHINGTON, D.C, 20220 February 10, 2011 ACTION MEMORANDUM FOR SECRETARY GEITHNER FROM: __ Jeffrey Goldstein Under Secretary for Domestic Finance SUBJECT: Approval of Housing Finance Study under Section 1074 of Dodd-Frank Recommendation(s) ‘That you (i) approve the attached study on reforming the housing finance system pursuant to Section 1074 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the study), and (ji) authorize the transmittal of the study to Congress and to make the study public on Friday, February 11, 2011. _____ Approve Disapprove __Let’s Discuss Background Under Section 1074 of the Dodd-Frank Act, you, as Secretary of the Treasury, are required to conduct a study on reforming the housing finance system. The study was due to Congress on Monday, January 31, 2011 and will be delivered on Friday, February 11, 2011. ‘Treasury staff has authored the attached study, and it has been reviewed by and circulated to the relevant agencies, including NEC, HUD, OMB, DPC, OVP, and CEA. We have completed the study in coordination with a broad interageney process. Public Affairs and Legislative Affairs have been briefed on the release of the study and Public Affairs has prepared accompanying materials. Attachment Tab 1: Study on Ending the Conservatorship of Fannie Mae and Freddie Mac and Reforming the Housing Finance SystemSENSITIVE / PRE-DECISIONAL, Acti ubject/Title: Approval of Housing Finance Reform White Paper rafted: proved: | Capital Markets ~ Brian Zakutansky (%22031) Domestic Finance ~ Sarah Miller (x24231) Public Affairs ~ Matt Anderson (20631) Domestic Finance ~ Jeffrey Goldstein - Financial Markets - Mary Miller — Capital Markets ~ Jeff Foster (2/10/11) ExecSec — Sam Valverde — 2/10/11 OK Public Affairs ~ Steve Adamske ~ Legislative Affairs - Charles Yi— General Counsel ~ George Madison ~ Banking and Finance — Laurie Schaffer ~ Economic Policy ~ John Bellows -- Delivery Instructions Return to policy office for delivery Deliver through the Executive Secretary (include specific instructions below) Other (see below)DRAFT/SENSITIVE/PRE-DECISIONAL HOUSING FINANCE REFORM WHITE PAPER FINAL DRAFT FOR CLEARANCE, PRE-FORMATTING February 10,2011 INTRODUCTION ‘This paper lays out the Administration's plan to reform America's housing finance market 10 better serve families and function more safely in a world that has changed dramatically since its original pillars were put in place nearly eighty years ago. Our plan champions the belief that Americans should have choices in housing that make sense for them and for their families. This means rental options near good schools and good jobs. It means access to credit for those Americans who want to own their own home, which has helped millions of middle class families build wealth and achieve the American Dream. And it means a helping hand for lower income Americans, who are burdened by the strain of high housing costs But our plan also dramatically transforms the role of government in the housing market. In the past, the government’s financial and tax policies encouraged housing purchases and real estate investment over other sectors of our economy, and ultimately left taxpayers responsible for much of the risk incurred by a poorly supervised housing finance market, Going forward, the government’s primary role should be limited to robust oversight and consumer protection, targeted assistance for low- and moderate-income homeowners and renters, and carefully designed support for market stability and crisis response. Our plan helps ensure that our nation’s economic health will not be jeopardized again by the fundamental flaws in the housing market that existed before the financial erisis. At the same time, this plan recognizes the fragile state of our housing market and is designed to ensure that reforms are implemented at a stable and measured pace to support economic recovery over the next several years. Under our plan, private markets — subject to strong oversight and standards for consumer and investor protection — will be the primary source of mortgage credit and bear the burden for losses. Banks and other financial institutions will be required to hold more capital to withstand future recessions or significant declines in home prices, and adhere to more conservative underwriting standards that require homeowners to hold more equity in their homes. Securitization, alongside credit from the banking system, should continue to play a major role in housing finance subject to greater risk retention, disclosure, and other key reforms. Our plan is also designed to eliminate unfair capital, oversight, and accounting advantages and promote a level playing field for all participants in the housing market. : "Be Aisa a work wh he eter Howse ate sens CEA develop a plan to responsibly reduce the role