Remarks as Prepared for Delivery
Melvin L. Watt, Director
Federal Housing Finance Agency
American Mortgage Conference, North Carolina Bankers Association
May 18, 2017
Thank you for inviting me to speak today. I don't get here as often as I used to and it's always a pleasure to be in North Carolina.
When I spoke at this conference in 2014, I was relatively new as the Director of the Federal Housing Finance Agency (FHFA). Among the early priorities I set was making the issues we deal with more understandable and transparent and making FHFA more open and receptive to stakeholder input. FHFA's receptivity to good stakeholder input has helped inform numerous decisions since then and many of you here today deserve thanks for the input you have provided on a number of these important decisions. Among many others, this includes decisions about Fannie Mae and Freddie Mac's (the Enterprises) guarantee fees, counterparty standards for private mortgage insurers, the Common Securitization Platform and Single Security, the credit risk transfer programs, affordable housing goals for Fannie Mae and Freddie Mac, and, most recently, duty to serve.
Because the status of the Enterprises in conservatorship and housing finance reform seem to be hot topics these days, it seems appropriate for me today to elaborate on some of the points I made about these topics last week when I testified before the Senate Banking Committee. In the written statement we delivered to the Committee before last week's hearing and in my testimony, I drew a distinction between decisions we have made (and continue to make) as conservator and the decisions Congress must make. The essence of what I said boils down to this: FHFA has made substantial progress during conservatorship on reforming Fannie Mae and Freddie Mac (what I generally think of as "GSE reform"), but it's the role of Congress to do the bigger job I generally think of as "housing finance reform."
As I'm sure you know, FHFA's role as conservator of the Enterprises has been unprecedented in duration (now approaching nine years) and in scope and complexity (considering that the Enterprises support over $5 trillion in mortgage loans and guarantees).
Reforming the Enterprises During Conservatorship
Decisions made by FHFA during conservatorship, many of which were made with your thoughtful input as I have indicated, have fundamentally reformed the Enterprises and their operations, practices, and protocols. They have also significantly aided the liquidity and efficiency of the housing finance markets and reduced exposure and risks to taxpayers. Many of the reforms made in conservatorship are extremely important and they should not be ignored or disregarded by Congress while Congress works on housing finance reform. There are a number of examples.
FHFA has taken steps to reform board governance and day-to-day operations of the Enterprises. Enterprise leadership today – both their boards of directors and senior management – is significantly different from pre-conservatorship. With new, committed leadership and with FHFA setting the course both through conservatorship decisions and through on-site regulatory oversight, Fannie Mae and Freddie Mac have significantly improved their risk management and operations. We've aligned certain business practices, such as loss mitigation standards and counterparty requirements. And we expect the Enterprises to compete on things that matter – like innovation to improve liquidity across all segments of the market, customer service to seller/servicers, and better business practices.
Many of the changes we have made during conservatorship have the effect of reducing the risk of the Enterprises' business model. Before conservatorship, the Enterprises undercharged for their guarantee fees and used their large retained portfolios for investment purposes to drive up their earnings, all while taking on additional interest rate, liquidity, and credit risk. And in conducting their guarantee business for single-family mortgages, except for loans for which they were required to have private mortgage insurance policies, they held on to all of this credit risk.
After careful review and adjustments, the Enterprises' guarantee fees are now appropriately priced. The Enterprises have reduced their retained portfolios by over 60 percent and are well ahead of schedule to meet their PSPA limits. In addition, they have created new programs that transfer a meaningful amount of credit risk to private investors on over 90 percent of their targeted mortgage acquisitions.
The Enterprises are also many years down a path toward developing a common securitization platform and a Single Security, which will facilitate market liquidity by eliminating the differences in the trading price of Fannie Mae and Freddie Mac securities.
We have also worked with Fannie Mae and Freddie Mac to develop policies and programs that safely and soundly further their missions. Many of their efforts are focused on addressing the challenge of providing greater access to credit and providing affordable housing, both ownership and rental. While capping overall participation in the multifamily market so as not to compete with the private sector, our exclusions from the multifamily purchase cap allow participation in the affordable rental and underserved markets, constrained of course by safety and soundness considerations.
FHFA, Fannie Mae, and Freddie Mac have also developed effective loss mitigation programs that minimize losses to the Enterprises, including the new Flex Modification that will be available in October, and allow borrowers to avoid foreclosure whenever possible. We also developed a Neighborhood Stabilization Initiative that focuses property dispositions on stabilizing neighborhoods in the areas hardest hit by the crisis.
The Enterprises have also eliminated volume-based discounts for larger lenders, which has leveled the playing field for lenders of all sizes – small, medium and large. This change, along with providing support for small lenders by purchasing loans through the cash window, has resulted in the percentage of Enterprise acquisitions from smaller lenders increasing significantly during conservatorship.
