AMERICA’S HOUSING FINANCE SYSTEM

IN THE PANDEMIC: TEN STRESS POINTS

TO WATCH
Thursday, March 26, 2020 | Don Layton

The coronavirus pandemic, as this is being written, is still on the upswing in the number of
reported cases, but has quickly caused a financial and economic crisis. And while the housing
finance system is not a central cause of today’s crisis, as it was in 2008, it is rapidly becoming
clear that many longstanding stress points in the country’s mortgage system are nevertheless
becoming highly problematic, even on a systemic-risk scale.

Here, in rough chronological order of when they may appear, is my list of ten stress points to
watch in the mortgage system, some of which the government has already begun to face (with
new announcements every day), and some of which are just beginning to emerge. If these
stresses are not adequately addressed, the impact on the mortgage markets could be severe,
making housing finance more expensive and more scarce, and making the mortgage system a
continuing source of financial instability.

1. AGENCY MBS MREITS – DOES THEIR BUSINESS MODEL FAIL?

Many REITs (real estate investment trusts) specialize in mortgage-related assets (called mREITs),
ranging all the way from highly liquid agency MBS (mortgage-backed securities) to much less
liquid commercial MBS and other real estate debt instruments. They are hedge funds in most
respects, relying on high leverage (secured by their assets) to produce good returns, but leaving
them with tremendous liquidity exposure because they need to keep rolling their debt as they
invest in long-term assets while financing them with short-term liabilities. That imbalance,
especially for mREITs that are in the more illiquid assets, is being stressed right now, as lenders
(mostly Wall Street firms) back away under the tremendous flight to quality and liquidity underway
globally (more on that below). Rumors of imminent failures were circulating last week. This stress
is also moving into mREITs which focus on agency MBS (which I will call “MBS mREITS”). These
have leverage and funding keyed to the extremely high historic liquidity of agency MBS, and since
the flight to quality and liquidity is so strong that even agency MBS is trading with far less than its
usual liquidity, those mREITs are under funding roll-over pressure too. It was announced on
Monday that the two GSEs (Freddie Mac and Fannie Mae) would help finance such inventories
(i.e. lend money to the mREITs using agency MBS as collateral), which definitely contributes to a
solution. The Federal Reserve’s market support programs, of which quite a few have been
announced, should also help.

It is unclear, however, what can be done in the longer run. MBS mREITs play a major role in the
agency MBS markets, and allowing too large a share to be so highly leveraged with such high
liquidity exposure is probably not consistent with being crisis-resistant and resilient.

2. MBS – WATCHING FOR AN AGENCY MBS “ACCIDENT”

The financial stresses today stem from an extreme global flight to safety and liquidity, resulting in
an ultra-high demand for cash and “Treasuries” (securities from the US Treasury), and severe
downward pressures on other securities, even including the agency MBS market, which has
dramatically declined in terms of its usual ultra-high liquidity. Although agency MBS is
government-supported, there is a high spread between the yield on MBS and the equivalent
maturity Treasuries. The agency MBS market has long been regarded as second in size and
liquidity only to the market for Treasuries themselves, and so agency MBS investors are rattled.
As one market analyst put it, this is setting up the conditions for an “accident” (an unusual word to
use in this situation): something that might cause the MBS market to seize up, or lead to an
inability of mortgages to be financed by agency MBS in ordinary course, or perhaps for MBS
investors to lose their funding. With $7 trillion outstanding of such bonds, this would be a major
transmitter of even more market stress. The government is all over this, especially via the Federal
Reserve. The question is how long it will take the Fed’s actions to help the market return to more
normal conditions.

3. FHLBS – WILL THEIR FUNDING “CRACK”?

The 11 Federal Home Loan Banks (FHLBs) together borrow about $1 trillion from the capital
markets, backed by the implicit guarantee of the US government. In the 2008 financial crisis, the
market confidence in that type of unwritten guarantee evaporated for the GSEs, and they fell into
conservatorship; for the FHLBs, market confidence was also shaken, but was ultimately
maintained by the government explicitly showing its support by putting in place a special credit
facility.

There is a risk, hopefully small, of a repeat in today’s stressed markets for the FHLBs. If this
happens, it will show up quickly. In the long run, there should be no implicit (and, as such, unpaid
for) guarantee – it should be made explicit and paid for, just as is being designed into the GSE
system for when the companies exit conservatorship.