of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) in the mortgage market and, 1 HR Whitepaper 2.10.11 vCLEARANCE FINAL 1700 doox 325015 140 aMDRAFT/SENSITIVE/PRE-DECISIONAL ins Sons. (NEIRCORAEHIEAIFA employ a number of policy levers — including increased guarantee fee pricing, increased down payment requirements, and other measures ~ to bring private capital back into the mortgage market and reduce taxpayer risk. As the market improves and Fannie Mae and Freddie Mac are wound down, it should be clear that the government is committed to ensuring that Fannie Mae and Freddie Mac have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations. We believe that under our current Preferred Stock Purchase Agreements (PSPAs), there is sufficient funding to ensure the orderly and deliberate wind down of Fannie Mae and Freddie Mac, as described in our plan. Successful reform will require more than just winding down Fannie Mae and Freddie Mac and reducing other government support to the housing market. In addition to fully implementing the reforms in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) (Pub. L. 111-203), the Administration will mobilize all tools available to address the nation’s broken system of mortgage servicing and foreclosure processing. Taken together, these steps will help restore trust in the underlying foundation of the mortgage market so borrowers, lenders, and investors have the confidence to purchase a home, issue a loan, or make an investment. The government must also help ensure that all Americans have access to quality housing that they can afford. This does not mean our goal is for all Americans to be homeowners. We should continue to provide targeted and effective support to families with the financial capacity and desire to own a home, but who are underserved by the private market, as well as a range of options for Americans who rent their homes. Finally, our plan presents several proposals for structuring the government's long-term role in a housing finance system in which the private sector is the dominant provider of mortgage credit. We evaluate these proposals according to their effects on four key criteria: access to mortgage credit; incentives for investment in the housing sector; taxpayer protection; and financial and economic stability. We ask Congress to work with us to determine the right balance of prioriti for a new, predominantly private housing finance market as soon as possible. Reform will not come overnight. Some reforms can take place immediately, like improvements to consumer protection and government oversight, while others will be implemented more gradually as the housing market heals. ‘We welcome the opportunity to work with Congress, independent regulators and agencies, and a wide range of stakeholders and partners to meet the goals laid out in the pages below. HER Whitepaper 2.10.11 vCLEARANCE FINAL, 1700doo% 25/0015 10 AMDRAFT/SENSITIVE/PRE-DECISIONAL HOUSING FINANCE FROM THE GREAT DEPRESSION TO THE GREAT RECESSION Nearly cighty years ago, in the midst of the Great Depression, the federal goverment began implementing sweeping reforms to the American financial system. ‘These reforms — deposit insurance, limits on the risks banks can take, better transparency and investor protections in securities markets, a stronger Federal Reserve — helped build a financial system that provided a solid foundation for America’s unprecedented prosperity. Improving how housing was financed was an important part of these broader Depression-era reforms. In the 1930s, following severe mortgage market disruptions, widespread foreclosures, and sinking homeownership rates, the government created the Federal Housing Administration (“FHA”), Fannie Mae, the Federal Home Loan Banks (*FHLBs”) (and, several decades later, Freddie Mac) to help promote secure and sustainable homeownership for future generations of Americans. They that drove improved standards within g a much-needed link between places with ing services and growing parts of the country without local funding sources for mortgages. For decades, borrowers, lenders, and investors benefited from the deep, liquid markets these institutions helped establish. This same marketplace gave American families access to simple, straightforward products, protecting them from sudden financial shocks and helping them build savings in their homes. But in the years leading up to the recent financial crisis, trillions of dollars worth of financial decisions were made across the U.S. economy and around the world on the faulty expectation that national house prices would only rise. Twenty years of economic stability had desensitized every player in the housing market to the possibility that home prices could fall. Indeed, despite occasional regional price declines, national home values in America had