Among these reforms, two areas of emphasis – the Enterprises' credit risk transfer programs and our efforts to improve access to credit – warrant further discussion.
New Credit Risk Transfer Programs Share Credit Risk with the Private Investors
I'll start with a discussion of credit risk transfer (CRT). The Enterprises' credit risk transfer programs are a significant departure from their prior business model. Instead of securitizing loans into mortgage-backed securities and then holding on to the credit risk of those mortgage-backed securities, the Enterprises have worked to develop programs that transfer a significant portion of this credit risk to private investors. These credit risk transfer programs are separate from, but complement, the role played by primary mortgage insurance and other forms of credit enhancements required by the Enterprises' charters for loans with higher loan-to-value ratios.
The credit risk transfer programs have become regular parts of Fannie Mae and Freddie Mac's businesses and are now part and parcel of the way the Enterprises do business. Both Fannie Mae and Freddie Mac have dedicated teams to carry out these transactions in a manner that reduces risk at a reasonable cost. FHFA and the Enterprises are committed to supporting these programs and are continually improving them.
Our annual scorecard directs the Enterprises to transfer a portion of credit risk on 90 percent of targeted loan categories. In setting these targets, we strategically focused on loan categories with the greatest amount of credit risk and on loans that could support a stable, liquid market for investors. This means we target fixed-rate mortgages with 20-year terms or greater and with loan-to-value ratios above 60 percent. For 2015, these targeted loans totaled about 55 percent of the Enterprises' new loan acquisitions.
The Enterprises have made a tremendous amount of progress on credit risk transfers in a short amount of time. The volume of single-family mortgages included in credit risk transfer transactions has increased from an unpaid principal balance of about $90 billion in 2013 for both Enterprises combined to $548 billion in 2016. Similarly, the risk in force of these transactions, which measures the maximum amount of credit losses that could be absorbed by CRT investors, has increased from $2 billion in 2013 to $18 billion in 2016. All total from 2013 through the end of 2016, the Enterprises have transferred a meaningful portion of credit losses on a combined $1.4 trillion in mortgages, with a risk in force of about $49 billion.
As we work to enhance and oversee the Enterprises' CRT programs, FHFA applies a number of principles. First and foremost, CRT transactions need to reduce taxpayer risk by transferring a meaningful amount of credit risk to the private sector. Here, we are working to develop additional metrics to quantify and describe the amount of risk being transferred.
Second, credit risk transfer transactions have to make economic sense. We take our statutory obligations to operate the Enterprises in a safe and sound manner seriously. So, consequently, the cost of these transactions should not exceed their CRT benefits. Like any kind of insurance, the Enterprises must either pay a premium or forgo a portion of their guarantee fee income to secure the participation of CRT investors, and these payments must make economic sense. There is no free lunch in securing this investor participation, and we expect the Enterprises to closely monitor both sides of this cost-benefit equation. Pursuing non-economic deals could reduce the value of existing transactions. Engaging in non-economic transactions could cause current investors to potentially back away from further CRT transactions and reduce the liquidity of the CRT market.
One takeaway from this monitoring is about the cost of transferring expected credit losses to investors. This is specifically about the credit losses that the Enterprises expect to face from borrowers defaulting in normal market conditions. We sometimes talk about this as transferring first dollar losses or first losses.
Prior to this year, the Enterprises experimented with selling the first 100 basis points of credit losses to investors. As a result of feedback we have received from market participants and from credit risk transfer transactions to date, we have learned that selling the first 50 basis points of this expected credit losses is expensive. Investors, like the Enterprises, know that there will be some degree of expected credit losses for any portfolio of mortgages no matter the economic conditions. As a result, investors charge more for providing credit risk protection for expected credit losses.
Based on this information, FHFA and the Enterprises have determined that it is better if Fannie Mae and Freddie Mac retain the first 50 basis points of expected losses in most transactions. This means that the Enterprises have begun selling credit losses between 50 to 100 basis points. Early indicators have not only reflected better pricing, but greater competition for credit losses beginning at 50 basis points, rather than zero basis points. In the terminology used in the industry, this is using an attachment point of 50 basis points, rather than an attachment point of zero. The detachment point for CRT transactions, or the point at which investors stop bearing credit losses, is generally 3.75 or 4 percent of the unpaid principal balance of the mortgages included in the transaction.
As in other parts of the Enterprises' business, we also expect the Enterprises to effectively manage their counterparty risks of credit risk transfer transactions. This is also another important part of ensuring that their CRT programs are based on sound economics. Consequently, for those transactions that are not fully collateralized, the Enterprises must work to appropriately mitigate the risk of a counterparty not being able to fulfill its credit risk sharing obligations in the event of a market downturn.
