Barney Frank: 03-21-09 Cancel Fannie and Freddie Bonuses

Frank Calls on Lockhart to Cancel Fannie and Freddie Bonuses

Barney Frank: 03-13-09 Wiggles out of Responsibility for Poor Home Loans

Washington, DC – Congressman Barney Frank today responded to a series of repetitive, wholly inaccurate efforts by Republicans to blame Democrats, and Frank in particular, for the failure to take appropriate action to prevent bad loans being made to people who could not pay them back.

“According to the Republican version of the history of the financial crisis, as presented on the House floor on Wednesday by Representative Todd Akin (R-MO), Congressman Frank is responsible for the fact that no legislation passed the Congress to regulate Fannie Mae and Freddie Mac until 2007, and no bill trying to restrict subprime lending passed the House between 1994 and 2007. The problem with their argument is that the Republicans were in power from 1995 through 2006 in the House, and they had complete control over what legislation did or did not pass.

“Being accused of having blocked legislation to prohibit irresponsible lending to low-income people from 1995 to 2006 is flattering in a bizarre way,” Frank noted. “Apparently those Republicans parroting these right-wing talking points believe that I had some heretofore undisclosed power over first Newt Gingrich and then Tom DeLay, which allowed me to keep them from passing legislation they wanted to pass. If that had been true, I would have used that power to block the impeachment of Bill Clinton in the House, the war in Iraq, large tax cuts for the very wealthy, the intrusion into the sad case of Terri Schiavo, and appropriations bills that badly underfunded important social priorities.

“I did not try to stop them from passing legislation to control subprime lending or to regulate Fannie Mae and Freddie Mac because in the first case they were never willing to do so, and in the second case, I worked together with Republican Chairman Mike Oxley on the only bill that the Republicans considered during that period to restrict Fannie Mae and Freddie Mac, and the bill was defeated because, in the words of Mr. Oxley, the Bush administration gave his efforts ‘the one-finger salute.’

“In another oddity,” said Congressman Frank, “the Republican history on this subject appears to end in 2003. I understand why they find later events unpleasant, since those events document the gathering series of policy mistakes that the Republicans made which ended in their being repudiated in 2006, and re-repudiated in 2008. In their view of the world, the last relevant thing that happened was a statement I made in 2003 in which I said that Fannie Mae and Freddie Mac were not in crisis. I did say that. And I would have said it as well – and may have – about Wachovia Bank, Lehman Brothers, Bear Stearns, the Royal Bank of Scotland, and dozens of other financial institutions in America and elsewhere which were not in fact in crisis in 2003.

“What happened subsequently,” continued Congressman Frank, “in the years the Republicans wish to ignore because they cannot defend what happened – is that the Bush administration pushed for even more subprime lending, Alan Greenspan refused to use congressional authority he’d been given in 1994 to regulate it, and the House Republicans blocked any efforts to legislate against it. In fact, as quoted in a story in the Bloomberg News, when the Bush administration ordered Fannie Mae and Freddie Mac to increase significantly the number of loans they bought for people below median income, I objected saying that this would be good neither for the borrowers who could not repay the loans nor for Fannie Mae and Freddie Mac.”

In his book, Financial Shock, Mark Zandi, who has advised political leaders of both parties and gained a great deal of respect for his views on the financial crisis, stated that “President Bush readily took up the homeownership baton at the start of his administration in 2001… To reinforce this effort, the Bush administration put substantial pressure on Fannie Mae and Freddie Mac to increase their funding of mortgage loans to lower-income groups…. By the time the subprime financial crisis both had become sizable buyers of the Baa tranches of these securities.”

“My response, along with other Democrats,” said Congressman Frank “was at that point to try to take regulatory action in two respects. First, we sought directly to regulate subprime lending. Secondly, I agreed to join Congressman Oxley in trying to regulate Fannie Mae and Freddie Mac.

According to Mr. Zandi, “Democrats in Congress were worried about increasing evidence of predatory lending… The Democrats wanted a federal equivalent (to North Carolina’s anti-predatory law) that would cover all lenders nationwide. The Bush administration and most Republicans in Congress were opposed, believing legislation would overly restrict lending and thus slow the march of homeownership.

“As to Fannie Mae and Freddie Mac,” continued Congressman Frank, “I joined with other Democrats in helping Mike Oxley bring out of our Committee a bill that would regulate Fannie Mae and Freddie Mac. I voted against it on the House floor after the Republican leadership dictated a change – over Mike Oxley’s objections – to the affordable rental housing piece, but it did pass the House anyway and I did not urge other Democrats to join me in voting no. So the argument that I blocked Fannie Mae and Freddie Mac legislation makes zero factual sense since the House, when I was in the minority, did pass the bill. It died because of Senate opposition, spurred by President Bush.”

In 2007, when the Democrats assumed control of both Houses of Congress and Mr. Frank became Chairman of the House Financial Services Committee, Congressman Frank moved quickly to pass a bill to regulate the GSEs. He introduced the Federal Housing Reform Act of 2007 (H.R. 1427), on March 9th and it was approved by the Committee on March 29th.

The bill was passed by the full House on May 22nd, with all 223 Democrats and 90 Republicans voting in favor of the bill, and 104 Republicans voting against it. Among those voting against regulation of the GSEs was Congressman Todd Akin (R-MO), who led the Special Orders on Wednesday.

In 2007, Congressman Frank, along with Representatives Brad Miller and Mel Watt, introduced the Mortgage Reform and Anti-Predatory Lending Act (H.R. 3915) which would regulate predatory subprime mortgages. The bill passed the full House on November 15th, with all 227 Democrats and 64 Republicans voting yes, and 127 Republicans voting no. Representative Akin voted against the bill.

Republican talking points omit the many factors which set the stage for the present financial crisis — the Gramm-Leach-Bliley Act of 1999 (opposed by Congressman Frank), which removed the wall between commercial and investment banks, the failure of the Federal Reserve to use oversight authority which it had been given by Congress, and the Security and Exchange Commission’s decision to allow large financial institutions to “self-regulate” and dramatically increase their risk exposure.

The Republican message also fails to mention the role of unregulated entities which aggressively marketed subprime loans, major financial institutions which packaged risky mortgages as Collateralized Debt Obligations and sold them as virtually risk-free investments, rating agencies which gave stellar grades to toxic assets while being paid by the companies who stood to benefit from their actions, and the massive growth in the use of Credit Default Swaps, ushered in by Senator Gramm’s 2000 legislation (also opposed by Congressman Frank.”

“The Republicans would have you forget all this,” said Congressman Frank. “They want to distract people from understanding the real causes of the crisis so they can further block real reform. This is cynical, partisan politics which will weaken our ability to prevent another meltdown in the future. These attacks may seem innocuous, but in the long run they will hurt ordinary Americans who are already suffering.”

Financial Meltdown: 02-19-09 Origin of Financial and Housing Crisis

The Bush Administration and Senator McCain warned repeatedly about Fanny Mae and Freddie Mac and what thus became the 2008 financial crisis — starting in 2002 (and actually even earlier — in the Clinton and Carter White Houses. Democrats resisted and kept to their party line, extending loans to people who couldn’t afford them. Watch below. Needless to say, it was the politicians.

White House: 02-18-09 Geithner, Donovan, Bair Talk

THE WHITE HOUSE

Office of the Press Secretary

________________________________

February 18, 2009

MR. GIBBS: Before I get my customary AP question, though this is off camera, we’re going to change the rules and the briefing is on the record. So let me bring out our participants.

SECRETARY GEITHNER: I’m just going to start with the broad imperative: Economic recovery requires actions on three fronts. The President signed into law yesterday this very powerful package of investments and tax incentives to help keep people working, help businesses stay operating. This is a absolutely necessary part of recovery.

As a complement to that, we’re going to have to take further actions to strengthen our financial system, to make sure it’s providing the credit necessary to spur recovery. You’re going to see additional details from us in the coming weeks on how we’re going to do that — again, how we’re going to make banks strong enough they can support recovery, how we’re going to provide direct support for the credit markets that are so important to small businesses lending, to consumer lending.

These are necessary but not sufficient conditions to help address the housing crisis. So the President is announcing today a very comprehensive plan of initiatives to help make housing more affordable and help, again, arrest this very damaging spiral we’re seeing in the housing markets as a whole.

This program has three important parts. Let me just walk through these very quickly. The first is a program to allow Americans who cannot take advantage of lower interest rates today to refinance. Right now if you’re a — got a typical mortgage, but the value of your house price has declined, you’re not able to take advantage of lower interest rates. So this program, which we think will reach between — could reach between 4 and 5 million Americans — will help people take advantage of lower interest rates and, in that context, provide substantial reductions in monthly payments.

The second program is a $75 billion program of incentives and measures to help improve affordability of mortgage payments for those families most at risk of foreclosure.

My colleagues, Shaun Donovan and Sheila Bair will provide more details on that program. You have a detailed fact sheet that shows how that works. It’s a combination of powerful incentives to lenders to participate and some conditions and other inducements to try to make it work.

This will reach between 3 and 4 million Americans. Again, the focus is on improving affordability in mortgage payments for people at risk of losing their home.

The third important part is some additional financial support to Fannie Mae and Freddie Mac. These two institutions, in effect, are the mortgage market today. They account for the vast bulk of mortgages originated today. They play a critical role in these markets, and we need to make sure that they have the ability to play that role going forward. And so we’ve increased substantially, using the authority Congress provided the administration last summer, to increase our financial commitment. This will be important to helping keep mortgage rates down and is a very critical, important part of recovery.

This is — all Americans have a stake in making this work, not just those Americans who were the victim of bad underwriting standards, or in communities where you’ve seen — foreclosure. It has broad-based effects, again, by helping Americans take advantage of lower interest rates, and helping improve affordability, helping keep overall mortgage rates low.

Important to just emphasize the way this affects the economy as a whole: Two important effects — again, by helping keep mortgage rates down and helping reduce monthly payments, you’re putting money in the hands of Americans. In that case, it acts like stimulus. Second is we’re going to help reduce the risk that housing prices fall more than they would otherwise fall. So again, by keeping interest rates low, by making it more affordable for people to stay in their homes, and by reducing the amount of foreclosures ahead, we can reduce the risk that housing prices fall further than they otherwise would. Those two — for those two reasons, again, all Americans have a stake in making this work.

This is necessary policy. It’s smart economics. And it’s just and fair — because Americans across the country that were responsible in how much they borrowed are being significantly damaged by the actions of those who are less responsible, both people who borrowed more than they could afford, and banks that took risks they didn’t understand and could not sustain.

I just want to end by complimenting Shaun Donovan, Sheila Bair, and a range of people across the administration who helped design this. They both have enormous credibility in this area. Sheila, I just want to say, was an early, powerful, pragmatic, creative advocate of action on the housing front. And I’m very pleased she was able to join the President and Shaun and I here today.

Thank you. Shaun, do you want to add anything?

