Where GSE reform could be headed and what it might mean for lenders

Reform of the government-sponsored enterprises has long been a contentious topic in Washington, one that has proven particularly resistant to bipartisan collaboration.

But since becoming Federal Housing Finance Agency director, Mark Calabria has sent ever clearer signals that the White House is prepared to take unilateral action that would at least start Fannie Mae and Freddie Mac back on the path to private-sector ownership.

Now, with a Treasury Department report on administrative and legislative solutions to ending the conservatorship of Fannie and Freddie slated for release in the first weeks of summer, it is possible that the U.S. financial services industry will indeed need to prepare for a fundamental overhaul of the nation's housing finance industry.

There is no shortage of ideas about steps the FHFA could choose to take, such as creating incentives to redirect mortgages currently sold to Fannie and Freddie to different buyers or establishing initiatives to lay the groundwork for a multiple guarantor system.

What follows is an exploration of a range of some potential reform scenarios, with a focus on the likely impact on various categories of lenders and thoughts on what industry participants can and should do to prepare themselves.

Some unilateral options

There is a consensus that the FHFA could take some initial steps on its own. One such option would be to adjust pricing for loans outside of those considered central to the GSEs' affordable housing mission in a way that could potentially increase private market competition for those products.

"It feels like there's going to be reduction in the footprint of Fannie and Freddie. I think they're going to make some incremental changes such as increasing the g-fees on certain types of loans," said Tom Pearce, CEO and chairman at MAXEX, a private market trading platform that also reviews, reps and warrants sellers' loans. Those could include investor properties, second homes, cash-out refinances, loans with debt-to-income ratios above 43% and some high-balance loans, he said.

In dollar-volume terms, such a step would be consequential. For context, second homes and investor properties combined made up 13% of the dollar volume of mortgages sold to Fannie and Freddie in 2017, according to GSE data analyzed by MAXEX. When combined with high-balance loans — with a balance of $450,000 or more — as a possible differentiating factor, loans in any one or more of these categories made up a little over half of their dollar volume that year.

The FHFA director has shown an interest in preserving current loan limits and maintaining guarantee fee parity, but Pearce and some others still think the FHFA could call on Fannie and Freddie to reprice conforming jumbos. The impact of that would have its primary impact on high-cost markets, which would address concerns Calabria has voiced about the concentration of GSE loans in markets like California and other pricey locations.

Other steps Calabria might contemplate would take longer to implement. For example, the agency also could direct Fannie and Freddie to reduce their prices for loans outside of the qualified mortgage definition, which is delineated by, among other things, a maximum 43% debt-to-income ratio.

But that change would almost certainly have to wait until the qualified mortgage patch expires, something that isn't scheduled to happen until after the next election.

The so-called patch refers to a temporary exemption Fannie and Freddie have from the need to make loans in line with the QM definition in order to get a safe harbor from ability-to-repay rule liability. It's supposed to expire in 2021 or whenever conservatorship does.

Calabria has made it clear the existence of the patch is a problem — one he would like resolved before 2021.

"The primary problem is that you've got one set of rules that applies to everybody else and one set of rules that applies to Fannie and Freddie," he said in an interview in April.

However, as Calabria himself acknowledges, the fate of the QM patch is ultimately in the hands of the Consumer Financial Protection Bureau.

Overall, Calabria said the best outcome would be for the CFPB to change its approach to Qualified Mortgages in the first place.

"To me, fixing a lot of the problems with QM will alleviate the need for a patch," he said. "I want to ... see the two converge in a place where everybody is under the same set of rules."

This would address the fact that most government-insured mortgages have a QM exemption with no expiration date as well.

An estimated 25%-30% of the mortgages the GSEs buy would be non-QM loans if the patch were not in place, according to estimates by Redwood Trust based on Fannie and Freddie's credit risk transfer data. That level of exposure should be enough to convince mortgage lenders to explore building or adding to their networks of secondary market buyers.

"If I'm a lender trying to think through what I'm going to do for the next year, I would try to have some private outlets for those marginal types of loans products. I'd also want to maintain relationships with whole loan buyers that hold for investment," said Larry Platt, a partner at law firm Mayer Brown who concentrates his practice on real estate finance, mortgage banking and consumer finance issues.

Of course, there isn't exactly a surfeit of private-sector buying interest at this point. According to Urban Institute numbers for 2017 that MAXEX analyzed, Fannie and Freddie were end-investors for more than 45% of loans originated and another 22% were absorbed by the government market. Of the remainder, 30% were kept by banks in portfolio leaving the private-label market as the end-investor for about 2%.

While banks' market share is significant, their interest in buying mortgages has declined and is considered unlikely to expand.

"It's not an important line item for the banks anymore," said Chris Whalen, chairman of consultancy Whalen Global Advisors.

Sharing more risk

There are other considerations behind some of the reform ideas. Risk sharing is a topic that has drawn consistent attention, especially given the nearly nonexistent capital held at the GSEs.

The preferred stock purchase agreements with the Treasury established in conservatorship have limited Fannie and Freddie's ability to retain capital as a buffer against risk. However, Calabria has repeatedly said that he wants that situation to change and with the Treasury and Department of Housing and Urban Development at work on potential conservatorship exit plans, the FHFA could soon have the ability to direct Fannie and Freddie to retain risk-based capital more in line with the private market's standards.

That would make holding risk more expensive for the GSEs, which could increase the need to shed it.

"To the extent FHFA requires more capital, it could make it more expensive to hold risk, and if it gets more expensive to hold risk, you're more likely to want to sell some of that risk off," said Ed DeMarco, president of the Housing Policy Council and a former acting director of the FHFA.

The GSEs already do this to some degree through the variety of credit risk transfer vehicles established during conservatorship, which Calabria wants to preserve. But they could go further, for example by expanding front-end risk sharing, which can be structured such that risk can be shared at origination. To date, this is something the GSEs' single-family operations have only dabbled in. More common are back-end deals in which risk is shared on closed, seasoned loans.

Front-end risk sharing can be attractive to some lenders because they may be able to get more of a direct benefit from a credit risk transfer if it's done upfront rather than on the back end.

Creating competition

Another alternative would be a legislative effort that would encourage the creation of more competing guarantors. Calabria has supported this idea and Senate Banking Committee Chairman Mike Crapo included it in his recent GSE reform proposal.

More buyers could arguably translate to more competitive pricing for lenders' loans.

"That might help, having some other players in the market," said Tom Millon, CEO of Computershare's North American loan services division.

While multiple guarantors might not become a reality any time soon, if the market starts to sense they are likely to become a reality down the road, it could lead to a shift in pricing that makes the private market more competitive, Millon said.

One upshot in many of these scenarios could be a transition to a market where banks and bigger players or groups have more of an upper hand and secondary marketing work takes on more importance.

Scott Olson, executive director of the Community Home Lenders Association, voiced concern about the prospect of Wall Street banks or other big players gaining significant market advantages in a post-reform era.

"An ongoing concern for our members and all smaller lenders is that g-fee parity policies stay in place, so that we don't have volume discounts, which could still occur, depending on how GSE reform is done," he said. "CHLA has been one of the most vocal opponents of chartering new GSEs on the grounds that they could act as securitization conduits, and that could open it up to Wall Street banks blurring the lines between the primary and the secondary markets."

Still, mortgages is already a scale market and some say that even if things stay as they are, continuing consolidation may eventually compel smaller players to respond, whether by pooling resources, automating where they can or merging with larger entities.

If the status quo were to be maintained, "the market becomes more and more commoditized, and it becomes a race to the bottom that benefits the larger player," Computershare's Millon said.