Edward J. DeMarco, Acting Director of the Federal Housing Finance Agency (FHFA) appeared before the Senate Banking Committee today.  According to his prepared remarks DeMarco will tell the senators about the progress his agency has made in its dual role as conservator of the two government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae and as regulator of the Federal Home Loan Banks (FHLBanks.)

DeMarco briefly recapped the goals set for FHFA as conservator and what has been accomplished to date. 

• The operations of the GSEs have largely stabilized while both mortgage originations and securitizations continued to function throughout the financial crisis.
• The focus on foreclosure prevention efforts has been critical to helping homeowners in distress and essential to meeting the conservatorship mandate to preserve and conserve the GSEs' assets.
• FHFA has clarified that the GSEs would be limited to continuing their existing core business and, while there is still legacy credit exposure to work through, there is now in place loss mitigation infrastructure to help borrowers and protect taxpayers.

With these accomplishments FHFA has moved into a third phase of conservatorship and its 2012 Strategic Plan presents three goals.

1.   Build a new infrastructure for the secondary mortgage market.

2.   Gradually contract the Enterprises' dominant presence in the marketplace while simplifying and shrinking their operations.

3.   Maintain foreclosure prevention activities and credit availability for new and refinanced mortgages.

DeMarco has covered these three goals in previous House and Senate testimony and in numerous public remarks.  A summary of the Strategic Plan from a 2013 perspective is available here along with a discussion of the proposed new securitization platform and uniform contracts which DeMarco also described in detail in today's testimony.

DeMarco reviewed some recent FHFA changes which include a new streamlined loan modification initiative that will require servicers to automatically offer eligible delinquent homeowners an easy way to lower monthly payments and modify their mortgage even without providing complete packages of documentation.   FHFA has also changed the representation and warranty framework for conventional loans sold or delivered to the GSEs.  These changes clarify lenders' repurchase exposure and liability and move the focus of quality control forward to the time loans are delivered to the GSEs rather than at the occasion of default.

The second strategic goal set for the conservatorship is to contract the GSEs' presence in the marketplace.  As part of this FHFA has set a target of $30 billion of unpaid principal balance in credit risk sharing transactions in the single-family credit guarantee business of both GSEs. To accomplish this the GSEs are encouraged to consider transactions involving expanded mortgage insurance, credit-linked securities, senior/subordinated securities, and perhaps other structures.  The goal for 2013 is to move forward with these transactions and to evaluate the pricing and the potential for further execution in scale.

DeMarco said FHFA expects to continue increasing guarantee fees in 2013 as a way to contract the GSEs' market presence and encourage private capital back into the market, not as a revenue measure.  He thanked senators for passing a resolution prohibiting the use of these fees for non-housing related purposes. 

FHFA is setting a target of a 10 percent reduction in new multifamily business acquisitions from 2012 levels.  This will probably be achieved through some combination of increased pricing, more limited product offerings, and tightened underwriting standards.

DeMarco said FHFA was also setting a target of selling an additional five percent of the liquid portions of the GSEs' retained portfolios above the 15 percent currently required by the revised Preferred Senior Stock Purchase Agreements.  DeMarco said that given natural run-off in the portfolios they would likely have satisfied the PSPA reduction targets in the next few years so requiring them to sell from the less liquid portions of their retained portfolios (delinquent loans and their own MBS) should lead to an even faster reduction than required by the PSPA. 

DeMarco highlighted other priorities for FHFA in 2013.  One is the near-term efforts regarding mortgage insurance, updating master policies by clarifying the role and responsibilities of carriers, especially when servicers pursue loss mitigation to help delinquent borrowers and formulating new eligibility standards to ensure financial, operational, and management capacity of the counterparties

Another project is the development of an aligned set of standards for forced or lender-placed insurance.  FHFA intends to address certain practices related to this insurance including sales commissions received by sellers and servicers when placing and maintaining coverage with particular insurance providers through entities owned or controlled by the seller or servicer.  It also hopes to establish a set of standards that might be adopted by a broader set of mortgage market participants similar to what was done with the Servicing Alignment Initiative.