not declined on a consistent basis since the Depression. But in the years leading up to the recent crisis, a robust expansion in credit, fueled by processes and financial instruments designed to shift risk away from originators, combined with other factors, fed a rising demand for housing that lifted prices well above sustainable values. Average home values in many parts of the country sky rocketed. Mortgages became tools for speculative, short-term investments and a ‘means to access easy cash. Lulled into a false sense of an ever-rising real estate market, some homebuyers took on more debt than they could afford to purchase homes beyond their means, and existing homeowners used their homes like ATM machines by converting home equity to cash. LHR Whitepaper 2.10.11 ¥CLEARANCE FINAL 1700 does 325015 140 aMDRAFT/SENSITIVE/P RE-DECISIONAL By mid-2006, however, housing prices across a broad range of markets began to turn, eventually declining consistently for the first time since the 1930s. Almost no one in the housing finance market was prepared. Homeowners, investors, and financial institutions—including Fannie Mae and Freddie Mac—did not have enough capital supporting their investments to absorb the resulting losses. In 2008, credit markets froze. Our nation’s financial system ~ which had outgrown and outmaneuvered a regulatory framework largely designed in the 1930s ~ was driven to the brink of collapse. Millions of Americans lost their jobs, families lost their homes, and small businesses shut down. Fannie Mae and Freddie Mac experienced catastrophic losses and were placed into conservatorship, where they remain today. Fundamental Flaws in the Housing Finance Market No single cause can fully explain the crisis. Misbehavior, migjudgments, and missed opportunities — on Wall Street, on Main Street, and in Washington — all came together to push the economy to the brink of collapse. Several fundamental flaws in our housing finance system contributed to the crisis and must be corrected to protect American families from the instabilities and excesses that helped bring us to a crisis point. (ERAN OMprolifera#e? Unregulated brokers and originators promoted complex mortgage products that “reset” to sharply higher rates after a few years, or required no income documentation or down payment. Some allowed borrowers to defer principal and interest payments, increasing their indebtedness over time. Often, brokers and originators had incentives to steer borrowers into these higher-cost loans, even if they qualified for more affordable options. Some speculators knowingly took on loans they could not afford, betting that future housing price increases would bail them out. Millions of borrowers who purchased these products proved unable to make required payments, resulting in widespread defaults and foreclosures once housing prices started to fall. + An pieijicte ane" OMeapreglatorregine failed to keep the system in check: Regulatory boundaries largely unchanged from the 1930s allowed large parts ofthe financial system that were deeply involved in housing finance to operate with virtually no oversight. To be sure, there were some problems that aruse from violations of the law. In many cases, however, weak and fragmented regulation and enforcement also allowed lenders to “shop” for weaker oversight and drove deteriorating standards in lending practices. Securitizers and investors could essentially opt-out of the parts of the system with heavier regulation and use whatever underwriting practices they saw fit. Other actors in the system were allowed to avoid consistent regulation and choose favorable jurisdictions. A ‘The market increasingly relied on an opaque and complex securitization chain — comprised of mortgage brokers, originators, securitizers, ratings agencies, and investors — to provide the money that helped fuel the rapid rise in home prices. Brokers and originators could profit from selling poorly underwritten mortgages to securitizers without regard to loans’ future 4 DPR Whitepaper 2.10.11 vCLEARANCE FINAL 1700 docx 37282015 1:40 AMDRAFT/SENSITIVE/PRE-DECISIONAL performance. Ratings agencies and investors failed to recognize that the deterioration in underwriting standards had undermined the quality of complex mortgage-backed securities. An overall lack of transparency and clear rules made it difficult for regulators and investors, to track and recognize risk as it moved through the securitization chain. © pinaderquateNeUPHEP ME BREHMCH financial institutions unprepared to absorb losses Systemically-significant financial institutions were not required to hold adequate capital against the true mortgage risk on their balance sheets because these institutions were allowed to hold less capital against securities backed by mortgages than if they kept the same