Restoring Trust in Mortgage-Backed Securities

The mortgage finance market has leaned heavily on government support over the past few years. More than 90 percent of mortgages originated in 2011 were securitized by government entities using taxpayer funds to guarantee investors against default risk. And over $5.8 trillion in home mortgage debt in the United States is now either owned or guaranteed by a federal entity – be it the Federal Housing Administration (FHA), Ginnie Mae, the Veterans Housing Administration, or one of the two government-sponsored enterprises (GSEs) under "conservatorship" since 2008. This support cannot continue forever.

The status quo perpetuates many of the policies that contributed to the housing bubble and consequently promotes an unstable mortgage market. And the mother lode of guaranteed mortgage debt constitutes a significant taxpayer liability. In order to avoid another crisis, the government must exit mortgage finance and private capital must shoulder mortgage default risk.

However, there are at least four roadblocks preventing this transfer from happening. In a newly released Reason Foundation study, we argue that there are:

1.  High conforming loan limits which perpetuate market share dominance of Fannie Mae and Freddie Mac, and the growing market share of Ginnie Mae and FHA;
2. Risk retention requirements in the Dodd-Frank Act;
3. The complex legal framework governing residential mortgage-backed securities (RMBS); and
4.  A profound lack of confidence in the models used by credit rating agencies to assess RMBS and in the rating agencies themselves.

The good news is that there has been a wide range of proposed solutions for the first three of these solutions, both as legislative drafts in Congress and in academic circles. For instance, there are dozens of plans suggested to unwind Fannie and Freddie. And the conforming loan limit for FHA could simply be lowered from the outlandishly high $729,750 to 80 percent of median housing price or a similar alternative. The Dodd-Frank rules could be repealed and legal clarity put into law for limiting future mortgage-backed security “tranche-warfare.”

However, the proposed rating-agency changes in Dodd-Frank are not enough to overcome the distrust in ratings agencies, the forth roadblock. In order to overcome private sector skepticism and encourage the wholesale transfer of housing credit risk away from the taxpayers, we propose in our study a series of legislative policy reforms, industry led reforms, and regulatory reforms.

First, Congress should authorize underwriters to include property-level address data in RMBS disclosures so that investors or independent analytic firms can perform more detailed and accurate risk assessments at lower cost. Naturally, banks want to know the address of the home they are loaning a few hundred grand to a borrower to buy. Mortgage investors should be allowed the same privilege. This would enable many investors to perform real-time due diligence be less dependent on the ratings agencies, whom they do not trust.

Second, the mortgage-finance industry should create an organization—a Mortgage Underwriting Standards Board—to provide self-regulation against misrepresentation and to enhance liquidity by replacing QRMs with industry established categories of mortgages that are transparently defined by risk appetite to compete with the status quo binary standard (i.e., AAA, BB-, CCC+) that improperly shields investors from the true nature of the mortgages they are investing in.

This group, based in-part on a Financial Accounting Standards Board (FASB) model, could provide all of the benefits of ratings that provide the ability to quickly assess the risk of a RMBS investment while avoiding the generalized label trap. With tight bands on the characteristics determined for each type of mortgage, the mortgage finance could be opened up to numerous smaller investors and a much wider liquidity pool.

Third, the mortgage-finance industry should encourage common formatting of RMBS collateral data and the inclusion of cash flow-waterfall models with prospectuses to make investor due diligence easier, more competitive, and less costly.

Fourth, the NRSRO system should be completely abolished. While it remains, regulators should encourage greater access to RMBS offering materials prior to origination (so that they are not only available to the issuer-hired rating agency), and allow third parties to challenge overly optimistic ratings used in the determination of bank regulatory capital requirements.

These proposals from our Reason Foundation study would encourage investor due diligence and facilitate the availability of third-party analysis. By increasing access to information and insight, they should encourage investors to buy private-label RMBS, enabling the government to scale back its involvement in residential mortgage finance without precipitating a collapse in home prices.

Ironically, there is more bipartisan support for reducing taxpayer mortgage debt liability and GSE market share than on many other political issues. Policy proposals from both Republicans and Democrats, a white paper from the Treasury Department and the Department of Housing and Urban Development, and a host of research groups and academics have almost all focused on reform ideas that view the private sector as the foundation for the housing market. However, agreement in principle is not agreement in practice. And the conversation on how to move the government out the way has stalled.

We hope these ideas contribute to the conversation and help nudge process forward. Attracting private capital to residential mortgage finance is challenging. But perpetuating government control of housing finance in today’s era of high deficits is unaffordable.

Anthony Randazzo is director of economic research for Reason Foundation. Marc Joffe is a principal consultant at Public Sector Credit Solutions. Here is a link to their full study.