GSE Reform Bill Falls Short of Assuring Small Lenders Survive

Much to the joy of community bankers, the Johnson-Crapo housing reform bill explicitly establishes a framework designed to ensure small lenders can effectively compete in the new mortgage secondary market. Reducing barriers to entry, ensuring regular access to the secondary market and competitive pricing will address many concerns about the competitive viability of community banks in a largely privately capitalized mortgage market. A number of important issues, however, remain unanswered.

These issues include the capitalization method for the new Small Lender Mutual cooperative that would serve the secondary market needs for community banks; liquidity for their securities; and potential pricing differentials between large lender securities and those issued on behalf of small lenders.

The long-term sustainability of small lender securitization could be preserved by capitalizing the Small Lender Mutual cooperative from a special guarantee fee assessment on large lenders; establishing multilender pools that provide broad geographic diversification to small lenders; and offering credit enhancement opportunities typically available to only larger banks.

Smaller lenders historically have faced a number of issues affecting their competitive position vis-a-vis large banks and mortgage companies. A lack of scale and differential pricing of guarantee fees (based in part on volume rather than credit risk) by Fannie Mae and Freddie Mac fed a secondary market that profited large lenders at the expense of their smaller brethren. Managing complex pipeline and interest rate risks, an inability to geographically diversify their portfolios and the operational complexities of the securitization process further handicapped many small lenders.

Drafters of the Johnson-Crapo bill clearly recognized the importance of preserving small lender access to the mortgage secondary market when they designed the Small Lender Mutual. Members of this new cooperative structure would be able to sell whole mortgage loans for cash as well as have access to securitization services. Large lenders historically were able to use their market power to extract substantial concessions in guarantee fees from Fannie and Freddie. These concessions were not typically passed along to small correspondent lenders. In recent years, the Federal Housing Finance Agency has improved pricing for small lenders via the cash windows at each government-sponsored enterprise. The Small Lender Mutual would go a long way toward insulating community banks from large lender pricing tactics.

Establishing the Small Lender Mutual structure does not, however, ensure small lenders' long-term success in the new secondary market.

First there is the issue of capitalizing the cooperative. Costs would be substantial for small lenders. One alternative, requiring a tweak to the bill, would be to levy a special assessment or even an ongoing charge on large lenders to capitalize the Small Lender Mutual.

Also, there is no assurance that the liquidity of securities issued by the cooperative would be as deep as it would be for large bank and nonbank issuers. And there very well may be structural differences in the pricing between large issuer securities and those issued by the Small Lender Mutual. We have seen consistent pricing differentials between Fannie and Freddie securities for years, owing in part to differences in the underlying collateral which may affect such critical factors in mortgage pricing such as prepayment.

Having large lenders contribute capital would be a reasonable way of redistributing legacy distortions in the market that have given rise to excessive concentration of power in a handful of firms. After all, the quest for scale in origination and servicing begat a massive breakdown in loan manufacturing quality which contributed significantly to the crisis. Allowing large lenders to join the cooperative is no solution; it would invite capture of the new entity by these firms regardless of how the governance structure is designed.

To succeed at securitization, small lenders could bundle their loans into multilender pools similar to what Ginnie Mae and the GSEs offer but with a twist that would allow small lenders access to credit-risk-sharing alternatives. Multilender pools should be assembled to provide broad geographic diversification and allow small lenders to retain a pro-rata share of the broader pool to lessen credit risk concentrations. With rigorous mortgage underwriting standards in place this could be an effective way for smaller lenders to mitigate excessive exposure to a particular geography.

The Federal Home Loan banks, in their Mortgage Partnership Finance programs, are an example of how small lenders can transfer credit risk easily to other counterparties. These structures, as well as others offered by private mortgage insurers (via deeper coverage and risk-sharing arrangements), should be part of any viable small lender secondary market strategy.

The Johnson-Crapo GSE reform bill has much to like from the small lender perspective by carving out an explicit placeholder for these companies. However, so many operational and financing details remain unanswered that community banks should cast a wary eye toward the future of secondary market reform.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland and and a principal in Chesapeake Risk Advisors LLC.