Why Capital Is Key Battleground in GSE Reform Debate

WASHINGTON — The Senate Banking Committee is making progress toward drafting legislation to overhaul the mortgage finance market, but one of the biggest unresolved issues is how much skin in the game private market participants must have in return for a government guarantee.

Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., introduced a bill this summer that would establish an explicit government backstop but require industry players to put up 10% in first-loss capital — a figure that continues to be debated as Banking Committee leaders write their own legislation.

Determining an appropriate amount of capital for the new system is proving to be both a political and technical issue, one that involves numerous trade-offs for stakeholders and will ultimately be critical to the market's functioning if Congress approves a plan like Corker-Warner.

"Lenders want to pass along as much of the risk as possible, and there's going to be pushback to make sure the taxpayer is protected. That's always going to be a fault line on this," said Mark Calabria, director of financial regulation studies at the Cato Institute and a former Republican Senate aide.

Below, we tackle some of the key issues in the debate over capital requirements as lawmakers work to unwind Fannie Mae and Freddie Mac.

Determining the Right Number
Experts and observers from across the political spectrum have begun weighing in on the proposed 10% figure in the Corker-Warner bill, with many predicting it could be lowered at some point before any plan is signed into law.

In many ways, the figure represents the types of very real compromises Democrats and Republicans will have to make to get legislation passed. It is enticing for conservatives like Corker because it provides a significant buffer for the market to bear losses before the government, and taxpayers, are on the hook, but it also preserves the role of the government in the market, a key goal for Democrats.

"10% is a political number," said Edward Mills, an analyst at FBR Capital Markets. "It is there to get Republicans to be willing to cosponsor a bill that lets the government backstop remain."

By comparison, many estimates suggest that roughly 5% capital would have covered losses at the government-sponsored enterprises during the financial crisis, leading some in the industry, including those that would have to front this capital, to argue that a figure closer to that amount would be more appropriate. Those observers warn that raising enough capital to meet the 10% standard could prove difficult and that the extra costs would get passed on to borrowers.

Ultimately, the politics of the debate may be the true driver behind wherever the number lands. Corker has been a strong defender of the 10% figure so far, which could make it harder for him and other Republicans to compromise down the line.

"It backs Sen. Corker into corner — the more he hears it doesn't work, the more he's forced to defend it and the harder it is to change," said Mills.

Still, the negotiating has largely shifted for now to the banking panel leaders, as Chairman Tim Johnson and Sen. Mike Crapo, the committee's lead Republican, work to craft their own plan — one that will likely draw on the Corker-Warner bill. It's not clear whether Crapo, who has suggested that in theory he would prefer a fully private market, would agree to lowering the 10% requirement in a system with a government backstop.

"The only way I see that number budging is if Crapo agrees to a taxpayer guarantee, but his price is that standards for the mortgages that can access that guarantee are as strong or stronger than [the qualified mortgage rule] and specific," said Brandon Barford, a vice president at ACG Analytics. "By imposing more stringent criteria, the quality of the potential loan pool improves and utilizing underwriting that is crystal clear reduces regulatory discretion."

He added: "If you look at the questions he asks at the hearings, they are always about reducing regulatory wiggle room and protecting the taxpayers."

At the same time, the committee leaders will also have to try and pacify more liberal members of the committee, such as Sens. Sherrod Brown, D-Ohio, and Elizabeth Warren, D-Mass., who have yet to sign on to any GSE reform plan.

"How do you build a bill that keeps on the 10 members who signed onto Corker-Warner while getting the liberals on the committee to be supportive and have bipartisan leadership approval? That's a very difficult task," said Mills.

The Role of a New Regulator
Even as specific figures are being debated on Capitol Hill, some have raised concerns about whether the final figure should be left to a proposed new regulator for the reformed system. Supporters of the idea, including David Stevens, president and chief executive of the Mortgage Bankers Association, argue that a regulator would have more flexibility to assess changing conditions in the market and other factors that might go into setting capital requirements. 

But others warn that handing off the decision to the regulator is tantamount to punting on the decision, and could very well lead to a lower figure.

"It's the fallback position of those who envision a malleable regulator," said Phil Swagel, a former Treasury official in the Bush administration who is now a professor at University of Maryland School of Public Policy. "This seems important enough for Congress to get it right."

Is There Enough Capital Out There?
Part of the debate, particularly for critics of the 10% number, has centered on whether there is enough private sector interest to raise the necessary capital, and how those funds should be held and structured. Unfortunately, many of these questions remain unanswered thus far.

"The focus has been on the 10%, and not as much on what's actually in that 10%," said Calabria. "The substance of that 10% matters a lot, and I suspect that is an aspect on which people might try to get some change."

The Corker-Warner plan suggests securitizers could use credit enhancements either on a specific pool of loans or via a bond-guarantor structure as a way to count toward the 10% figure, but the details have not been fleshed out. Questions have also been raised about whether the 10% capital requirement would include both equity and debt.

"It seems as if Sens. Corker and Warner have taken 'field of dreams' approach - if you build they will come," said Mills. "You can't wish and have private capital formalize. There are ways to conceptually come up with this credit enhancement requirement, but the investment community will need a lot more information about what their goals are before a final determination can be made on whether it will or will not work."

Meanwhile, others note that it's less a question of the capital being available, but how high the cost might be.

"There is a large amount of money out there and an increasing universe of investors want to potentially participate. The question is, money at what price?" said Barford. "What does the rate of return have to be, and what does that mean for mortgage rates?"

Indeed, mortgage rates are likely to increase under a new system, though experts are just now beginning to offer estimates as to how much.

Mark Zandi, chief economist at Moody's Analytics, has argued that the Corker-Warner plan could increase interest rates for the average borrower by 50 to 75 basis points for the first 15 years in the wake of a system overhaul and then drop to between 35 and 55 basis points, based on the 10% capital figure and other provisions. A recent study by the Urban Institute put the additional costs for mortgage originators closer to 39 basis points for a loan, which would likely be passed on to consumers.

Still, observers note that those increased costs are less than what would be likely under a fully private system, like that advocated by some House Republicans. By comparison, Zandi has estimated that Rep. Jeb Hensarling's bill to overhaul the GSEs could raise interest rates for the average borrower by 90 basis points.