SECRETARY DONOVAN: Thank you, Tim. As Tim has said, this is critical — the announcement today is critical to getting the American economy back on the right path. And let’s be clear, housing has been a significant part of initiating the economic slide that we’re in, and will be a key part of getting us out.

Close to 10 percent of all American families today are either in foreclosure or behind on their mortgages. And to dramatize how important this is to the continuing slide in home prices that we see, estimates are that in December, 45 percent of all home sales were distressed sales — 45 percent of all sales were distressed sales — which is continuing to drive prices lower. So we have to get out of that spiral.

Here in Arizona, over 6 percent of all mortgages are more than 90 days late or in foreclosure — so a crucial problem to be solved here, as well as across the country.

With the first two pieces of the announcement that Secretary Geithner has talked about, between our refinancing initiative — or so-called “underwater” borrowers — and our modification plan, mortgage modification plan, we will reach between — up to 7 to 9 million American families. This is a smart, targeted investment which can reach and help to make more affordable more than $1.5 trillion of mortgage debt. Those 7 to 9 million families hold roughly over $1.5 trillion in mortgage debt. So we just have a scale that can have a real impact on turning the housing problems around in this country.

First of all, to focus on the refinancing portion, this will be focused on up to 4 to 5 million homeowners who have played by the rules, that have been making their payments on time. These families have seen, through no fault of their own, values in their communities on houses drop by 20, 30, 40, even 50 percent, and find themselves in a situation where even if they’re holding a mortgage that is far above market rates, they cannot take advantage of refinancing down to what are really historically low mortgage rates that we see in the market today. This just isn’t fair, and it’s something that we will help to fix through the announcement today.

The typical family that has one of these so-called conforming mortgages, or Fannie Mae or Freddie Mac mortgages, that can re-fi to today’s markets rates will save roughly $2,300 a year in lower interest payments, simply by refinancing to today’s market rates. And let me be clear: These families have played by the rules; they’re families that only have been victims of their houses falling in value and, therefore, their mortgages are close to or higher than the value of their homes today.

So that’s the first. The second is a mortgage modification plan, in many ways, based on the pioneering work that Sheila Bair did at FDIC, to show that a streamlined, large-scale modification plan can have major impacts. It will reach between, we believe, up to 3 to 4 million American families. Let’s be clear about the scale here. Our expectation is that — we saw 2.2 million foreclosures, a record number, last year. We expect to see as many as 6 million foreclosures in the coming years. So between these two initiatives, reaching 7 to 9 million families is at a scale that can really begin to turn this problem around.

The modification program — first of all, we must be clear that while this crisis in housing started as a mortgage crisis, in many ways, it has become a job-loss crisis, as well. And so the signing yesterday of the recovery plan, which will create about 3.5 million jobs, is a critical piece of getting housing back on track by getting people back to work. But beyond that, this modification plan does a number of things to make sure that up to 3 to 4 million families can stay in their homes and have affordable mortgages.

First of all, it focuses on the right people: investor-owners, flippers, speculators will not be eligible for the program; only owner occupants. Second of all — and this is something that is I think very innovative about this plan — is that we are saying for the first time that any borrower that is current — you don’t have to be delinquent to qualify for this plan. This is different from what’s been done in the past. What we’ve found in our research is that the earlier we can get to homeowners that are in trouble, the more chance they have at successfully modifying their mortgage and being homeowners in the long term.

And so we are providing new, innovative incentives for servicers to modify mortgages where people are current, where they haven’t reached the state of 60 or 90 days delinquent, when they’re more likely to fail. And those again are the most deserving borrowers because they played by the rules, they struggled to make payments, but they have made those payments and they haven’t been able to benefit from modification programs before. So we are changing that.

Finally, we will provide a series of incentive payments for success both for owners where you can benefit from a $1,000-a-year payment up to five years — if you’re successful and succeed in your modification for up to five years, $5,000 that can reduce the principal on your home mortgage — as well as incentive payments to servicers and lenders that if the modifications work over the years we will make payments to them as incentives to keep people current.

And in all, this will help, as I said, 3 to 4 million families. But let’s be clear: This will also help millions of other families, as well. Recent research shows that neighboring homes to foreclosed homes lose as much as 9 percent of their value. So people who are not in danger of foreclosure still are suffering from nearby foreclosures. This will help those families, as well. Our estimates are that the average home — not the average home in foreclosure, but the average home across the country will gain $6,000 in value relative to had this plan not been put in place.

And finally, the third leg of this plan which Tim has talked about, keeping the GSEs providing low interest mortgages is absolutely key. Together with FHA they represent more than 90 percent of the mortgage market today, all new mortgages issued. Combined with the $8,000 first-time homebuyer tax credit that was in the recovery bill signed yesterday, we believe these efforts can help to prop up the housing market and return it to stability.

Thank you.

MS. BAIR: Well, I would just like to thank the President and Secretary Geithner and Donovan, and Larry Summers in absentia, for the leadership they have shown in putting this package together so early in the new administration. They’re committing real resources to this problem. And the FDIC has long felt that the missing link really in all of our strategies so far is we’ve not tackled the problem at the core, which is at-risk borrowers, millions of unnecessary foreclosures weighing down home prices and creating a lot of external costs for neighborhoods, communities, and the economy as a whole.

So that missing link is being filled today in a way that I think is effective and responsible. It’s a program of shared responsibility, looking to servicers, investors, borrowers, as well as the government, to all work together and make a contribution to get these loans restructured.

It aligns economic incentives in the right way. Because of the securitization features, where a lot of these at-risk mortgages are held, economic incentives have been skewed, so that loan restructurings that make sense, that are more valuable than a foreclosed home, have not been happening. And with this package the economic incentives should be aligned so that those loan restructurings that make economic sense and are viable will occur.

So I would just like to thank again the new administration for their leadership in getting this done, being willing to commit real resources to it. And I’d be happy to answer any questions.

Q We’ve been hearing $50 billion and now today we’re talking $75 [billion]. Why the increase there? And also, if you’re doubling the financial guarantees for Freddie and Fannie, does that mean that you have a more dire view of their books and the state they’re in?

SECRETARY GEITHNER: The $75 billion because we think that’s necessary to make a program like this work. We wanted to make sure we were putting enough resources into this that we were going to achieve as much as possible.

On the Fannie and Freddie front, again, you should view this as underscoring our commitment to stand behind these institutions so that they can play this critical role going forward. This is not a judgment about the expected losses ahead; it’s just a way to make sure people understand that they will be able to play this role going forward. It underscores a commitment to make sure they can do that. And that is very important to try to help keep mortgage rates low.

Q The President talked in his speech about the inter-relatedness of the mortgage crisis, the banking crisis and the economy. So I want to ask you, do you think there will be fewer bank failures as a result of this specific housing plan? And then also I have a technical question: Are there any income limits on the incentives for borrowers, or is anybody eligible for them if they’re underwater?

SECRETARY GEITHNER: Okay, let me start with the first. All these things are closely related. The recovery act, which is a very powerful set of investments and — is not going to be as forceful if we have a financial system that’s not providing credit to businesses and consumers. So those two things work together.

If those things are effective that will help make sure that people can — because they’re not losing their jobs — more likely to stay in their home. They’ll also help support the housing crisis as a whole.

But we think that alongside those things you need to get directly to the housing thing, too. As Sheila Bair said, I think, the cost of inaction on this front has been very severe. So you’re absolutely right — you need to think about these things together. Each will be more effective if you’re moving with as much creativity and careful design force as we can, each will be more effective moving together.

Now on the –

Q — overall banking plan more effective.

SECRETARY GEITHNER: More people will stay in their homes if fewer people lose their jobs. Banks will be stronger if fewer people lose their jobs. House prices will fall less than they otherwise would if you have a stronger economy and a financial system that’s working better to support recovery.

Now, on the issue about qualification. These programs are targeted to people that, again, were relatively responsible. It’s not going to be directed at helping those who borrowed just huge amounts of money, well beyond their capacity to repay, and it’s not going to go — it’s not going to be targeted at those people who really don’t need the assistance, have very substantial amounts of equity in their home and, therefore, are able to refinance, take advantage of lower interest rates.

So it’s targeted to those people really in the middle and to make sure, again, they can refinance to take advantage of lower interest rates and they can take advantage of lower mortgage payments and, therefore, are more likely to be able to stay in their home, afford their home.

Q Can I ask about income — just to follow up — there are people who are struggling in San Francisco with million-dollar mortgages, even though they have two incomes and things like that. Would they be — would any of those people be eligible?

SECRETARY DONOVAN: The program does have a limit on mortgages that are below what we call the conforming loan limits, which were — just in the recovery bill signed yesterday, were maintained at a higher level than they have typically been. The highest — they vary around the country, depending on home prices — up to just over $700,000.

So just to be clear, only about 2 percent of mortgages around the country are above that, but we want to try and make sure that this assistance is not targeted at millionaire homes, homes where we, frankly, don’t think that assistance is needed, that it’s targeted to people who really do need the assistance.

Let me just mention one other thing on your question about the help to the banking system. Obviously Secretary Geithner is focused on the entire banking system. But within the homeownership market you hear about these toxic assets — well, these toxic assets are really toxic mortgages in housing. And there are two fundamental problems. One is it’s been hard to value these mortgages. This plan helps because it establishes a standardized net present value test, which will be released on March 4th when we release the broader guidance that we’re going to put in place as part of this plan. That will help to create a more standardized system to value these mortgages across the country and take some of the uncertainty away.

The other thing, frankly, is the reason they’ve been toxic is because families haven’t been able to pay. And so this will take millions of mortgages that currently aren’t affordable to families and make them affordable. That will also help to stabilize the balance sheets of these banks, as well. So those are two key points.

Q It’s kind of a technical one — the $10 billion — is that part of the $75 billion, or is it an additional dollar amount?

SECRETARY GEITHNER: It’s part of the $75 billion total cost.

Q And is the $10 billion coming from TARP?

SECRETARY GEITHNER: Yes.

Q Are you able to enact this just by executive order, or do you have to go through a legislative process? And then I have a follow-up.

SECRETARY GEITHNER: We’re using authority that already exists for the bulk of these initiatives, although an important part is some changes to the HOPE for Homeowners program. And there is legislation now pending before Congress that would help strengthen that program, make it more effective.

There are other pieces of the program, too, that require legislation, like the bankruptcy reform provisions. But the core parts of this program — to improve affordability, to help people refinance — are using authority Congress has already provided.

Q And then, I know you’re trying to realign the incentives. But how do you respond to critics who say that when it comes to especially the pay for success program, that you’re providing rewards for things that lenders and borrowers — I’m sorry — lenders and lendees already should be doing because of the extraordinary measure the government is taking?

SECRETARY GEITHNER: You’ve seen a lot of experience over the last year or so — people try other approaches to help fix this problem, and they are not working. So what we try to do is put together a more powerful package of incentives and other inducements, I’ll call them, to try to make sure you get a level of participation and a level of relief in mortgage payments that has not been achieved. We haven’t even begun yet.