mortgages themselves. When home prices started to fall and these institutions experienced substantial losses, they had inadequate capital to weather the storm, putting the health of the entire financial system and broader economy at risk. + Thenservicing industrpovassillcemuippey 10 serve the needs of borrowers, lenders, and investors once housing prices fell. The servicing industry, which processes borrower payments and forwards the proceeds to investors who own the pool of mortgages, was unprepared and poorly structured to address the higher levels of default and foreclosure that occurred after the housing market collapse. Servicing contracts did a poor job defining the Obligations of servicers to minimize losses on defaulting loans. Servicers’ flat fee compensation structure also failed to provide appropriate incentives for servicers to invest the time, effort, and resources necessary to prevent foreclosure, even when doing so would have been in both the homeowner and mortgage investors’ interests. ‘The Failure of Fannie Mae and Freddie Mac Initially, Fannie Mae and Freddie Mac were largely on the sidelines while private markets generated increasingly risky mortgages. Between 2001 and 2005, private-label securitizations of Alt-A and subprime mortgages grew fivefold, yet Fannie Mae and Freddie Mac continued to primarily guarantee fully documented, high-quality mortgages. But as their combined market share declined — from nearly 70 percent of new originations in 2003 to 40 percent in 2006 — Fannie Mae and Freddie Mac pursued riskier business to raise their market share and increase profits. Not only did they expand their guarantees to new and riskier products, but they also increased their holdings of some of these riskier mortgages on their own balance sheets. Fannie Mae and Freddie Mee strayed farthest from their core business in 2006 and 2007 ~ the very moment the housing market was extending credit to the riskiest borrowers and home prices were peaking, When home prices began to fall and adjustable-rate mortgages with low teaser rates reset to higher rates, the Alt-A morigages that Fannie Mae and Freddie Mac had accumulated started to default at alarming rates. By 2008, mortgages across the product spectrum, including high-credit, well-documented prime mortgages, were defaulting at historically high rates. Fannie Mae and Freddie Mac’s losses had become far too substantial for their thin capital buffers to absorb, and it became clear they would 5 LHR Whitepaper 210.11 vCLEARANCE FINAL 1700 docx srasn0i5 140 AMDRAFT/SENSITIVE/PRE-DECISIONAL be unable to fully honor their debts and guarantees. In September of 2008, in consultation with the Bush Administration, FHFA placed Fannie Mae and Freddie Mac in conservatorship under the authority provided by the Housing and Economie Recovery Act of 2008 (“HERA”) (Pub. L. 110-289), which Congress had passed to support the housing market two months earlier. The Treasury Department agreed to exercise its authority under HERA to provide financial support — to date, over $130 billion — so both Fannie Mae and Freddie Mac could honor their debt and guarantees. These measures, though unfortunate, were necessary to prevent a more severe disruption in the mortgage market and broader economy, Fannie Mae and Freddie Mac’s structural design flaws, combined with failures in management, were the primary cause of their collapse. loans held by banks and other private market institution masa ggposl ‘(y"FainiewMae,and"Preddie Mac, including loans qualifying for the affordability goals. While Fannie Mae and Freddie Mac’s affordability goals were poorly designed and did not effectively serve their purposes (as detailed below), fundamental structural flaws and poor decision-making are the principal reasons these institutions failed. je Mae and Freddie Mac’s congressional charters require them to promote market stability and access 10 mortgage credit. But their private shareholder structure, coupled with a weak oversight regime, encouraged management to take on excessive risk in order to retain market share and maximize profits, jeopardizing their ability to support the mortgage market and leaving taxpayers to bear major losses. Their pursuit of profit leading up to the financial crisis caused them to fail when their broader public mandate to support the market was needed most. * Fannie Mae and Freddie Mac's perceived government backing conferred sof Fannie Mae and Freddie Mac benefited from preferential tax treatment, far lo’ pital requirements, and a widely perceived government guarantee — the commonly held assumption that large losses would be backstopped by the taxpayer. These advantages gave them substantial pricing power that helped them dominate segments of the market in which they participated, build up large investment