DeMarco said that while planning for the future, FHFA continues to fulfill its supervisory role with both the GSEs and the FHLBanks.  The agency has strengthened its supervision and oversight of GSE activities and, in the last year has put in place several changes that will allow it to quickly and effectively respond to emerging risks and developments.  In 2013 FHFA intends to:

• Assess the risks posed by new initiatives, including the new securitization platform, contract harmonization, and multifamily and REO disposition programs, to insure they are being implemented under a sound control framework.
• Maintain a full understanding of the Enterprise's overall risk profile, particularly for the incremental risk created by implementing the new initiatives while maintaining and upgrading information systems and internal controls.
• Determine if the board and management are taking appropriate steps to comply with conservatorship and supervisory directives.
• Develop a formalized process for the ongoing monitoring program.
• Implement the CAMELSO rating system.

After recapping the current financial condition of the GSE's, both of which posted positive net income in the most recent quarter, and the FHLBanks, DeMarco turned to the issue of the future role of the government in housing finance and how large that role should be.

DeMarco that while the role of government is ultimately up to the lawmakers, in his opinion the main purpose of housing reform should be to promote the efficient provision of credit to finance mortgages for single-family and multifamily housing.  An efficient market system for providing credit to people who want to buy houses should (1) provide consumer choice, (2) provide consumer protections, (3) allow for innovation by market participants, and (4) facilitate transparency.

The size of government's present role can be measured in several ways; the proportion of loans that are government guaranteed (65 percent), a flow basis (84 percent) or by securities issuance (over 90 percent.  "However measured," Demarco said, "it should be clear that today's housing finance market is dominated by government support."

DeMarco said the question is how do we move from the market of today where almost all new single-family originations have some form of government support to a future market far more reliant on the private provision of mortgage credit. 

From the point of view of an economist, the answer to the size of government involvement begins with consideration of a potential market failure.  One type of failure might arise if market participants have undue or unnecessary concerns about the ongoing stability and liquidity of mortgage credit in a purely private market across various economic environments.  If this view prevails less credit will be provided than in the absence of this type of uncertainty.  Government response in this case could range from establishing standards and greater transparency for the market, providing liquidity or credit support, or providing a guarantee to largely eliminate uncertainty.

Another potential market failure is the positive externality associated with homeownership.  In this view, the benefits of homeownership extend beyond the individual household to the broader aspects of society, i.e. the opportunity to build family wealth, the willingness of homeowners to improve their property; hence if left solely to the market the number of homeowners will be less than optimal.  A common government approach to increase market demand is to provide some type of subsidy or other assistance to encourage or facilitate such consumption.  Direct subsidies to lower the cost of mortgage credit or easing the eligibility terms for a mortgage are methods of delivering subsidies through the housing finance market.

There seems to be relatively broad agreement that the model of providing private companies with benefits while expecting them to achieve public policy goals does not work.  The first option to this would be to establish standards and rules for enforcing contracts that would provide a degree of certainty to investors.  Investors would be required to price their risk and enforce their rights under standard contracts. 

The second options would be to create a federal backstop that would preserve the availability of credit in times of stress.  For example, could the Treasury Department, the Federal Reserve or the Federal Home Loan Banks play such a role in a market with a standardized framework?

The third option is for a secondary market that would operate with some type of government guarantee somewhat similar to what exists today but one in which private sector capital would stand in first loss position with a guarantee, funding through an insurance premium to cover additional losses.  

DeMarco concluded his testimony by saying that "few could have imagined in 2008 that we would be approaching the fifth anniversary of placing Fannie Mae and Freddie Mac in conservatorship and that we have made little meaningful progress to bring these government conservatorships to an end."  They were never intended to be a long term solution, he said, and the housing finance system cannot really get going again until Congress removes the cloud of uncertainty the conservatorship represents.