Housing Finance Reform: A Pipe Dream?

A crucial piece in our economic-recovery puzzle

Weekly market view from NewOak

The long-awaited reform proposal for the U.S. housing finance system and government sponsored enterprises (GSEs) was finally released by the Committee on Banking, Housing and Urban Affairs. The comprehensive plan provides for a five-year winding down of the current GSE model. The eventual establishment of a Federal Mortgage Insurance Corporation (FMIC) and mandating 10 percent private capital up front are essential to the plan. The five-year transition period to the new system requires the creation of specific benchmarks and timelines for FMIC and private-sector participation.

Most experts agree that a critical contributor to U.S. economic prosperity and long-term growth has been the existence of a healthy, stable and reliable housing finance system that integrates both public policy and private economic forces. The contentious debate has been the separation of the roles of GSEs and the private sector.

For over 50 years, GSE-guaranteed conforming mortgages have been the primary driver in the standardization of conforming-balance, fixed-rate mortgages (fully amortizing over 30 or 15 years) that has led to a highly liquid $5 trillion securitized Agency residential mortgage-backed securities (RMBS) market. The corresponding to-be-announced (TBA) Agency forward trading has also been critical to the growth of the market. The development of the liquid TBA market allows easy hedging of the origination pipeline and hence incentivizes small and large mortgage originators to expand their lending operations with modest amounts of capital. The GSEs and Ginnie Mae have been charged with enhancing the flow and reducing the cost of credit for housing in the United States. They are the most critical mechanism through which mortgages are financed. The soundness of U.S. Agency RMBS threads through the stability of the entire financial system as it constitutes a significant core investment of all banks, credit unions and insurance companies domestically and to some extent globally.

Developing a highly liquid securitization platform under the new model will be critical to its ultimate success. The new platform is mandated to issue a standardized security guaranteed by the FMIC. The FMIC securitization platform will be owned by members. The new system will also strive to maintain a highly liquid TBA market for hedging new and secondary issues. The liquidity of the legacy Agency RMBS should also be maintained.

At a first glance, the bipartisan proposal by Congressmen Tim Johnson (D-SD) and Mike Crapo (R-ID) seems to address all the right issues and be well intended. However, time and again the market has come to doubt congressional initiatives to reduce reliance on GSEs. Perhaps this time congress’ crying wolves may be real, but many believe dismantling GSEs may still be a pipe dream given their 50-year-long success to be the envy of the world in establishing a robust housing finance system. Time will tell.

FDIC Sues Banks Over Lingering Libor Issues

Some people say the Libor scandal is too big to litigate. Last week, the Federal Deposit Insurance Corporation (FDIC) disagreed and filed a lawsuit against the 17 banks and the British Bankers’ Association for the manipulation of Libor and for the damage it did to 38 failed banks.

A number of the world’s largest banks involved in the scandal have already reached settlements with regulators and paid more than $5 billion in penalties around Libor-related claims globally. The FDIC’s lawsuit is the latest chapter in the financial litigation tsunami hitting banks and most certainly won’t be the last.

At this point, there is no argument that Libor was manipulated. The outstanding—and far more complicated issue—is whether financial institutions were harmed or benefitted as a result. With both floating rate assets and liabilities on the books, a netting calculation needs to take place in order to determine whether an institution was negatively affected.

The FDIC alleges that the defendants’ manipulation of the interbank lending rates caused substantial losses to the 38 failed banks. It sounds like the FDIC has done its calculations on these banks and reached the conclusion that they did, in fact, end up on the wrong side of the collusion.

Many other holders of floating rate assets and liabilities are doing their own calculations to see how they fared. Given the zero-sum nature of the floating rate market, where you either paid or received less as a result of the manipulation, if the banks accused of wrong doing are assumed to be the winners, there must be many losers yet to come.