portfolios at a cost far lower than their competitors, and take on irresponsible risks through their guarantee business that ultimately resulted in their failure. fe, Fannie Mae ‘and Freddie Mac were required to hold far less capital than other regulated private institutions. Since they did not have to maintain higher levels of capital, they could set the LHPR Whitepaper 2.1011 yCLEARANCE FINAL 1700.does 3572015 140 AMDRAFT/SENSITIVE/PRE-DECISIONAL fee that they charged to guarantee mortgage-backed securities at artificially low levels. It also left them with an inadequate cushion to absorb losses once the housing crisis hit. sofiRéderal Mousingstinterprises Oversight (“OFHEO”), Fannic eee eddie Mac’s previous regulator, did not have adequate enforcement mechanisms or authority to set capital standards to constrain risky behavior. Over the years, Fannie Mae and Freddie Mac’s aggressive lobbying efforts had successfully defeated efforts to bring them under closer supervision. The financial crisis also exacerbated fundamental flaws in the FHLBs, which help mostly insured depository institutions access liquidity and capital to compete in an increasingly competitive marketplace. Prior to the crisis, the FHLBs suffered from inadequate regulatory oversight, and were allowed to build large investment portfolios that subjected them to excess risk, while providing concentrated funding to banks engaging in unsound business practices. Today, eight of the twelve banks are under regulatory orders with respect to their capital or have voluntarily suspended dividends or the repurchase of excess stock. Because each of the twelve FHLBs is also liable for the losses of other FHLBs, additional losses could adversely affect the entire FHLB system, damaging the mortgage finance market and potentially constraining access to capital for financial institutions, Reforms to the FHLB system are necessary to restore its important primary role of providing a stable source of mortgage credit for financial institutions of all sizes. ‘The Current State of the Housing Market Since taking office in January 2009, the Obama Administration has actéd to help stabilize the housing market and provide critical support for struggling homeowners. ‘The Administration worked with Congress to put in place expanded tax credits for first-time homebuyers, additional support for state and local housing agencies, neighborhood stabilization and community development programs, mortgage modification and refinancing initiatives, housing counseling programs, expanded support for mortgage credit through FHA, and strengthened consumer protections. The Administration has also provided ongoing financial support for Fannie Mae and Freddie Mac through the PSPAs following the Bush Administration’s decision to put that support in place and FHFA’s decision to place them into conservatorship. These policies helped avert a deeper economic collapse and a more severe housing crisis. However, the housing market remains fragile and will take years to fully recover. An elevated unemployment rate, lower household wealth, and higher credit standards are constraining demand for housing. Sales of new and existing homes are well below their recent peaks. At the same time, the large inventory of unsold homes, including a backlog of foreclosed homes that have yet to appear on the market, will take an extended period to work through the system. As a result of both supply and demand factors, housing construction is at historically low levels, and home prices remain weak. FR Whitpaper?.10.1] vCLEARANCE FINAL 1700 docx 3252015 1:40 AMDRAFT/SENSITIVE/P RE-DECISIONAL Towarps A NEW SYSTEM OF HOUSING FINANCE ‘The Obama Administration has already begun the critical process of reforming our nation’s housing finance market. The Dodd-Frank Act, enacted in July 2010, provides vital protections for consumers and investors that will help end abusive practices in the mortgage market and improve the stability of the overall housing finance system. Since Fannie Mae and Freddie Mac were placed into conservatorship, the FHFA has monitored their business operations closely and strengthened underwriting standards, reducing risk to the American taxpayers. Since 2008, FICO scores and loan-to-value ratios — both key measures of how likely a borrower will be to make mortgage payments — are meaningfully better on new mortgages. Fannie Mae and Freddie Mac have also increased their guarantee fees and adjusted their pricing to better reflect risk. The FHA has also implemented important changes and reforms over the last two years, including strengthening underwriting standards, improving processes and operations, and raising premiums to improve its financial condition. But these measures are only first steps. We must move forward with additional reforms to better protect taxpayers and improve the long-term health of the housing market. ‘The Qhama Adminisiration's.reform lai is designed to: 1. Pave the way for a robust private mortgage market by reducing government support for housing finance andiwinding/OWia annie Masland Freddi)MGSn a responsible timeline. 