So this represents our best judgment of that. And you have to look at those costs against the very substantial benefits this will bring to homeowners across America and to the overall economy as a whole.

Q Are there any aspects of the plan that could work right away? There was an official who said March 4th as a possible guideline.

SECRETARY GEITHNER: We’re going to put out the detailed guidelines on March 4th. We expect people to go ahead and continue modifying today. And although it will take a little longer for the entire operation or architecture of this thing to be in place, modifications done as of March 4th will benefit from these financial incentives.

So this is going to work, our judgment is, really quite quickly. You’ll start to see the effects quite quickly, really a extraordinarily rapid pace for a program — for an administration this early in office.

Q A senior administration official says 23 percent of the nation’s mortgages are underwater right now. Does that mean that most people who bought homes in the past couple of years are now underwater?

SECRETARY GEITHNER: It is true that a substantial number of families — you can see in our program, there’s 4 to 5 million Americans who have had the value of their homes decline and therefore cannot refinance, take advantage of lower interest rates. And this program will help those. And there was no program on the table in prospect before this program to be directly affected those families — at those families. And that’s very important.

Now, there are other families who have much, much higher levels of mortgages outstanding relative to the value of their home, that this program should not reach, really cannot reach. So it won’t reach all homeowners. It won’t prevent all foreclosures. And it can’t really help a range of people who were — got themselves in the position where they had just borrowed way, way beyond their means.

Shaun, do you want to add to this?

Q Excuse me, if 23 percent of the nation’s homes are underwater, and you hope to help 9 million — 7 to 9 million — how many people won’t this reach? What percentage of 23 percent of the nation’s homes is 7 to 9 million?

SECRETARY DONOVAN: A couple things I would say on that. One of the problems is there is no good accurate information about exactly the value of these homes. So there are estimates like the 23 percent that you mentioned. One of the features of this plan is to try and create through standardized guidance that will be issued by Treasury that will apply not just to Fannie and Freddie, not just to FHA, but across the mortgage market in general, to try to get a more standardized process for valuing these mortgages. So that’s a critical piece of it.

What we are all — there are a couple different groups of homeowners within those who are underwater. So it’s not just the 4 to 5 million that Secretary Geithner talked about that are currently in conforming mortgages that are underwater that will benefit. You also have a group of homeowners who are part of the 3 to 4 million — that are included in the 3 to 4 million that we will help, as well, who are both underwater and have affordability problems. Those will benefit, as well. So all of the folks who are being helped today through those first two initiatives are part of that group.

And then, finally, recognize that HOPE for Homeowners is a program that, if we can get legislative changes, will help underwater borrowers. And frankly, allowing Fannie Mae and Freddie Mac to continue to be active at lower interest rates, because of the support that we’re providing, will help a large share of those homeowners, as well. So I think the scale of the plan that we got through the various components is adequate to get to the scale of folks who are underwater. We’re not going to be able to bring every one of those borrowers to a point where they have equity in their homes. But at least we can make sure they benefit from refinancing, lower their payments, and get to an affordable level in their home.

Q You suggested that there would be help for people with non-conforming loans. I thought that there was not.

SECRETARY DONOVAN: To be clear, the modification program that is being announced today will allow any servicer who — whether that loan is a conforming loan with the GSEs, or it is held by a private label security — any type of loan as long as the servicer and the investor are willing to step up, they have some skin in the game, so to speak, they’re willing to bring the payments down to 38 percent what we call DTI — debt to income ratio — we will provide incentives. We will split 50/50 the reduction of those payments down from 38 percent to 31 percent.

So any loan, whether it’s a GSE loan or not, can participate in that program. And those homeowners who are underwater and also can’t afford to pay their mortgages can participate.

Q — respect to the lender?

SECRETARY DONOVAN: Just to be clear, we do have guidance — as Secretary Geithner said earlier, we have guidance as part of TARP, that anyone receiving TARP funding must participate in this program. And we have a range of incentives that will make sure that servicers who have not been able to participate before can do so.

Let’s be clear: One of the problems is these securities that hold many of these loans are so complex — they’ve been sliced and diced into so many pieces — that they are lots of problems for servicers that have a financial incentive to modify, but they haven’t been able to do that. So we’re going to provide standardized guidance across all the mortgage market that defines what a reasonable modification is. That will provide a lot of comfort to these servicers who have been concerned about lawsuits. That’s first of all.

Second of all, we’re going to provide the incentives that I talked about before, so there’s a financial incentive to participate. And third, a program which really Sheila Bair has been a leader on — we’re going to provide this insurance pool — the $10 billion insurance pool — to make sure that future price declines aren’t a reason for servicers to not participate. Right now, many are afraid if they modify and home prices fall further, that they’re going to lose from that. We’re going to help ensure against that so we get greater participation, as well.

We think the combination of the carrots and the sticks will be effective in getting much greater participation.

Sheila, do you want to add on this?

MS. BAIR: Yes, I just need to clarify, there’s a difference between a conforming loan and a loan under the conforming limit. So the loans, the modification, “do they have to be below the conforming limit?” That doesn’t mean they have to be conforming loans. A lot of them are not. A lot of the high-risk mortgages are in these private label securitizations.

And I guess to go back also to an earlier question about, well, why pay them for doing something that makes economic sense already. And I can assure you, our hands-on experience when we became conservator of IndyMac and we’re dealing with the investors to try to get those loans modified in the servicing portfolio of IndyMac, and there were two key problems. One, is that investors have different interests. If you reduce the interest rate on these loans, some investors get hurt by that, some get help. If you foreclose, some get hurt, some get help. So the economic incentives are misaligned. The servicer has no skin in the game at all, right? So there’s inertia there to begin with. The investors are pushing different ways, perhaps threatening lawsuits.

So I think what we’re trying to do is align economic incentives by saying, if you come this far for us, 38 percent, then we’ll help with the interest deduction between 38 and 31. We’ll also give you some protection. We know home prices are going down. We know that some of these loans will redefault — may redefault later and you will have to take a loss because the foreclosure value will be less. So we’re going to give you some additional insurance, guarantee against that.

Those are the two huge issues that we’ve heard from investors over and over again. And we think — it would be nice if it happened voluntarily. We tried voluntary. It didn’t work. And we are woefully behind the curve. So I think this program is necessary. I think it does have the right incentives that should get the job done.

These modifications, though, absolutely make business sense. At IndyMac, we — even assuming a 40 percent redefault rate, which is very high, higher than we think — we’re still making $50,000 on average for every loan we modify, just because the value of a performing loan is so much higher than that of a foreclosed home.

So this is — this makes economic sense. It will help the economy. It will help stabilize home prices and prevent us from overshooting, which I think we are in a distinct danger of doing right now.

Q It’s my understanding that this only applies to first mortgages, so that if you had a second — a first mortgage and you’re not technically underwater with it, but you are with your first and second combined, you’re not eligible for assistance, correct? And why not?

SECRETARY DONOVAN: That’s not correct, actually. We do have one element of the program that says if your total debt, including second lien but also credit card and other debt, is more — your payments on all that debt is more than 55 percent of your income, then we think you’re very unlikely to succeed. And therefore, we’re going to require those families to go into counseling to try and reduce their other debts, and then they could become eligible for the program.

Q (Inaudible.)

SECRETARY DONOVAN: If they want to benefit from the program, we’re going to have to do something to reduce their overall debt. What we don’t want is to provide a modification that’s set up for failure. We want to make sure that we’re setting people up to succeed. So if their overall household debt is too high, that’s going to be a requirement to be able to participate in the program, if they want to get the — but on second liens, you are eligible to participate. And what we have generally seen is that the second liens on modifications are not a problem to participation, because no payments are made to the second liens whatsoever under this program.

We’re going to focus on getting affordability. Their payments have to get down to the 31 percent level. And we will not be making payments to those second liens, because, frankly, they’re not — they don’t have a value in this case if the homeowner can’t even afford to pay the first mortgage. So no payments will be made. We’ve been in extensive discussions with the servicing community; we don’t believe that’s going to be an issue for the program and they will be able to participate.

Q How quickly are you going to go push this bankruptcy change in Congress? Is it –

SECRETARY GEITHNER: We’re working with the leadership in Congress to find a appropriate way to move that forward, and we’re working on it.

Q — is it weeks, months?

SECRETARY GEITHNER: We’re working on it. We’re trying to find the best path to early enactment. And we want to have a carefully defined package of reforms.

Q As you said, there are millions of people who ultimately could be eligible for this help, and they’re all wondering how do I go about doing this? Can you in a concise way explain who is eligible for this and who absolutely would not be eligible for the various forms of these programs?

SECRETARY DONOVAN: So you are eligible if your debt-to-income ratio — in other words, the payments that you have to make on your mortgage — are above 31 percent of your income; if the size of your mortgage — and Sheila’s clarification is important — the size of your mortgage is below the amount of the conforming loan limits. It doesn’t have to be a GSE loan, but it has to be below that limit, which varies across the country depending on home prices. And you have to have a reasonable chance of success as measured by whether your mortgage is underwater. In other words, if you’re so far underwater, more than about 150 percent loan-to-value, we think you’re very unlikely to succeed — those will not be eligible, as well.

Q You answered part of my question. So the lower threshold on refinancing is loan-to-value of 150 [percent]?

SECRETARY DONOVAN: In other words, if you’re over 150 percent loan-to-value right now you’re not eligible for the program.

Just one point, one thing that’s not in the list is being delinquent. Programs have typically required 90-day delinquency. We believe that we have to move this modification process earlier to help people be successful. And so we do not have a requirement that you have to be delinquent. In fact, we have incentive payments to try to bring non-delinquent borrowers in, because we think we have a better chance of success.

Q From 38 down to 31 — does that include principal, as well, or just interest?

SECRETARY DONOVAN: That is up to the servicer. We are willing to match payments for principal reduction or interest reductions or extending out the term. Whatever the combination is that can get payments down to 31 percent, that’s critical. We’ve seen a lot of modifications that have failed because they’ve actually increased payments rather than reduced payments. So getting payments to 31 percent debt-to-income ratio is critical.

Q I did hear you say that you’re eligible — not eligible if the size of your mortgage is below the amount — or has to be below the amount of the conforming limits. I thought you just said in an earlier answer that the non-conforming mortgages were eligible.

SECRETARY DONOVAN: Yes. So just to be clear, two different things. A conforming mortgage is a Fannie Mae or a Freddie Mac mortgage. Conforming loan limit is a dollar figure, okay? So what we’re saying is, very large mortgages aren’t eligible. Smaller mortgages are eligible whether they are Fannie Mae or Freddie Mac mortgages or other kinds of mortgages. Sorry about that.

Q What’s the definition of that? Because in New York or San Francisco, very large is very large — but, I mean, there’s different levels –

SECRETARY DONOVAN: And we’d be happy to provide more detail to you. It varies across the country, depending on what home prices — the maximum is about $730,000 in the highest-priced areas. There’s a relatively complex formula I don’t want to bore you with, but we’d be happy to get you what those numbers are across the country.

