In the latest of a protracted series of hearings on mortgage finance reform, the House Financial Services Committee, chaired by Rep. Jeb Hensarling, R-Texas, held a hearing Wednesday titled “Building a Sustainable Housing Finance System: Examining Regulatory Impediments to Private Investment Capital.” The hearing featured leading mortgage investors explaining how the mortgage market and the federal entities that now dominate it — Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA) — would have to be restructured if policymakers expect private capital to participate in a market, given the damage caused by the 2008 episode of the ongoing financial crisis.
By way of review, I have been saying that it is doubtful that the damage from decades of abuse can ever be repaired, partly because nothing has ever been done to contain the proclivity of the industry, enabled by compliant so-called regulators, to engage in ever-riskier activities, backed by little or no capital, with the expectation that they will be bailed out by the federal government whenever market conditions turn adverse to the ability to generate abnormal profits.
This hearing did not fully test the theory, because the most demanding industry participants did not testify. The recommendations made on behalf of investors, difficult as they would be to enact and implement, are reasonable compared with those of mortgage originators, who tend to view federal mortgage guarantees as an entitlement program designed to enable them, through the so-called “originate-to-distribute” model, to make fortunes by originating mortgages that will be bought by federal enterprises without the bankers having to put up any meaningful amount of capital.
Admittedly the Dodd-Frank Act is supposed to require originators to retain at least 5 percent of the risk of mortgages they securitize, but as with much of Dodd-Frank regulations, they have yet to be promulgated nearly three years later, and it is doubtful whether they will ever be effectively implemented.
If one were to look at the witness list and ask, “Which of these is not like the others?” it would be Arnold Kling, a teacher who is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. Kling advocates a return to the days of “It’s a Wonderful Life,” when mortgages were held in the portfolios of banks and savings and loans, a model that failed spectacularly before it was replaced by the originate-to-distribute model, which failed even more spectacularly. His testimony was useful in pointing out the limitations of the latter model, but while he is quite knowledgeable about the mortgage market, he is not an investor.
The investor representatives were Chris Katopis, executive director of the Association of Mortgage Investors; Martin Hughes, CEO of Redwood Trust Inc.; and James Millstein, CEO of Millstein & Co. Katopis runs a trade association of mortgage investors that he claims is “the sole unconflicted buy-side investor group.” Hughes represents the only significant private securitizer of mortgages, and Millstein is a leading investor who was in charge of restructuring AIG following the 2008 crisis episode.
Katopis stated, “The current mortgage investor suffers from market opacity, an asymmetry of information between investors and originators or, it can be said, a thorough lack of transparency.” His testimony included a chart with bars representing the levels of private mortgage securitizations from 2000 forward. But from 2008 onward, the bars come to an end, meaning they are near zero.
His principal proposal is that reform should be based on a revival of the principles embodied in the Trust Indenture Act, a Depression-era statute that defined the rights and remedies of investors in corporate bonds. Katopis stated that enactment of such standards is necessary because the current state of the mortgage securities market is that “underwriters do not negotiate with smart investors or even average investors, they write legal documents and make selective disclosures to sell deals to the marginal investor, the one who doesn’t read the papers and doesn’t know or understand what he or she is buying.”
Hughes’ firm is responsible for the 14 private securitizations that have taken place over the past several years, but at the same time, it has become a focal point of the debate, as advocates for government-backed securitization complain that the only mortgages suitable for securitization by Redwood are those with pristine credit. Hughes counters that if needed reforms are instituted, an extensive list that he presented in his testimony, the range of mortgages would gradually expand as the dominance of the government-sponsored entities (GSEs) recedes.
He emphasized that the housing bust was marked by a preponderance of second liens and cash-out refinancing that undermined both the equity of homeowners and the ability of investors to analyze the quality of the securities they were buying. He warned that “since investors have no way of knowing which borrowers will cash out their equity, they must assume that everyone will. This uncertainty leads private investors to demand higher rates in return for the increased risk and means that conservative borrowers will pay higher rates to offset the risk from more aggressive borrowers.”
Millstein associated himself with the consensus that has been expressed by legislators that the dominance of the mortgage market by the GSEs must be brought to an end through the return of private capital, and he offered ideas that he asserted could 1) end the conservatorships (of the GSEs) within three years; 2) fully recover the taxpayers’ investment in the GSEs; and 3) create conditions under which private investment capital can return to the market.
However, in response to a question, he acknowledged that the transition he envisions could take 20 years or indefinitely longer.
In addition to the difficulty of establishing the standards and practices that investors would require, two other difficult issues emerged during the hearing that may come to the fore over the coming months and years.
One is the spreading practice of state and local governments condemning mortgages in order to restructure them for the benefit of the sponsoring lawyers and governments. The other is the interest-rate risk that could overtake the mortgage market while the debate is dominated by credit risk. This could occur if and when the authorities or the market itself unwind the prevailing, but unsustainable, monetary policy known as quantitative easing.
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