4. NON-BANK SERVICERS – ADVANCES

Servicers of Ginnie Mae-related MBS have to advance cash, in lieu of missed payments from
borrowers, for principal and interest to MBS investors in order to insulate those investors from
credit risk. For GSE-related MBS, interest payment replacement similarly comes from the servicers
while principal replacement (much the smaller of the two) comes from the GSEs themselves.
Servicers also have to advance property taxes and insurance when due. The non-bank servicers,
which account for half of the $7 trillion agency MBS servicing market and with limited access to
sources of cash, are being squeezed in two ways by this requirement in today’s crisis. First, the
announced forbearance programs mean that servicers have to advance cash for the missed
payments in likely much larger size than ever experienced before. Second, actual delinquencies
outside or beyond the forbearance programs look set to rise, creating more demand for such cash
advances – especially for Ginnie Mae MBS, where the servicers are obligated to keep MBS
investors cashflow-whole until final credit resolution (e.g. foreclosure), which could be years away.
For GSE MBS, this obligation only lasts 120 days.

The industry and government are on top of this issue, but it needs resolution quickly because the
impact will hit servicers hard in a matter of weeks, and will grow quickly in the coming months.
Without help, the non-bank servicers are likely to fail in large numbers, disrupting the MBS
marketplace.

Longer term, this system of “advances” is unsustainable, and has been a known market stability
problem for some time. It needs to be fixed, likely with MBS investors (especially Ginnie Mae-
related ones) absorbing some of the risk related to late principal and interest cashflows, while
ultimately being protected from credit losses.

5. NON-BANK SERVICERS – MORTGAGE SERVICING RIGHTS (MSRS)

AND ACCOUNTING
The current system of servicer compensation – a flat fee, usually 0.25 percent of loan principal –
worked fine until GAAP (generally accepted accounting principles) required MSRs be put on the
balance sheet of the servicer at an always-changing fair value. This introduced structural
instability in the net worth of all servicers, where large declines in interest rates generate massive
reductions in MSR value and thus servicer net worth. The servicers are suffering from just such a
decline right now, especially given the unprecedented drop in interest rates engineered by the
Federal Reserve as part of its attack on the crisis conditions in the markets. For those servicers
that are not part of much larger organizations, their solvency is at risk. As some servicers also
finance their MSRs (i.e. borrow against their value), this can lead to liquidity strains too. (Hedging
MSRs is done by some, but the risks behind MSR values are so complex that it is only possible to
do so in relatively rough form.)

It is unclear what the government can do in the short run to alleviate the impact of this net worth
issue. The most obvious solution is to move the riskiest servicing from standalone (usually non-
bank) servicers to bank-affiliated ones (which are usually part of larger, broadly-diversified
companies), although this takes time and can only be done in modest size in the immediate future.
Longer term, changing the system of compensation for servicers – getting rid of the simple 0.25
percent fee and replacing it with a schedule of price per functional activity done – will eliminate the
MSR asset and, therefore, its problematic accounting. This has been discussed for years, but
never acted upon. It should be.

6. PMIS – DOWNGRADES, INELIGIBILITY, OR A HIDDEN RESCUE?

There are six private mortgage insurance companies (PMIs) which the GSEs, according to their
charters, must in all practicality use for their “high” (over 80 percent) LTV mortgage purchases. It
is likely, given the economic impact of the pandemic, that the credit quality of the existing
mortgages they have insured will deteriorate. Since PMIs do the riskier part of the riskiest loans for
the GSEs, they will be disproportionately hit with credit losses. Their stock prices have already
dropped by about half in anticipation of this.

The PMI firms going into this crisis were rated from the middle of investment grade down to the
top of below-investment grade.  But downgrades inevitably will follow. Because the GSEs are
unsecured creditors of the PMIs in large size, with no collateral to back up PMI promises to
reimburse the GSEs for credit losses on insured mortgages, the two companies need the PMIs to
be strong enough to back up their promises to pay. At some point, however, it is likely that one or
more PMI firms may become ineligible to do new GSE business (the rules to be eligible were set
by FHFA during conservatorship), because they will have deteriorated so much in
creditworthiness. Because GSE business accounts for virtually 100 percent of PMI revenues, this
would lead to an immediate collapse of such a company, which would then be placed by its state-
level insurance regulator into run-off (i.e. orderly liquidation).