2. Address fundamental flaws in the mortgage market to protect borrowers, help ensure transparency for investors, and increase the role of private capital. Target the government's vital support for affordable housing in a more effective and ‘transparent manner. Any responsible reform effort that addresses the flaws in the pre-crisis housing market will make credit less easily available than before the erisis. Any such changes should occur at a measured pace that allows borrowers to adjust to the new market, that preserves widespread access to affordable mortgages for creditworthy borrowers, including lower-income Americans, and that supports, rather than threatens, the nation’s economic recovery. 1 Paving the Way for a Robust Private Mortgage Market In the wake of the financial crisis, private capital has not sufficiently retuned to the mortgage market, leaving Fannie Mae, Freddie Mac, FHA, and the Government National Mortgage Association (“Ginnie Mae”) to insure or guarantee more than nine out of every ten new mortgages. Under normal market conditions, the essential components of housing finance ~ buying houses, lending money, determining how best to invest capital, and bearing credit risk — are fundamentally private-sector activities. Although the government still has an important role to 8 HER Whitepaper 210.11 yCLEARANCE FINAL 1700 docx 372872015 1:40 AMDRAFT/SENSITIVE/PRE-DECISIONAL play in housing finance, private markets ~ subject to strong oversight and standards for consumer and investor protection — should be the primary source of mortgage credit and bear the burden for losses, The Obama Administration, in consultation with FHFA and Congress, will work to restrict the areas of mortgage finance in which Fannie Mae, Freddie Mac, and the FHLBs operate, so that overall government support is substantially reduced. Our commitment to ensuring Fannie Mae and Freddie Mac have sufficient capital to honor any ‘guarantees issued now or in the future and meet any of their debt obligations remains unchanged. Ensuring these institutions have the financial capacity to meet their obligations is essential to continued stability, and the Administration will not waver from its commitment. Given Fannie Mae and Freddie Mac’s current role in the mortgage market, we must proceed carefully with reform to ensure government support is withdrawn at a pace that does not undermine economic recovery. We believ inder the P’ d Winding Down Fannie Mae and Freddie Mac on a responsible timeline. The Administration will work with FHFA to determine the best way to responsibly reduce Fannie Mae and Freddie Mac’s role in the market and ultimately wind down both institutions, i finance. These efforts must be undertaken at a deliberate pace, which takes into account the impact that these changes will have on borrowers and the housing market. + Increasing guarantee fees to bring in more private capital. We support ending the unfair capital advantages that Fannie Mae and Freddie Mac previously enjoyed and recommend FHA require that they price their guarantees as if they were held to the same capital standards as private banks or financial institutions. This will mean that the price of the guarantee offered by Fannie Mae and Freddie Mac explicitly reflects its risk, and will help the private market compete on a level playing field, reducing Fannie Mae and Freddie Mac’s market share over time. Although the pace of these price changes will depend significantly on market conditions, such changes should be phased in over the next several years. * Increasing private capital ahead of Fannie Mae and Freddie Mac guarantees. In addition to increasing guarantee pricing, we. wi sue additional credit-loss protection from private insurers and other capital providers. We also support increasing the level of private capital ahead of Fannie Mae and Freddie Mac's guarantees by requiring larger down payments by borrowers. Going forward, we support gradually increasing the level of required down payment so that any mortgages insured by Fannie Mee or Freddie Mac eventually have at least a ten percent down payment. + Reducing conforming loan limits. The conforming loan limit is the maximum size of a loan that Fannie Mae and Freddie Mac are allowed to guarantee. In order to further scale back the enterprises’ share of the mortgage market, the Administration recommends that Congress allow the temporary increase in limits that was approved in 2008 to expire as scheduled on 9 [HER Whitepager 2.10.11 vCLEARANCE