Q So there’s a regional –

SECRETARY DONOVAN: Yes, there’s a regional variation, depending on home price, exactly.

Q Three very factual questions. First, does the $75 billion come from the TARP money, the second tranche of the $350 billion of TARP money?

SECRETARY DONOVAN: Most of it but not all of it is from the TARP.

Q Where is the rest from?

SECRETARY DONOVAN: Part of the way that we’re going to implement this program, Fannie Mae and Freddie Mac will do modifications of their own loans that qualify in this program. And we are not providing TARP funds to Fannie Mae and Freddie Mac for modifying their mortgages. But obviously that has a cost to them to modify them, and we are including that in the $75 billion that will be dedicated to doing that.

Q And secondly, you said you would expect about 6,000 foreclosures in the coming years. Can you be specific about the coming — what do you mean by “the coming years”? And also, again, can you give us your best estimate of how many people will still go into foreclosure despite this effort?

SECRETARY DONOVAN: So, two things. Roughly 6 million foreclosures is expected over the next three years. Those estimates vary, depending on — but that’s, we think, a good estimate at this point, without implementing this program.

We believe we can help a very large share of these. It’s going to depend on participation in the program. As I said earlier, between 7 and 9 million homeowners, families can benefit from the modification and the refinancing program. So it’s a substantial scale. What’s impossible to predict is exactly how many of those 7 to 9 million families would go into foreclosure. But we think we can get to a majority of the foreclosures.

Let me also be clear: There are speculators who are not owner occupants who will continue into foreclosure because this program is not targeted for them. There are families, frankly, whose debt is so high that even with this modification we’re not going to be able to help them. One of the things that we do with our plan is to provide incentives for those families to be able to transition out of homeownership in a way that doesn’t hurt them and doesn’t hurt the communities around them.

What do I mean by that? Right now a foreclosure hurts their credit rating, makes it very hard for them to ever buy a home again, and also hurts surrounding communities because those homes tend to sit for months vacant, lowering prices of surrounding homes. So we’ve provided incentives for transitions short of foreclosure, like deed in lieu, or short sales, through this plan as well. So we believe even for those who are headed towards foreclosure, we’ve provided tools that will limit the impacts on families and on communities, and help to limit the decline in housing prices in surrounding communities.

SECRETARY GEITHNER: Can I just add one thing on this? It’s just important to recognize that one of the biggest factors that effects the level of foreclosures is what happens to the economy as a whole and what happens to the path of unemployment. So these programs will address part of that risk. But overall path of foreclosures is hugely dependent on how quickly we get growth back, how quickly we get job creation back on track.

Q Two questions. One, does having Fannie and Freddie endorse these loans or continue to be involved in loans where people are below 20 percent increase their exposure in the long term? Have you tried to do any estimate of that? Is it going to be good for them in the long term in your estimate?

And the other question is on the investors and speculators. How are you sure that these aren’t investors and speculators, and could there be second homes that are eligible for this program?

SECRETARY GEITHNER: On the first, Fannie and Freddie believe that the program we announced, this refinancing program is economically sensible for them and will leave them overall in a better position going forward.

As Shaun said, I think Sheila said, too, to be eligible this has to — you have to be in an owner-occupied home. And that simple test will reduce the risk that any investors or second homes would benefit from the program.

SECRETARY DONOVAN: Second homes are not eligible.

Q How is that verified?

SECRETARY GEITHNER: It will be verified. It’s easily verifiable.

Q I have two questions. The first is on the second part of the program, will people apply for the help, or will the servicers suggest the help to their debtors? And is the interest rate

– by changing interest rates alone, will that be enough to get all these people to 31 percent of their income?

SECRETARY GEITHNER: On the first — Shaun or Sheila may approve this, but you want — for this to work, borrowers are going to have to take the initiative to approach their lenders to try to take advantage of the program. And you want servicers to take a more proactive approach to contact borrowers who are at risk and where it may make economic sense for everyone for them to be in. So you need to have both those two things happen. And this program creates pretty powerful incentives for initiative by the servicers to move.

On your second point –

Q (Inaudible.)

SECRETARY GEITHNER: Absolutely. Absolutely. You can come and initiate that process. And there’s a variety of — to make that easier, easier to happen more quickly.

On your second part of your question, as Shaun said, you can bring those mortgage payments to 31 percent through a mix of interest rate reductions, principal reductions, or extensions of the loan. And we’re trying to incent and help that actually happen. And whatever mix works is okay.

Q — the principal, as well?

SECRETARY GEITHNER: That’s right.

Q And also, just one more thing. Do you think that Fannie and Freddie can sort of — are they strong enough to absorb this much new responsibility? Are you at all concerned about their ability to handle –

SECRETARY GEITHNER: They are confident they can handle this. And they have a substantial economic incentive in doing so.

Q (Inaudible) — foreclosures are skyrocketing. And the number one thing we hear from homebuyers, homeowners struggling: lenders won’t play ball. So I hear the incentive, and then I hear TARP involvement. Are there penalties for lenders if they don’t participate?

SECRETARY GEITHNER: Well, as Shaun said, you’re seeing there’s a, I think, pretty powerful set of incentives, positive inducements and conditions, other types of incentives. And we think it will change behavior on a significant scale.

Q Thank you.

END 9:40 A.M. MST

Treasury: 01-08-09 Role of GSEs

Remarks by Treasury Secretary Henry M. Paulson, Jr. on The Role of the GSEs in Supporting the Housing Recovery before the Economic Club of Washington

Washington – Good afternoon. Thank you, David and thanks to the Washington Economic Club for this opportunity to provide my thoughts on long-term reform of the housing Government Sponsored Enterprises, the GSEs, Fannie Mae and Freddie Mac.

Debate over the role and function of these entities has raged for years. Congress established Fannie and Freddie decades ago to meet a public policy goal – to increase the funding available for home mortgage financing. The GSEs achieve this through providing liquidity to the secondary market for a limited range of home mortgages, either through credit guarantees on mortgage-backed securities (MBS) or by directly investing in mortgages and mortgage-related securities through their retained mortgage portfolios. To further this mission, their congressional charters grant the GSEs several benefits which together created a perception that the GSEs were backed by the U.S. government, even though this was not the case. This “implicit” government guarantee provided the GSEs with a funding advantage over other mortgage market participants.

The inherent conflict in this structure is obvious – the GSEs served both a public mission and private shareholders – they received public support but operated for private shareholder gain. While policymakers of every ideological stripe have acknowledged the risks created by this conflict, entrenched debate, often with little recognition of market realities, prevented reform. Over time, the GSEs’ advantages enabled them to grow at a phenomenal pace, so that today they have $5.4 trillion in obligations outstanding, held by investors in the U.S. and around the world. As a comparison, that is almost 40 percent the size of the entire $14 trillion U.S. economy. The systemic risk posed by such size was heightened by the fact that investors assumed that GSE securities were backed by the U.S. government and therefore virtually risk-free, despite repeated statements by consecutive U.S. administrations to the contrary. These debt-holders would be the largest, but not the only, conduits of systemic impact should either GSE fail. Derivative counterparties, for example, would also be overwhelmed by a default of either GSE.

For some time market participants had questioned whether the GSEs were adequately capitalized for the risk they were taking, and therefore able to withstand losses without triggering a systemic event. Policymakers acknowledged that the GSE regulator did not have the authorities to address these risks, yet they could not reach consensus to improve it, and instead left a clearly inadequate regulatory structure in place. When I came to Washington, I saw an opportunity to improve the regulatory structure, even if it wouldn’t be perfect. I set to work in the fall of 2006 to broker progress in the House, and we did begin to solve some of the seemingly intractable differences.

Even as Washington debated GSE oversight, there was little debate over the extent to which government should subsidize homeownership, and whether such government support was contributing to a housing bubble. The U.S. government has many policies that subsidize homeownership – it would be oversimplifying and wrong to blame Fannie and Freddie for the bubble, but they clearly are part of the public policy bias that contributed to it.

In sum, the GSE reform debate was largely frozen in place, or moving at glacial speed. Then suddenly, the unprecedented housing correction shifted the ground under that debate and forced action.

Today I will review the actions we have taken and their effect, and address two issues before us. First, in the short-term, how do we use the GSEs to mitigate the current credit crisis and housing downturn? Second, given the temporary nature of their current status, how might we address the appropriate long-term structure?

Prelude to Recent Actions Regarding Fannie Mae and Freddie Mac

As we progressed through the current housing market downturn, investors fled mortgages that carried any credit risk. But because the GSEs take the credit risk on the mortgages they guarantee and because investors believed there was implicit government backing, the conforming loan market continued to function relatively well. As a result, the GSE share of new mortgage business rose from 46 percent in the second quarter of 2007 to 84 percent in the second quarter of 2008. Without the GSEs to finance mortgages, it was very clear that mortgage finance would essentially dry up.

However, as the extraordinary housing correction deepened, weaknesses in these entities became apparent. In July 2008, investors lost confidence as they became increasingly uncertain about Fannie and Freddie’s capital position. The GSEs’ already depressed stock prices plummeted further. Shareholder losses did not pose a public policy concern, but the share price drop further weakened confidence among the holders of the $5.4 trillion of GSE debt and MBS. Investors at home and abroad were reducing purchases and even selling from their holdings of GSE debt. The consequences of either GSE failing would be catastrophic. We couldn’t wait for a failure; we had to act preemptively to shore up confidence in these enterprises.

In July, I requested that Congress quickly complete work on long-sought GSE regulatory reform and also provide Treasury with expanded authority to support Fannie, Freddie and the Federal Home Loan Banks. Congress did so – giving us enormous temporary authorities to inject capital if the GSEs asked for it, and to create a back up liquidity facility for GSE debt.

Immediately after passage of the legislation, in coordination with the Federal Reserve, the newly-constituted GSE regulator, FHFA, and our advisor Morgan Stanley, we began a comprehensive financial review of the GSEs. At the same time, mortgage market conditions continued to deteriorate. Negative earnings announcements by Fannie and Freddie in August reflected those worsening conditions, and further roiled markets. Neither company appeared to have any reasonable prospect of raising private capital to allay those concerns in the foreseeable future, and our examination found capital to be inadequate – in terms of both the quality of capital and the embedded losses stemming from worsening mortgage market conditions.

Confidence in the GSE model was largely shattered. It was clear to me that simply injecting even a great deal of equity into their business model would not create the market confidence necessary to fund these enterprises going forward and to bolster confidence in the $5.4 trillion of extant GSE obligations, which posed the greatest systemic risk. Market fragility and the GSEs’ deteriorating balance sheets required that we take responsibility for the GSE structural ambiguities that U.S. policymakers had let fester for decades. If we had asked Congress for, and received, the power to explicitly guarantee the GSEs’ obligations, we would have done so. But without that authority, we had to be creative and find a way to effectively guarantee the GSEs’ obligations.