The question then is how much high LTV lending is going to be crimped, and what losses might
be passed onto the GSEs themselves? In the 2008 financial crisis, when three PMI firms failed, the
government engineered a covert rescue of the four other firms by eliminating the requirement that
they have a strong (specifically, AA) credit rating. This kept high LTV lending going in the interest
of countering a major recession. In the short run, then, watch the credit ratings of the PMI firms,
and watch whether FHFA engineers another covert rescue by materially loosening the criteria
under which they can still insure new loans sold to the GSEs and, if so, on what terms? In the long
run, the structure of PMI needs to be revamped so that the GSEs are no longer unsecured
creditors of companies without the very strongest credit ratings, such as the AA rating that was
required prior to 2008.

7. GSES – CRT, EXISTING AND NEW

In 2013, Freddie Mac and Fannie Mae began to do credit risk transfer (CRT) on their single-family
mortgages, which put private capital at risk of losses. They have done a large volume of CRT
since then, but the program is only designed to partially lay off such credit risk. The current crisis
will be a robust stress test of the CRT program in two ways:

Will completed CRT transactions already on the books of the GSEs perform as expected?
This will take time to work through, as loans impaired by the economic downturn can take
years to be fully resolved and their losses known. And this might get beyond economics if
perhaps CRT investors sue, claiming fraud perhaps, or otherwise maneuver to get out of
their obligation, and would such a suit prove successful?
 What damage does the disrupted credit market cause the GSEs? While CRT transactions
were being done through mid-March, the overall fixed income market is now in enough
distress that no such transactions could be issued today. Watch to see if this causes any
permanent damage to the GSEs or the mortgage market. Will the GSEs stop purchasing
more mortgages? Or raise g-fees? It may not do any overt damage at all, except for the
GSEs needing to fully carry the credit risk of new mortgage purchases until the markets
open up again. Since they previously kept 100 percent of the credit risk for the full 30-year
life of mortgages, this should be an easy lift for them, especially while in conservatorship.

8. GSE LOSSES
The GSEs between them have about a $5 trillion book of credit guarantees, mostly in single-family
mortgage, as well as securities investments. They lost large amounts on both in the 2008 financial
crisis, but claim to have since eliminated most of the major sources of those losses: (1) the
investment portfolios are much reduced, with almost no high-risk mortgage securities; (2) they
claim to have laid off significant credit risk via CRT; (3) they claim to have a well-balanced “credit
box” (i.e. credit risk appetite) that is neither too tight nor too loose and which avoids riskier
mortgage products (as defined by the Qualified Mortgage rule); and (4) they even claim their
affordable lending is done prudently. We shall see how this all works out in the coming quarters,
as higher credit loss reserves are generated by the current economic downturn. Ideally, their
credit reserves should rise – they are, after all, supposed to take appropriate credit risk – but not
anything like in the last crisis. The manner in which GAAP accounting works, however, means that
this will only be substantively revealed, with all the disclosed analysis of what caused it, through
the second half of 2020, as second and third quarter earnings are released, and perhaps into
2021. (Some investment-related and interest rate hedging-related losses could occur very much
up-front, by comparison. We will find out about that when first quarter earnings are released
during the second quarter.)

In addition, the forbearance programs being offered to people in distress will cause a spike in
delinquencies. And while delinquencies will apparently not be reported to consumer credit
agencies, they will definitely impact the GAAP-compliant credit reserves required – perhaps not as
much as a straight delinquency would, but certainly by a material amount.

Finally, if credit losses are far higher than believed to be consistent with a properly underwritten
credit box, the ongoing market for CRT will be impacted, either becoming noticeably more
expensive (in which case it won’t be used a lot) or much smaller as investors exit after feeling they
have been “burned.” Watch for CRT volume and pricing when the credit markets open up again –
are they reasonable or not for market conditions at that time?

9. FHA/VA CREDIT LOSSES

The FHA and VA take the credit risk on riskier mortgages than do the GSEs – that’s their function,
and why the two agencies are directly on the books of the government, with no stockholders or
credit ratings to worry about. For years, there has been industry discussion about how poor the
credit risk profile of their books of business really are. Most in the industry, based upon my
interactions over several years, believe the VA book has adequate credit quality, but the larger
FHA one does not. Additionally, while the FHA grew its book of business strongly in the 2008
financial crisis (which was a good thing in terms of being a countercyclical provider of credit), it
never really cycled back down to its traditionally smaller market share, despite the mortgage
market being robust since 2012. That means the FHA book of business is both large and reputed
to be of poor credit quality – a possibly toxic combination.