FINAL 1700 docxDRAFT/SENSITIVE/PRE-DECISIONAL October 1, 2011 and revert to the limits established under HERA. We will work with Congress to determine appropriate conforming loan limits in the future, taking into account cost-of-living differences across the country. As a result of these reforms, larger loans for more expensive homes will once again be funded only through the private market. + Winding down Fannie Mae and Freddie Mac's investment portfolio: Fannie Mae and Freddie Mac were allowed to behave like government-backed hedge funds, managing large investment portfolios for the profit of their shareholders with the risk ultimately falling largely on taxpayers. Jos BSB sndlleaSa uae inians by winding down their investment portfolios at an annual pace of no less than 10 percent Implementing a wind down of Fannie Mae and Freddie Mac's future participation in the housing market requires recognition of both the fragile state of that market today and the private sector's need for clarity about the speed with which that transition will take place. As the market begins to heal and private investors return, we will seek opportunities, wherever possible, to accelerate Fannie Mae and Freddie Mac’s withdrawal. Returning FHA to its traditional role as targeted lender of affordable mortgages. In addition to winding down Fannie Mae and Freddie Mac, FHA should retum to its pre-crisis role as a targeted provider of mortgage credit access for low- and moderate-income Americans and first-time homebuyers. (Today, FHA’s market share is nearly 30 percent, compared to its historic role of between 10-15 percent.) As Fannie Mae and Freddie Mac's presence in the market shrinks, the Administration will coordinate program changes at FHA to ensure that the private market — not FHA — picks up that new market share. To accomplish this objective, we recommend decreasing the maximum loan size that can qualify for FHA insurance — first by allowing the present increase in those limits to expire as scheduled on October 1, 2011, and then by reviewing whether those limits should be further decreased moving forward. As we begin to pursue increased pricing for guarantees at Fannie Mae and Freddie Mac, we will also increase the price of FHA morigage insurance. We have already acted on this front, raising premiums two times since the beginning of this Administration, And we will put in place another 25 basis point increase in the annual mortgage insurance premium that is detailed in the President’s 2012 Budget. This will continue the ongoing effort to strengthen the capital reserve account of FHA, and put it in a better position to gradually shrink its market share, Going forward we will coordinate reforms of Fannie Mae and Freddie Mac with changes at FHA to help ensure the private market, not FHA, fills the market opportunities created by reform. Ensuring FHLB support for small and medium sized financial institutions. ‘The Administration believes the FHLBs have played a vital role in our housing finance system by helping smaller financial institutions effectively access liquidity to compete in an increasingly competitive marketplace, But these institutions also developed significant weaknesses as the housing market evolved that should be addressed as part of housing finance reform. HERA has 10 HR Whitepaper 2.10.11 vCLEARANCE FINAL 1700.d0e% snot 1:40 AMDRAFT/SENSITIVE/PRE-DECISIONAL already placed the FHLBs under stricter regulatory oversight, but further reform is required. We will also work with Congress to consider additional means of advance funding for mortgage credit, including potentially the development of a covered bond market. + Focusing on small and medium financial institutions. The Administration supports allowing each financial institution to be an active member in only a single FHLB Bank. We also support limiting the level of advances, which would only have an impact on large financial institutions that can access capital markets already. * Reducing portfolio investments, Similar to Fannie Mae and Freddie Mac, several of the FHLBs were allowed to build up large investment portfolios. These portfolios should be reduced and their composition altered to better serve the FHLB’s mission of providing liquidity and access to capital for insured depository institutions. We support FHPA’s efforts to address this issue, and we will work with Congress to clarity the FHLB’s investment authority. Improving coordination among existing government housing finance programs. In addition to changing the level of government support for the housing market, we also must reform the way government support is delivered. The Department of Housing and Urban Development, the Department of Agriculture, and the Department of Veterans’ Affairs will set up a task force to explore ways in which their