We had to stabilize the situation immediately. We knew that markets were exceptionally fragile and would be further threatened in September when we expected that a number of large financial institutions, including Lehman Brothers, would post disappointing earnings. Chairman Bernanke, FHFA Director Lockhart and I met almost daily, over a 10 day period, to work toward a comprehensive action plan. As I made clear at the time, we sought a temporary solution that would achieve three goals: (1) stabilize markets, (2) promote mortgage availability, and (3) protect the taxpayer.

In comprehensive action taken on September 7th, FHFA placed Fannie and Freddie into conservatorship, enabling Treasury to take creative steps to support their obligations. We moved quickly to do what was necessary. Our actions would have been impossible to implement were it not for the GSE reform legislation that gave FHFA the expanded power to make qualitative and quantitative judgments about capital and also gave Treasury the financial authorities necessary to make conservatorship a stabilizing, as opposed to a destabilizing, event. We devised Preferred Stock Purchase Agreements to effectively guarantee the GSEs’ obligations by ensuring Fannie and Freddie would maintain a positive net worth. This commitment ensures that they can fulfill their financial obligations, even after the temporary authorities expire in December 2009. Additionally, Treasury established a new secured lending credit facility intended to serve as an ultimate liquidity backstop. To further support the availability of mortgage financing, Treasury initiated a program to purchase GSE MBS and has purchased over $50 billion thus far.

We took these actions first, to avert the financial market meltdown that would ensue from the collapse of these institutions and, second, to allow the GSEs to continue, in the midst of overall market stress, to perform their essential role of providing mortgage finance. This conservatorship, with the explicit backing of the federal government, is temporary and must be resolved for the long-term. In the meantime, the GSEs must serve the taxpayers’ interest by assisting in turning the corner on the housing correction, which is critical to return normalcy to the capital markets and resume U.S. economic growth. The GSEs can facilitate progress through the housing correction by keeping mortgage rates low and by mitigating foreclosures.

Keeping Mortgage Rates Low

Lower mortgage rates enable more potential homebuyers to return to the market and help put a floor under home prices. Initially, following our September actions, mortgage rates did fall. Market turmoil subsequently increased and mortgage rates rose, but not nearly as much as the cost of other forms of credit. Still, neither the taxpayers nor the economy were getting the full benefit of the agreements put in place to effectively guarantee GSE debt. We could have gone back to Congress to ask for authority to directly guarantee GSE debt, however this would have been difficult to achieve. While a simple, direct government guarantee of GSE MBS might have reduced rates further – given the extraordinary strains in today’s markets it probably would still have failed to produce all of the desired mortgage rate reductions. Therefore, we examined other means of deploying our authorities that could reduce mortgage rates.

We immediately noted that, given the effective government guarantee and the spread between Treasury rates and those of the GSEs, the taxpayers would profit if the government simply issued Treasuries to buy GSE securities. And in fact, we have funded the purchase of GSE securities with the issuance of Treasury bonds. But to make an impact on mortgage rates, such an initiative would have to be very large and those Treasury issuances would count against the debt limit.

On November 25, the Federal Reserve announced a new program to purchase up to $100 billion in GSE debt securities and $500 billion in GSE MBS. This Federal Reserve program had a significant impact. The 30-year fixed rate has fallen from an average of 6.04 percent the week before the policy was announced to a record low 5.10 percent last week, accomplishing a vitally important step in addressing this housing correction – lower mortgage rates that may bring additional credit-worthy buyers into the housing market.

Foreclosure Mitigation Efforts

While the GSEs are in this temporary form, we have also worked to increase their impact on foreclosure mitigation. In November, FHFA, the GSEs, Treasury and the HOPE NOW Alliance announced a major streamlined loan modification program (SMP) to move struggling homeowners into affordable mortgages. The new protocol relies heavily on the “IndyMac model” developed by the FDIC and creates sustainable monthly mortgage payments by targeting a benchmark ratio of housing payments to monthly gross income. Together with the IndyMac/FDIC protocol, the SMP creates a powerful new model that should help ensure that no borrower who wants to stay in their home and can make a reasonable monthly payment will fall into foreclosure.

The SMP will directly and immediately apply to the 50 percent of homeowners with loans serviced under the GSEs’ auspices. Fannie and Freddie announced that they would suspend foreclosure sales and cease evictions of owner-occupied homes until January 9th to allow time for implementation of the modification program. The timing of this initiative is especially important as prime loans now account for almost 50 percent of new delinquencies, and delinquencies are increasingly the result of overall economic factors rather than the loan features and underwriting practices associated with Alt-A and subprime products.

And the impact of the SMP will go much further. The vast majority of servicing contracts for non-GSE mortgages reference the GSEs’ practices, and we therefore expect the SMP to be widely adopted and quickly move hundreds of thousands of struggling borrowers into sustainable, affordable mortgages. Further, this streamlined protocol frees up servicing industry resources that can be redirected to providing case-by-case assistance to more difficult cases that fall outside the SMP protocol.

Impact of Temporary Authorities to Stabilize the GSEs

Given the authority granted by Congress last summer, we have gone about as far as we can to avert systemic risk and to use the GSEs to speed progress through the housing correction that lies at the heart of our economic downturn. Although the effective guarantee of GSE debt and MBS has brought some degree of stabilization, it is not the most efficient way to remove the ambiguity inherent in the GSE structure, even temporarily.

To the extent that the Congress and the next Administration wish to use the GSEs as a tool to further reduce mortgage rates, they could, under existing authorities, make large purchases of mortgages made at a target rate of, say, 4 percent – although very large volumes of Treasury issuances would be required for such a program to be effective. A targeted program such as one that purchases only new mortgages made for home purchases, as opposed to refinancing, for a one year period would require less but still substantial funding. Separately, the next Administration could pursue legislative authority to directly guarantee GSE debt for the remainder of the conservatorship period.

Long-Term Policy Recommendations

The GSEs are playing a necessary role supporting the mortgage availability which is essential to eventually turning the corner on the housing correction, reducing the stress in our capital markets and returning to growth in our economy. This must continue to be our first priority. But we will make a grave error if we don’t use this period to decide what role government in general, and these entities in particular, should play in the housing market.

The public debate over the long-term structure of the GSEs is dramatically changed today – no one any longer doubts the systemic risk these entities posed. It is clear to all conservatorship is a temporary form, and that returning the GSEs to their pre-conservatorship form is not an option.

The debate about the future of Fannie and Freddie requires answering the much larger and more important question of the federal government’s role in the mortgage market and in housing policy, generally. Given the bubble we have experienced, policymakers must ask what amount of homeownership subsidies are appropriate. Numerous long-standing indirect subsidies already exist, including the mortgage interest deduction, subsidized FHA mortgages, and the variety of other HUD programs that expand homeownership opportunities.

Is that enough? Or should government also reduce mortgage rates for a larger group of homebuyers? Policymakers must decide if the GSE subsidy is a public policy priority. If the GSEs are to play a role, then, the debate is clearly framed: Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. Any middle ground is a recipe for another crisis. Although there are strong differences of opinion over the government’s role in supporting housing, under any course policymakers choose, there are structures and choices that can resolve the long-term conflict of purposes issues.

And it is clear that to protect against systemic risk in the future, the GSEs should be constituted with a portfolio no larger than what is minimally necessary for warehousing purposes. Without portfolios of significant size, the enterprises’ management of interest rate risk would remain a vital function for the safety and soundness of the enterprises, but would no longer present the same potential systemic risk.

As a public policy tool to expand homeownership, the GSEs, like FHA-Ginnie Mae, reduce mortgage rates for borrowers by taking on the credit risk that mortgage investors would otherwise bear and guaranteeing that mortgage investors will be paid in full should the mortgage borrower default. As Congress considers the future role and structure of the GSEs, it must consider how much credit risk the Federal government should take.

Addressing Credit Risk

In today’s stressed mortgage market, between FHA-Ginnie Mae, Fannie Mae, and Freddie Mac, almost all new mortgage market originations have federal government credit support. This is not sustainable over the long-run. It will lead to inefficiency, less innovation and higher costs. It also contradicts basic U.S. market principles. We must have some degree of private sector involvement in the evaluation of credit risk if we are going to have a mortgage market that allocates resources with efficiency.

In the mortgage market of the future, I clearly see a role for the FHA and Ginnie Mae for first-time and low income homebuyers. Beyond the explicit guarantee provided to FHA and Ginnie Mae policymakers must decide how much to further subsidize mortgage credit risk, if at all, and must decide the role of private capital in any subsidy plan. Depending on the degree of subsidy policymakers choose, there are a variety of options for structures to replace the GSEs, including:

(1) Expanded FHA/Ginnie Mae. Some advocate that beyond the current credit crisis the U.S. government’s long-term policy should make the implicit, explicit. Explicitly guaranteeing Fannie and Freddie’s obligations would essentially nationalize this significant portion of the U.S. housing finance market. Under this model, the GSEs could become a government entity, or their functions could be absorbed by FHA/Ginnie Mae . In either case, the GSEs would no longer have private shareholders. The size of the eligible population of homebuyers would determine how large a share of mortgage credit exposure the government would own.

I view the permanent nationalization of the GSEs, essentially expanding the role of FHA and Ginnie Mae, as a less-than optimal model. While it offers the perceived advantage of explicit government support, it eliminates the necessary private sector evaluations of credit risk and the private market stimulus to innovation.

(2) Partial Guarantee. A hybrid of this would be to create a Ginnie Mae-like entity for non-FHA mortgages, structured as a partial guarantee mechanism. The new entity could operate on a similar basis as Ginnie Mae, but provide only partial guarantees for MBS. Investors would then have a floor under potential MBS losses, but would still evaluate the credit risk associated with individual issuers. While such a hybrid program would clearly define the extent of the government’s guarantee, developing risk sharing parameters compatible with profit incentives would be as problematic, and potentially as inefficient, as in the current GSE structure.

(3) Privatization. A third alternative would be to remove all direct or indirect government support, completely privatizing these companies while breaking them up to minimize systemic risk. As appealing as this alternative sounds, it is difficult to envision a sound, practical, private sector mortgage insurance business of any significant size that does not require large amounts of capital, and consequently generates only a modest return on capital. The recent problems encountered by monoline insurers, which ventured into guaranteeing mortgage product as well as the experience of the GSEs, underscores this point. Moreover, a break up scenario does not look particularly promising, as reverse economies of scale would take hold. It is also worth noting that a regional mortgage insurer would lack diversity as a risk mitigant. Perhaps a consortium of banks would find it advantageous to own a national mortgage insurer to wrap their product, or some other good private sector business model may emerge. But I am skeptical that the “break it up and privatize it” option will prove to be a robust or even viable model of any substantial scale, without some sort of government support or protection. However, should policymakers choose to scale back public policy bias toward homeownership, we will eventually find out what business model the free market would support.