Our third principle is that the Enterprises' credit risk transfer programs must cultivate a more stable, robust, and mature CRT market. While there have been a lot of positive developments, we also view the credit risk transfer market as still in development and not yet fully mature. With this in mind, we expect the Enterprises to develop a portfolio of different CRT transaction structures that can attract a broad and diverse investor base, can be brought to scale, and can remain stable through different housing and economic cycles. The Enterprises will, therefore, continue to refine and improve their existing transaction types and support pilots for new structures that can be brought to scale. After issuing a request for input about front-end credit risk transfers transactions, the Enterprises launched pilots with mortgage insurer affiliates in 2016 and these front-end pilots are continuing into 2017.
Earlier this month, Fannie Mae and Freddie Mac also announced that they are exploring changes to their STACR/CAS transaction structure to expand the investor base for this product. The Enterprises are gaining market feedback about these potential changes and will be working toward a decision of whether to move forward with these transaction changes over the next several months.
In addition, the Enterprises are exploring ways to do credit risk transfers on non-targeted loan categories, such as 15-year term loans and adjustable rate mortgages. Pursuing different transactions is exactly what we want the Enterprises to do to continue developing the credit risk transfer market. We want them to do responsible innovation.
A final principle to emphasize is that we also expect the Enterprises to provide a transparent and level playing field for their credit risk transfer programs. Just as we've done on the guarantee fee pricing side, the Enterprises' credit risk transfer transactions cannot provide volume based guarantee fee concessions that benefit larger entities over smaller ones.
Work Is Needed to Support Responsible Access to Credit
I also want to say a few words about FHFA's priority of supporting sustainable homeownership and improving access to credit. FHFA has undertaken a number of initiatives with Fannie Mae and Freddie Mac to try and break through difficulties in supporting responsible access to credit for borrowers. We worked with Fannie Mae and Freddie Mac on a multiyear initiative to provide certainty to lenders by revising the Representation and Warranty Framework. This was an extensive process to improve certainty, which lenders needed to eliminate overlays and lend within the Enterprises full credit box.
While we have seen some progress in improving access to credit and reducing lender overlays, I think it's safe to say that we're not yet where we want to be.
This year, as part of our annual scorecard, we have required the Enterprises to take a broader assessment of barriers to access to credit and to think more holistically about how to develop pilots and initiatives that help address these challenges. While we understand that there are a number of headwinds keeping some potential homeowners on the sidelines, we continue to work diligently to find areas where we can have a positive impact.
FHFA continues to move forward on the related effort of implementing the Enterprises' duty to serve three underserved markets – manufactured housing, affordable housing preservation, and rural housing. We published our final rule in December of last year, and the Enterprises just posted their initial Duty to Serve plans last week. Receiving public input on these draft plans is an essential part of our process, and we will receive input until July 10. I encourage all stakeholders to submit your views to FHFA for our consideration. After reviewing public input and FHFA's feedback, the Enterprises will update their plans and the plans will go into effect on January 1, 2018.
Fannie Mae and Freddie Mac also continue to focus on how to responsibly meet their housing goals, and FHFA is in the process of developing our proposed rule for the Enterprises' housing goals from 2018-2020. We also look forward to receiving public comment on this important aspect of the Enterprises' work to support affordable and sustainable homeownership for low-income families.
As lenders, you are partners with the Enterprises to provide access to credit for prospective, creditworthy homeowners across all geographic areas and all demographics. I encourage you to innovate and work aggressively to find new ways to develop responsible solutions that help households achieve homeownership. While I have focused my remarks on the Enterprises, I should note that the Federal Home Loan Banks also offer solutions that support liquidity in the housing finance market, including programs that support access to credit and affordable rental housing.
Appropriately, virtually everything I have said thus far today has been about what we have done, and continue to do, to reform the Enterprises while they are under FHFA's control in conservatorship. This is what I often refer to as our work focused on the "here and now." As the summary I have provided confirms, the reforms we have made lay a good foundation. But, as I said at the outset, we view these reforms as GSE reform, not housing finance reform. Housing finance reform is the responsibility of Congress and it goes far beyond what we can, or should, do in conservatorship. Consequently, last week I encouraged the Senate Banking Committee to move forward expeditiously on housing finance reform and suggested questions that they will have to answer to do so.
- How much backing, if any, should the federal government provide and in what form?
- What process should be followed to transition to the new housing finance system and avoid disruption to the housing finance market, and who should lead or implement that process?
- What roles, if any, should the Enterprises play in the reformed housing finance system and what statutory changes to their organizational structures, purposes, ownership and operations will be needed to ensure that they play their assigned roles effectively?
- What regulatory and supervisory structure and authorities will be needed in a reformed system and who will have responsibility to exercise those authorities?
These are questions that only Congress can answer. We should all encourage them to answer these questions soon.
I want to thank you again for having me here with you this morning.