housing finance programs can be better coordinated, or even consolidated, to serve the public more effectively. Though they serve different targeted groups of Americans, their programs and borrowers will benefit from greater coordination of systems, information, and market standards. IL Restoring Trust and Integrity in the Broader Housing Market ‘Addressing Fannie Mae, Freddie Mac, FHA, and the FHLBs alone will not give rise to a housing finance market that meets the needs of families, lenders, and investors. Nor will it guarantee that private markets can effectively play a more dominant role in the mortgage market. Fundamental flaws occurred at almost every link in the housing finance chain. ‘The Administration supports the vigorous implementation of reforms to help address pre-orisis flaws and rebuild trust and integrity in the mortgage market. Taken together, these reforms will improve consumer protection, support the creation of safe, high-quality mortgage produets with strong underwriting standards, restore the integrity of the securitization market, restructure the servicing industry, and establish clear and consolidated regulatory oversight ‘The Dodd-Frank Act laid the groundwork for many of these reforms. We will implement its provisions in a thoughtful manner to protect borrowers and promote stability across the housing finance markets, Together, these reforms will form the foundation of a market in which borrowers, lenders, investors ~ along with the broader economy — will all be better off. ret LHR Whitepaper 2.1011 CLEARANCE FINAL 1700.doo% Sr252015 140 AM.DRAFT/SENSITIVE/PRE-DECISIONAL Empowering consumers to avoid unfair practices and make fully informed decisions. The Administration is committed to full implementation of the Dodd-Frank Act’s consumer protection provisions, including the following: * Curbing abusive practices. Under rules to be developed by the Bureau of Consumer Financial Protection (“CFPB"), which was created by the Dodd-Frank Act, lenders will be prohibited from originating high-cost loans with certain abusive features, and mortgage brokers and other originators will be prohibited from accepting financial rewards for steering borrowers into more expensive products than those for which they are qualified. + Promoting choice and clarity. The CEPB also will have the authority to set clear, consistent tales that allow financial services providers to compete on a level playing field and let consumers clearly see the costs and features of consumer financial products and services. The CEPB will take steps to improve and simplify the required disclosures for mortgage loan ‘transactions to promote fairness, transparency, and competition in the mortgage market. Stronger underwriting standards, including requiring lenders to verify ability to pay. Under rules to be prescribed by the CFPB, lenders will be required to make a reasonable and good faith determination that all borrowers have a reasonable ability to repay their mortgage, including by verifying a borrower's income. Increasing transparency, standardization, and accountability in the securitization chain. The Administration believes the securitization market should continue to play a key role in housing finance. That market, however, requires meaningful reform so private investors can confidently participate in the housing market and provide an alternative funding source for mortgages outside of the traditional banking system and government-supported institutions. Requiring originators and securitizers to retain risk ‘The Administration is working with federal regulators to set rules requiring securitizers or originators to retain five percent of a security’s credit risk when sold to investors. Combined with an exemption for mortgages that meet high underwriting standards (Qualified Residential Mortgages, or “QRM”), this requirement will improve alignment of interests between mortgage originators, securitizers, and investors. Rules will be finalized in 2011 and become effective in 2012. Improving access to information among all market participants. The SEC will implement Dodd-Frank Act provisions that set stricter disclosure and reporting requirements so that regulators and investors can more easily understand the underlying collateral and risks of securities. Strengthen transparency and disclosure in credit ratings agencies’ analysis. The Securities and Exchange Commission (“SEC”) will establish an Office of Credit Ratings. This new office will have dedicated compliance resources with the ability to improve disclosure for ratings methodologies, set new requirements to prohibit conflicts of interest, and authorize the SEC to deregister ratings agencies that perform poorly. 12 HR Whitepaper 2.10.11 vCLEARANCE FINAL 1700

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