FHFA's DeMarco Offers Two Ways Forward on Housing Finance Reform

CHICAGO — Federal Housing Finance Agency Acting Director Edward DeMarco outlined two strategies on Thursday to help draw private capital into the housing market to replace Fannie Mae and Freddie Mac.

Speaking to the Federal Reserve Bank of Chicago's annual banking conference, DeMarco said one idea would be to re-create a model similar to that used by Fannie and Freddie prior to their collapse, but give it an explicit -rather than an implicit — guarantee from the government. Another approach, he said, would rely on "standardization and transparency" in the securitization market to attract private capital.

Both approaches face challenges, he warned, and reiterated that policymakers should outline a concrete way forward on housing finance reform.

"Deciding what part of that market should be served by traditional government credit program is essential to framing the debate for the government's role in the rest of the market," said DeMarco. "Most people are referring to private capital absorbing the credit risk that is supported by the federal government through the financial support currently provided to Fannie Mae and Freddie Mac."

Hoping to jolt a broader policy discussion, DeMarco suggested that his two approaches could be utilized to help draw private capital in the near-term to the mortgage market. Both would be retooled methods from the past, but with certain adjustments could potentially aid the transition away from Fannie and Freddie.

He dubbed the first an issuer-based approach, in which a specially-chartered financial institution would pool capital from the company's shareholders and provide the basis for a guarantee of principal and interest to mortgage-backed securities holders.

"The corporate guarantee could be further backstopped by a taxpayer guarantee, for which investors would pay a government-set fee to the Treasury," said DeMarco.

The concept, DeMarco noted, was not "novel," but similar to Fannie and Freddie's model pre-conservatorship. The looming question, he said, that would need to be addressed is whether swapping an implicit guarantee with an explicit guarantee would resolve past shortcomings or create new problems.

"Clearly if the securities offered in a reformed housing finance market have a government guarantee, those securities will be priced favorably and have a high degree of liquidity to reflect that guarantee," said DeMarco. "This would ensure a reliable source of funds to the housing market."

But, he said using such an approach would not provide market-based pricing of credit risk and would require a significant amount of regulatory oversight. It also raises a number of issues, including the government's ability to price exposure or a continuation of the principal-agent problem between stockholders and taxpayers that plagued the government-sponsored enterprises.

"While it is somewhat similar to the past, we have experience setting up government insurance structures and establishing regulatory regimes to address some of these challenges," said DeMarco. "We have also experienced the failures of those regimes in the past. We have learned from those experiences and improvements can be made."

The other approach was securities-based and would rely on a structure that would help pool capital needed to absorb future losses in the mortgage-backed securities market.

"The simplest structure is a senior-subordinated security structure where the investors in the subordinate piece absorb credit losses ahead of the senior security holders," said DeMarco. "A sufficiently large subordinate security should insulate the senior investors from credit losses in all, or almost all, credit outcomes."

In order to attract investors, policymakers would need to address a number of areas including standard data definition, loan quality assurances, servicing standards, and data disclosure.

"What the securities-based approach would be establishing is a market infrastructure for the pricing and capitalizing of mortgage credit risk," said DeMarco. "If such an approach were established, it would allow for the broader disposition of credit risk across capital market investors, as opposed to the equity investors in the issuer-based approach."

But just like the issuer-based approach, there are a number of considerations that need to be made, including the increased volatility in the price of mortgage credit versus the price that comes with a government guarantee and the amount of capital available to absorb the credit risk currently undertaken by the enterprises.

DeMarco noted under both approaches, private investors would be compensated for pricing and bearing mortgage credit risk ahead of a government guarantee, if such a guarantee exists at all.

"In either approach, the point is to pool capital sufficient to bear mortgage credit risk while efficiently pricing such risk," said DeMarco.

However, he said both approaches differed from each other based on the varying institutional and regulatory frameworks that would be needed and in the potential systemic risk that could result.

DeMarco noted that under either approach, an ultimate government backstop could be deployed, although the securities-based approach has" more flexibility" in how that might be done.