(4) Housing Utility. Finally, given traditional U.S. public policy support for marshalling private capital to expand homeownership, establishing a public utility-like mortgage credit guarantor could be the best way to resolve the inherent conflict between public purpose and private gain. Under a utility model, Congress would replace Fannie Mae and Freddie Mac with one or two private sector entities. The entities would purchase and securitize mortgages with a credit guarantee backed by the federal government, and would not have investment portfolios. These entities would be privately-owned, but governed by a rate setting commission that would establish a targeted rate of return, thereby addressing the inherent conflicts between private ownership and public purpose that are unresolved in the current GSE structure. This commission would also approve mortgage product and underwriting innovations to continually improve the availability of mortgage finance for a population to be defined by the Congress. In this model, continued safety and soundness regulation would be essential.

Need to Support Vibrant Private Market

If we are to maintain a private-sector secondary mortgage market – which I believe serves the taxpayer and the homebuyer equally well – then we must enhance the ability of depository institutions to fund mortgages, either as competitors to a newly-established government structure or as a substitute for government funding. One way to do this is for the government to receive some compensation for its guarantee. The current GSE Preferred Stock Purchase Agreements take a small step in this direction, in that as of 2010 the GSEs must pay the government a fee for the taxpayer backstop on their guarantees. Of course, if this rate perfectly reflected the risk versus the cost of the guarantee, there would be no subsidy to mortgage availability. It is obviously inherently difficult to reach an exactly correct price, yet a long-term fee-like structure in exchange for explicit government backing would help to reduce advantages over private institutions. Over time, another approach might be to offer other financial institutions the opportunity to pay a fee for government backing on securitized, conforming loans, a structural transformation that would lower entry barriers, and increase competition and innovation in housing finance.

Covered bonds are another private sector alternative worth exploring. The FDIC has made regulatory changes to support the emergence of covered bonds, which could provide enhanced opportunities for depository institutions to fund and manage mortgage credit risk. There is strong interest in developing a U.S. covered bond market, but we will have to work through the credit crisis before a new market is likely to take hold. Some have advocated dedicated covered bond legislation, which could be helpful to establishing this market, and should be considered in the context of broader housing finance reforms.

Additionally, the President’s Working Group on Financial Markets has recommended extensive reforms in the mortgage securitization process by investors, ratings agencies, underwriters and regulators, especially with respect to mortgage origination oversight. When these reforms are in place, we expect private label securitization to return with greater oversight and market discipline.

Conclusion

My thoughts today are intended to inform the necessary debate over the future structure of the housing GSEs. By allowing the GSE structural ambiguities to persist for too long, U.S. policymakers have created an untenable situation. Today, Fannie Mae and Freddie Mac are in a temporary form that, while stable, cannot efficiently serve their Congressionally-chartered mission and protect the taxpayers’ investment over the long-term. We took the right actions to meet a specific need at a specific time.

The GSEs are critical to getting us through this current period, and this is our first priority. More may need to be done to clarify and simplify their structure and to increase their effectiveness in curbing further housing price correction. But we cannot look only at this short-term need; policymakers must resolve the question of long-term structure because the pre-conservatorship model has been disproven.

The first step must be for policymakers to decide – in light of the recent housing bubble and the severe financial and economic penalty it has imposed on our nation – the role government should play in supporting home ownership. We cannot allow a repeat of the devastation this housing correction has wreaked on families and communities across the United States. Once that decision is made, the GSEs should be restructured to meet that public policy choice and satisfy three objectives: First, there must be no ambiguity as to government backing. It must be explicit or non-existent. Second, there must be a clear means of managing the conflict between public support and private profit. Third, there must be strong regulatory oversight of the resulting institutions.

As I have outlined, whatever role the U.S. government chooses to play in subsidizing mortgage finance, there is a structure that can meet the objectives. With the knowledge of recent experience, we have a responsibility to begin work now on a long-term GSE structure which avoids the dangerous mix of policy and market distortions created by the former flawed GSE model. Thank you.

FED: 12-30-08 MBS Purchases

The Federal Reserve on Tuesday announced that it expects to begin operations in early January under the previously announced program to purchase mortgage-backed securities (MBS) and that it has selected private investment managers to act as its agents in implementing the program.

Under the MBS purchase program, the Federal Reserve will purchase MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae; the program is being established to support the mortgage and housing markets and to foster improved conditions in financial markets more generally.

Further information regarding the structure and operation of the MBS purchase program is provided in the attached set of Frequently Asked Questions (FAQs).

Frequently asked questions

Fannie & Freddie: 12-15-08 W. Scott Frame

Fannie Mae and Freddie Mac and the Stabilization of the U.S. Mortgage Finance System

W. Scott Frame
Financial Economist and Policy Adviser
Federal Reserve Bank of Atlanta

Atlanta Rotary Club
Atlanta, Ga.
December 15, 2008

Thank you for that kind introduction, Jack. And thank you all for inviting me to speak to you this afternoon. This is a real privilege.

Fannie Mae and Freddie Mac have become the subject of a great deal of attention and controversy. The source of this dispute lies in the institutions’ unique federal charters that allowed them to become exceptionally large, profitable, and politically powerful. Recently, however, Fannie Mae’s and Freddie Mac’s exposure to risky mortgages compelled the federal government to intervene to stabilize both institutions and mortgage markets more generally.

Indeed, on September 7, 2008, Fannie Mae and Freddie Mac were placed into conservatorship by their federal regulator, the Federal Housing Finance Agency. And concurrent with this action, the U.S. Treasury entered into “senior preferred stock agreements” with each institution, obligating the federal government to inject up to as much as $100 billion each in Fannie Mae and Freddie Mac. Little did we know at that time, but this action would only be the first of many public-sector capital infusions for financial institutions.

In my remarks this afternoon, I will first provide you with some background about Fannie Mae and Freddie Mac. Then I will describe the sources of financial distress facing these two systemically important institutions, outline the federal government’s steps to stabilize them, and present some evidence concerning the effectiveness of this and other recent federal interventions in secondary mortgage markets. At the end of my talk, I will offer some principles for federal involvement in these markets over the long term.

Who are Fannie Mae and Freddie Mac?

Fannie Mae’s roots are in the Great Depression. The National Mortgage Association of Washington, as it was first known, was created within the federal government in 1938 to allow geographic diversification and improved credit availability. Its business was to purchase FHA-insured mortgages from financial institutions around the United States. Fannie Mae was subsequently spun off in 1968 as a publicly traded company as a way to reduce the federal debt during the Vietnam War. By contrast, Congress in 1970 created Freddie Mac, which was owned by the 12 Federal Home Loan Banks and the savings and loans that were members of these banks. Freddie Mac became publicly traded in 1989 as part of the resolution of the thrift crisis.

Hence, today Fannie Mae and Freddie Mac are quasi-public/quasi-private financial institutions, which are often referred to as government-sponsored enterprises, or GSEs. On one hand, each was created by Congress and maintains an exclusive federal charter. On the other hand, shares of Fannie Mae and Freddie Mac are traded on the New York Stock Exchange. This unusual governance arrangement resulted in two, often opposing, corporate objectives: fulfilling certain social policy goals and assisting related political constituencies and maximizing shareholder value.

By law, Fannie Mae and Freddie Mac are limited to operating in the secondary mortgage market. Their participation in this market takes two forms. The first is the issuance of credit guarantees against mortgage pools, called “securitization.” And the second is leveraged investment in mortgages and mortgage-backed securities. As of June 30, 2008, Fannie Mae and Freddie Mac together held almost $1.8 trillion in assets and had another $3.7 trillion in net credit guarantees outstanding. This $5.5 trillion in obligations slightly exceeded the $5.3 trillion in publicly held U.S. Treasury debt at that time. It also reflects about one-half of all U.S. residential mortgage debt outstanding.

Hence, while Fannie Mae’s and Freddie Mac’s federal charters limit the scope of their activities, the scale is tremendous. One important reason for this is that the charters also confer several statutory and regulatory benefits that result in the capital markets viewing Fannie Mae and Freddie Mac obligations as being implicitly guaranteed by the federal government. Examples of such benefits include Treasury lines of credit, the ability to issue government securities for purposes of the Securities Exchange Act of 1934, and the ability to use the Federal Reserve as their fiscal agent.

The perception of an implied federal guarantee conveys a subsidy on Fannie Mae and Freddie Mac, part of which is translated into lower mortgage rates for consumers. These perceptions have also insulated Fannie Mae and Freddie Mac from market-imposed limits on the institutions’ size and risk-taking. These features were well understood by the federal government, which created a regulatory structure for the two institutions in 1992. Unfortunately, this structure proved deficient in many respects.

Sources of financial distress

As we are all aware, housing and mortgage markets have become increasingly stressed over the past two years. This stress has led to significant dollar losses at a variety of financial institutions, including Fannie Mae and Freddie Mac. The losses borne by the GSEs emanate from four places.

The first source of losses is the write-down of the value of private-label mortgage securities backed by subprime and so-called Alt-A mortgages. (Private-label mortgage securities are those not guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae.) Holdings of such securities likely reflected a couple of factors. One is that Fannie Mae and Freddie Mac faced distorted risk-taking incentives because of the perceived implied federal guarantee. Another factor was the federal requirements that mandate a certain percent of each institution’s business be devoted to affordable housing.

The second source of financial distress at Fannie Mae and Freddie Mac has been a substantial increase in provisioning for expected mortgage-related credit losses. These expected losses are associated not only with subprime and Alt-A mortgages but also prime loans.

A third problem has been a loss in the market value of each institution’s holdings of their own mortgage-backed securities. An unusual and unforeseen widening of the yield spread between Fannie Mae- and Freddie Mac-guaranteed mortgage-backed securities and 10-year Treasuries has led to mark-to-market losses. This widening is believed to be primarily caused by the financial market turbulence, although the aforementioned credit problems at Fannie Mae and Freddie Mac have also likely played a role.

Finally, following the imposition of the conservatorship, both Fannie Mae and Freddie Mac wrote off so-called tax-deferred assets in line with accounting conventions required of other regulated financial institutions. This write-off was also caused by dim prospects for positive profitability any time soon.

Total losses for Fannie Mae and Freddie Mac over the past four quarters have been about $67 billion. While significant, these losses are modest relative to each institution’s overall book-of-business. The problem was that both institutions were extremely leveraged, leaving little room for error. This point had been made previously, most notably by former Federal Reserve Bank of St. Louis President Bill Poole.

Earlier this year, debt investors became increasingly concerned about the financial condition of both Fannie Mae and Freddie Mac. These investors also sought clarity from the federal government about whether bondholders would be shielded from losses. The attendant uncertainty caused a dramatic fall in Fannie Mae’s and Freddie Mac’s share prices during June and early July. In response to concerns that the two institutions would be unable to rollover their debt, U.S. Treasury Secretary Paulson requested that the federal government be given broad authority to invest in Fannie Mae and Freddie Mac. That provision was included in the Housing and Economic Recovery Act that passed in July 2008.