We’ll now find out if this is true. If so, because both FHA and VA are just part of the federal
government and its budget, there will not be immediate overt signs of distress – like credit rating
downgrades or liquidity problems. The FHA does not need to adhere to GAAP accounting, and so
it may take an extended time for the credit performance of its book to become clear.  But watch
for it – and if it does lose large amounts, will Congress take a hand in revising the business model
of the two organizations, especially FHA, to avoid a repeat?
10. GSE CAPITAL PROPOSAL – A HELPFUL STRESS TEST?
FHFA has outstanding a capital rule proposal to apply to the GSEs when they exit
conservatorship. Such a rule is the very core of financial institutions being safe and sound, and
able to resist collapse in the next market crisis. It was put out for comment under the previous
FHFA director and the current director, Mark Calabria, withdrew it for revision, with the latest date
for its re-publication (which begins a minimum 60-day comment period) being in the back half of
the second quarter of this year. Observers believe the revision will be targeted at certain items
only (such as its procyclical nature) but otherwise take the basic approach of the withdrawn
proposal. However, we’re going through just the kind of stressed markets where such capital
requirements either stand up to that stress, or prove defective in some manner. To that end, FHFA
and the industry more broadly should watch how the proposed capital rule would work in the
current stress environment to understand its dynamics and see if it passes muster or not. FHFA,
while being in a rush related to its desire to keep the exit from conservatorship moving along,
should seriously consider holding the finalization up until the current distressed market works itself
out. As that will take a while to play out (the last one started in roughly 2006-07 and did not really
end until 2011-12), it makes sense for FHFA to wait until at least early 2021 to reach a conclusion.

A STRESS POINT TO NOT WATCH

The GSEs, of course, remain in conservatorship. Each is supported by a written legal agreement
by which the US Treasury gives it access to support in the form of being able to draw down on
funds to be invested in its equity. And the amounts are huge – over $100 billion each. As a result,
the marketplace treats the two companies as being virtually treasury-equivalent risk (i.e. almost
none). So, in this crisis, watching for stresses to the solvency or liquidity of Freddie Mac or Fannie
Mae is very much not on my list. In that sense, the two companies still being in conservatorship
has proved an island of stability in the current market stresses. As described above, they are even
being used to help others.  It’s an unanticipated benefit of the conservatorship taking so long, but
a welcome one right now, nevertheless.

CONCLUSION: LET’S HAVE A PROPER POST-MORTEM

After the 2008 financial crisis, the government (Congress, the administration, and independent
regulators) did lots of comprehensive post-mortem analysis of what did and did not work in the
financial system and what changes needed to be made. But this analysis focused heavily on
banks and Wall Street, in part because it was politically easy to do so. It did not focus
comprehensively on the housing finance system, which is immense – roughly $12 trillion in size –
and exists mostly outside the traditional banking system. Many of the stresses being revealed
today – like the need for non-bank mortgage servicers to make large advances in distressed
markets, that so much agency MBS is owned by highly-leveraged mREITS, and that the FHLBs
rely on funding supported by an implied guarantee mechanism which proved weak back in 2008 –
have been long known in the housing finance industry and policy community.

And while there have been hit or miss efforts to fix these sources of systemic weakness and stress
amplification, hit or miss is proving not good enough right now. No single regulator is in charge,
and lobbying has proven effective at blocking or watering down many proposed changes
because they hurt someone’s bottom line or might make mortgage credit a bit more expensive.

One industry observer recently referenced “our Frankenstein’s monster of a mortgage finance
system.” In many ways it is, and has the longstanding weaknesses now bedeviling it to prove its
monster nature. After the crisis subsides, it will be time for a proper, comprehensive review of
housing finance to improve its liquidity, capitalization, and the many operational mechanisms that
do not do well in a stressed environment. There should be no exceptions to this
comprehensiveness – no exclusion of the PMIs because they are state-regulated, no exclusion of
the non-bank mortgage servicers because they are not banks, and so on. In fact, one could argue
a major conclusion of such a comprehensive review would be to put a single regulatory agency in
charge of the safety and soundness of the entire housing finance system. Such an agency could
be responsible and accountable for making the housing finance system stronger, more resilient,
and a source of strength to the financial system rather than one of the first components to seize up
and amplify problems.