Government intervention
During August, the U.S. Treasury studied investment options and sought third-party opinions about the financial conditions at Fannie Mae and Freddie Mac. The Treasury also engaged the Federal Housing Finance Agency (FHFA) in discussions about the legal and operational hurdles to government involvement at one or both institutions.

On September 7, FHFA Director James Lockhart, U.S. Treasury Secretary Henry Paulson, and Federal Reserve Chairman Ben Bernanke spoke at a press conference. These officials outlined a plan to stabilize the residential mortgage finance market that included placing both Fannie Mae and Freddie Mac into conservatorship and establishing new Treasury-operated liquidity facilities aimed at supporting the two institutions—a mortgage-backed securities purchase facility and a standing credit facility.

By becoming a conservator, the FHFA assumed the responsibilities of the directors, officers, and shareholders of both Fannie Mae and Freddie Mac. Also, new chief executive officers were named to act as agents of the conservator.

Concurrent with the conservatorships, the U.S. Treasury entered into a senior preferred stock agreement with each GSE. The purpose of the agreements is to ensure that Fannie Mae and Freddie Mac maintain positive net worth going forward. If the regulator determines that either institution’s liabilities exceed assets under GAAP, the Treasury will contribute cash capital equal to the difference in exchange for senior preferred stock. Each of these agreements is of an indefinite term and for up to $100 billion.

In exchange for the senior preferred stock agreements, the Treasury received from each Fannie Mae and Freddie Mac $1 billion of senior preferred shares and warrants for the purchase of common stock representing 79.9 percent of each institution on a fully diluted basis. The agreements also included various covenants.

Effect on mortgage rates
The intent of the senior preferred stock agreements was to provide comfort to Fannie Mae’s and Freddie Mac’s senior and subordinate creditors and holders of mortgage-backed securities. This action, in turn, was expected to lower and stabilize the cost of mortgage finance. Of course, the senior preferred stock agreements had significant negative consequences for stockholders.

The initial market reaction to the federal intervention at Fannie Mae and Freddie Mac was tighter spreads on each institution’s debt and mortgage-backed obligations. Related to this, conforming mortgage rates fell by about 50 basis points. These market reactions, coupled with a relatively smooth operational transition, suggested that the imposition of conservatorships at Fannie Mae and Freddie Mac was, so far, a success.

However, by the first of November, mortgage rates and yields on Fannie Mae and Freddie Mac obligations had climbed back to preconservatorship levels. Policymakers searched for additional tools to lower and stabilize the cost of mortgage finance. In response, the Federal Reserve announced November 25 that it was establishing new facilities to purchase up to $500 billion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, and purchase up to $100 billion in debt obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System.

Looking ahead
The federal intervention into Fannie Mae and Freddie Mac consisted of both the imposition of conservatorship regimes and the senior stock purchase agreements. Congress will likely need to pass new legislation to move these institutions out of the current arrangements. Today’s consensus is that the previous public-private business model is inherently flawed and unstable.

Indeed it is unclear what role Fannie Mae and Freddie Mac will ultimately play in the U.S. housing finance system. And the reasons for this uncertainty do not solely rest with the two enterprises. The financial distress at Fannie Mae and Freddie Mac has occurred along with significant and well-publicized problems at private mortgage insurance companies, monoline bond insurers, and a host of mortgage originators. The federal government has stepped in to fill some of this void. FHA-insured mortgages have increased as a share of mortgage originations, and Ginnie Mae securitization activity has similarly expanded. Hence, the federal government may need to redefine its role in supporting secondary mortgage markets.

Secondary mortgage markets can help reduce mortgage rates by increasing liquidity, allowing geographic diversification, and encouraging competition. The federal government played a historically important role in developing these markets—both directly through Ginnie Mae and indirectly through Fannie Mae and Freddie Mac. However, based on my research, I conclude the reliance on secondary mortgage markets has probably been excessive, owing to a couple of factors. One factor was regulatory capital requirements for GSEs and depository institutions that encouraged more securitization than otherwise would have been the case. Another factor was the weak mitigation of the numerous conflicts-of-interest inherent in the originate-to-distribute model of financial intermediation.

Looking ahead, I think it would be helpful for the federal government to develop a set of principles to guide its involvement in secondary mortgage markets. Among other things, I believe that policymakers should reassess various public policies encouraging homeownership, reconsider the mechanisms relied upon for ensuring the flow of funds to mortgage markets during times of stress, revisit regulatory policies that act to distort financial risk-management decisions, and require that any interventions are made transparent by accounting for them in the budget process.

The past two years have been a time of extraordinary upheaval for U.S. mortgage markets. In my opinion, the associated adjustments are likely to continue in 2009 as the new Administration and Congress take the lead in further action to stabilize our nation’s mortgage finance system.

Federal Reserve: 12-12-08 Randall Kroszner, Housing Conference

Remarks on Improving the infrastructure for non-agency mortgage-backed securities at the Federal Reserve System Conference on Housing and Mortgage Markets, Washington DC, (December 4 2008)

I very much appreciate the opportunity to participate in this conference and to hear your insights firsthand about such a range of important topics.

As you know, housing markets are weak. Sales of new homes and of existing homes are well below their respective peaks around the middle of this decade. House prices have fallen sharply – the national price index published by the Federal Housing Finance Agency is down almost 8 percent from its high in the spring of 2007, and the Case-Shiller national index is down more than 20 percent from its peak about 2-1/2 years ago. Residential construction has remained weak, with single-family housing starts having declined to less than a third the number seen early in 2006. Even with the drop in homebuilding, the inventory of unsold new homes represents more than 10 months’ supply at the recent pace of sales. Taken together, these data suggest continuing near-term challenges for stabilization of the housing market.

With the plunge in home sales and house prices as well as very tight lending conditions, mortgage borrowing by households has fallen sharply over the past two years or so. Indeed, the latest information suggests that, on net, home mortgage debt may not have increased at all since the spring. Moreover, most of the new mortgages that were originated in the past several months were funded with mortgage-backed securities (MBS) guaranteed by the government housing agencies – Fannie Mae, Freddie Mac, and Ginnie Mae. That is, origination of mortgages not eligible for a government guarantee has fallen dramatically as issuance of private-label MBS has virtually come to a halt this year. The rapid deterioration in credit quality of mortgages in subprime and so-called alt-A MBS pools – and the subsequent severe rating downgrades of the securities they backed – has significantly eroded the value of and investor confidence in private-label MBS.

In my remarks today, I would like to suggest some fundamental changes in the structure of private-label MBS that might help a recovery, over time, in investor confidence and in the market for these securities. I believe that mortgage securitization has the potential to deliver economic value to investors, lenders, and, ultimately, borrowers.[Footnote 1 Some form of government backstop may be necessary to keep the market functioning under the most stressed circumstances. See Ben S. Bernanke (2008), "The Future of Mortgage Finance in the United States", speech delivered at the UC Berkeley/UCLA Symposium: The Mortgage Meltdown, the Economy, and Public Policy, Berkeley, California, October 31.]

Several conditions would be necessary for the potential of private-label MBS to be realized going forward. A necessary condition is for comprehensive and standardized loan-level data covering the entire pool of loans backing MBS to be made available and easily accessible so that the underlying credit quality can be rigorously analyzed by market participants more easily than is now the case. But comprehensive data will not be sufficient. In addition, a number of aspects of the securities themselves will probably need to be changed. First, the structures of cash flows from mortgage payments in the pool to the various tranches of MBS should be much less complex than some of those created in recent years. Second, securitization contracts will need to be made more homogeneous so as to allow greater comparability of risk profiles across deals and perhaps promote more robust liquidity. Third, securitizations should involve fewer and larger tranches of MBS, which, in addition to further promoting liquidity, could also reduce the exposure of some securities to certain tail risks and model uncertainty.

I believe that a new infrastructure built upon these foundations might reasonably be expected to lower the costs of information production and processing in the marketplace. The reduction of these costs will facilitate broader independent credit analyses, greater due diligence by potential purchasers, and, hence, greater ability to provide a double check on credit rating agencies’ evaluation of the riskiness of the securities. In other words, market participants would be more likely to acquire the expertise to evaluate securities issues that were more homogeneous and less complex. This change would make the situation closer to what occurs in the corporate bond market, in which standardized disclosures about relatively homogeneous and straightforward securities of publicly traded companies allow many analysts and potential purchasers to come up with their own evaluations, in addition to those of the credit rating agencies. Moreover, such changes might also lead to the creation of structures whose credit analyses are less sensitive to certain tail risks and types of model uncertainty and more likely to be liquid even in times of market stress. Thus, this new infrastructure might allow investors gradually to regain confidence in their ability to assess the risk-return tradeoffs inherent in MBS, allowing them to reconsider how those securities may best fit into their overall portfolios.

As I mentioned, in principle, mortgage securitizations make good economic sense: By providing access to the broad capital market, securitization allows loan originators to access a wider source of funding than they can obtain directly. In addition, securitization can limit an originator’s exposure to prepayment risks associated with interest rate movements, to geographic concentrations of loans, and to credit and funding risks associated with holding mortgages all the way to maturity. Effectively, securitization can significantly lower the cost of extending home loans, and some of those cost savings can be passed along to homeowners in the form of lower mortgage rates.

It seems clear that the housing government-sponsored enterprises (or agencies) played an important role in the development of mortgage securitization in the United States. In large part, the broad appeal of agency MBS can be traced to the explicit guarantee of the securities by the sponsoring agencies. This agency support may have meant that the returns to undertaking a thorough and costly credit analysis of underlying mortgages in agency MBS pools were low, so that task was essentially left to the agencies themselves. Indeed, even as agency MBS issuance took off in the 1970s and 1980s, the most basic infrastructure needed to conduct credit analysis on home mortgage pools – comprehensive loan-level data that was broadly accessible in a standardized format – went essentially undeveloped.

The paucity and inaccessibility of data about the underlying home loans was, in my opinion, one of the reasons that private-label MBS was able to expand so rapidly in 2005 and 2006 despite a deterioration in underwriting and prospective credit performance. That is not to say that better data would necessarily have led investors to completely sidestep the private-label MBS that have caused them so much difficulty. But I do think it was a significant hindrance that the information needed to infer, in real time, the extent to which subprime and alt-A mortgage underwriting was sliding simply did not exist in a form that allowed the widespread scrutiny or objective analyses needed to bring these risks more clearly into focus.

Thus, I believe that markets for private-label MBS are unlikely to recover unless comprehensive and standardized data for home mortgage pools are made widely available to market participants. As you may be aware, the American Securitization Forum (ASF) is in the midst of a large-scale project called RESTART, or Residential Securitization Transparency and Reporting. This project seeks to develop a standardized format for mortgage data that would be available to all investors and other market participants, with the goal of substantially improving disclosure and transparency related to private-label MBS.

RESTART has wide support in the industry, and the project is receiving input from a wide range of market participants, including investors, mortgage originators, loan servicers, credit bureaus, credit rating agencies, MBS trustees, legal counselors, and data vendors. Indeed, just yesterday, a report issued by a consortium of several securitization industry groups endorsed the RESTART project in its first recommendation for an “action plan” to work to restore confidence in securitization markets.[Footnote 2 See Global Joint Initiative to Restore Confidence in the Securitization Markets (2008), Restoring Confidence in the Securitization Markets, a report sponsored by the Global Joint Initiative's Steering Committee, a consortium of the Securities Industry and Financial Markets Association, the ASF, the European Securitization Forum, and the Australian Securitization Forum, December 3. BIS Review]

Although, to be sure, some time will be required to develop specific recommendations and then to overcome implementation issues, I am encouraged by the ambition of the project and the vigor with which participants appear to be working on it.

While comprehensive loan-level data for mortgage pools are necessary to rebuild confidence in private-label MBS, I now wish to elaborate a bit on improvements in the contractual structure of private-label MBS that are, in my view, also needed to revive the market. First, in recent years, the complexity of many deals made non-agency MBS difficult to value. For example, looking at private-label MBS deals constructed in the heyday of 2006, some subprime trusts included three separate pools of mortgages – for example, prime-rated jumbo loans, alt-A first liens, and a blend of subprime first and junior liens – with cash flows that were prioritized using complicated payoff rules among more than a dozen different securities. The securitization contract might have dictated that one AAA-rated tranche might have been paid using only cash flows from the prime jumbo loans, while another AAA-rated tranche could have received no payments at all from that pool.

Second, non-agency mortgage securitization contracts contained numerous idiosyncratic features that limited the comparability of deals that may have appeared to be similarly structured. Not only might there have been subtle but significant differences in the cash flow obligations to each tranche, but there was also much variation in other important provisions, such as duties on servicers of the loans in the pool and the representations and warranties that govern the circumstances under which poorly performing loans can be put back to the originator. Thus, even if comprehensive data on the loans in the pools had been available, a thorough credit analysis would have required both a detailed reading of the deal-specific documentation describing a particular deal’s potentially unique structure and a careful analysis of how its cash flow prioritization would affect returns to holders of the particular tranches of securities as laid out in the contract. Although such an analysis is possible, it may be beyond the available resources for many investors. I believe that more homogeneous mortgage securitization contracts could significantly lower the barriers to entry for credit analysts, thereby promoting greater transparency and perhaps more confidence among investors about the securities’ underlying risk-return attributes.

Third, larger tranches in private-label MBS could have a couple of key benefits. For instance, investors might view larger security issues as being more likely to sustain liquid trading conditions, which would allow investors to rebalance their portfolios, as conditions evolve, at reasonably predictable prices and with transaction costs comparable to those of other securities traded in “thick” markets. In addition, as has become evident, tranched securitizations are exposed to tail risks – situations that can be expected to occur only rarely but which convey very negative returns. My intuition is that thinner tranches are more vulnerable to tail risks, because it seems more likely in the latter case that widespread credit losses in the underlying loan pool could wipe out designated cash flows for the entire tranche – so-called nonlinear, or cliff, effects. Thus, future mortgage securitizations that rely on simpler cash flows and larger tranches might reduce some of the exposure to tail risks and enable investors to gain confidence.

As an aside, I should note that I do not expect a revival for some of the most complex structures that were created in recent years to finance a portion of subprime and alt-A mortgages. I am thinking specifically of collateralized debt obligations (CDOs) that were themselves backed by other structured credit products, including the lower-rated tranches of private-label MBS. These so-called two-layer securitizations were far more complex and much more exposed to systematic losses than were the MBS themselves. Indeed, investors in – and more importantly, financial institutions that retained – the super senior tranches of CDO-squared securities took substantial losses as the severity of the downturn in the housing market and in mortgage credit quality became evident. Given the magnitude of those losses and the recognition that rigorous credit analyses are extremely information-intensive (and very sensitive to assumptions about loss correlations), I would expect investors to remain skeptical of two-layer securitized financial products for the foreseeable future.

To the extent that larger tranches of simpler and more homogeneous securities might encourage broader information processing and credit analyses, they could play a role in rebuilding investor confidence. Corporations that issue large amounts of bonds, for example, tend to be followed by quite a number of analysts. Consequently, investors can access a wide range of information and opinions about those companies, providing a check – and less overall reliance – on credit analyses produced by the credit rating agencies themselves.

In sum, an improved infrastructure for non-agency MBS should include comprehensive, loan-by-loan data that are available in a standardized format that is readily accessible, but a robust data platform will not be sufficient. A new infrastructure will probably also include less-complex cash flow waterfalls, more homogeneous contract designs, and larger tranches of securities. With these features, the new infrastructure could increase transparency, and promote independent, objective credit analysis for the various classes of non-agency MBS. By facilitating detailed information processing and independent risk analyses, the reliance on credit rating agencies could be reduced, easing the way for investors to regain confidence in these securities and for liquidity to return in these valuable markets.

That said, the recovery in the market for non-agency MBS – and, more broadly, for the origination of home mortgages that depend on these securities for funding – is bound to be a gradual process. It will take time to develop and implement a new infrastructure such as the one I have outlined, and for investor confidence to be rebuilt. In addition, investors could remain wary of re-engaging in the market for private-label MBS until they become convinced that housing markets around the country are on the mend.

Release here.

Federal Reserve: 12-12-08 Donald Kohn, Housing Forum

I thought I might use these brief introductory remarks to put some of our challenges as regulators in the broad context of the tremendous shifts in the pattern of financial flows that we are witnessing. Traditionally, funds have been channeled from savers to borrowers in two ways: through financial markets and through financial intermediaries, such as banks and savings institutions. The turmoil in the U.S. financial system during the past 16 months has put both channels of financial intermediation under great strain and, in doing so, has produced a significant financial crisis. Large losses taken by financial institutions and investors, mostly from mortgage-related assets, have increased uncertainty and undermined confidence; these events have caused lenders to greatly tighten credit conditions for households and businesses, which, in turn, have contributed to a downturn in the economy that has reinforced the strains in the financial system.[Footnote 1 The views expressed are my own and not necessarily those of my colleagues on the Federal Reserve Board and the Federal Open Market Committee. Karen Dynan, J. Nellie Liang, and Sabeth Siddique of the Board staff contributed to these remarks.]

One consequence of the distress in financial markets is that banks are being pushed to take a greater role in financial intermediation, which reverses, in part, a long-term trend away from bank-based financial intermediation and toward market-based intermediation. And, indeed, bank lending surged earlier in the fall following a lull over the summer. However, the degree to which the pickup represented deliberate choices by banks is unclear, as many households and businesses reportedly drew on previously committed lines of credit, and selling of loans in securitization markets was hampered by further deterioration in those markets. In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters as well as the weakening of economic activity.

The need for greater bank intermediation has occurred at a time when banks are managing losses and are worried about meeting their funding needs. Concerns about banks’ creditworthiness have made it costly for them to issue long-term debt. Growth in bank deposits has been fairly strong this year, and the recognition that deposits can be a reliable source of funds protected by the federal safety net has perhaps helped to draw investment banks to convert to bank holding companies. But the competition for deposits has raised their relative cost, and deposits cannot be expected to make up fully for reduced funding from other sources.

The challenge for regulators and other authorities is to create an environment that supports greater bank intermediation, which should help to restore the health of the financial system and the economy. We want banks to be willing to deploy capital and liquidity, but they must do so in a responsible way that avoids past mistakes and does not create new ones.

Banks need access to funds to make loans – especially with securitzation markets impaired – and the authorities have taken several steps to enhance the supply of funds to banks. The Treasury, working with the regulators, has used its authority under the Emergency Economic Stabilization Act, or EESA, to inject capital into banks so they will be stronger and more stable. The Federal Deposit Insurance Corporation has expanded its guarantee on deposits and is insuring new senior debt obligations of banking firms. The Federal Reserve has reduced the cost of borrowing at the discount window and created a new facility to provide term credit to banks.

The Federal Reserve and the other federal banking agencies have also issued regulatory guidance to promote greater lending by banks. This guidance encouraged banks to meet the needs of creditworthy borrowers in a manner consistent with safety and soundness – specifically, by taking a balanced approach in assessing borrowers’ ability to repay and making realistic assessments of collateral valuations.[Footnote 2 See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2008), "Interagency Statement on Meeting the Needs of Creditworthy Borrowers", joint press release, November 12] Additional capital, liquidity backstops, and regulatory encouragement should all reinforce financial stability and set the stage for increased bank lending.

As it is neither realistic nor desirable for banks to meet all financial intermediation needs, the Federal Reserve and other authorities are also making efforts to stabilize financial markets more broadly. In this regard, the Federal Reserve has created facilities to lend to primary dealers, to purchase highly rated commercial paper at a term of three months, and to provide backup liquidity for money market mutual funds. We are also creating a facility to support the issuance of asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration.
In related actions, policymakers are taking steps to address the problems in housing and mortgage markets. The Federal Reserve supported placing Fannie Mae and Freddie Mac into conservatorship to help stabilize an important source of housing finance. More recently, the Federal Reserve has announced that it will purchase $600billion in debt issued by the housing-related government-sponsored enterprises and in mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae, which could reduce funding costs for mortgages. It also is supporting foreclosure prevention and neighborhood stabilization efforts, which help reduce unnecessary foreclosures and their costs on communities. Limiting foreclosures will also help reduce the risk that house prices will sink significantly below the level justified by fundamentals.

The events of the past year and a half have highlighted the need for changes in our financial system. Presumably, such changes may include a different balance between bank-based and market-based financial intermediation. As regulators of banks and thrifts, our job is not to determine what this balance should be. Rather, our job is, and has been, to create an environment in which, in the short run, banks can step up to fill as much of the gap as possible that has been left by still-dysfunctional markets, consistent with a strong, stable banking system. Over time, of course, we will need to work with the Congress and the new Administration to construct a system of oversight over both markets and institutions that better protects the stability of the financial system and the U.S. economy.

Release here.

Financial Markets: 12-11-08 Karthik Ramanathan, Financial Markets & Treasury Outlook

Release here.

New York – Good afternoon. I’d like to thank you for this opportunity to discuss financial markets, the fiscal outlook, and what recent trends may mean for debt management. The Treasury market is the deepest, most liquid market in the world, and to maintain this status, we act in a highly transparent manner and in a way that avoids disruptions to the financial markets. As major participants in the market for Treasury securities, you need to understand our objectives and constraints as you evaluate the investment outlook. As a result, I believe our discussion will be mutually beneficial.

Without a doubt, the economic and financial landscape is evolving rapidly. In just the past four months, events have come to pass that few could have anticipated or even imagined. The Treasury began investing in Agency MBS and making investments in financial institutions. The Federal Housing Finance Authority, a newly formed and better equipped regulator, placed Freddie Mac and Fannie Mae under conservatorship. The Federal Reserve introduced a series of innovative lending and asset purchase programs while aggressively easing monetary policy. The last remaining investment banks have become bank holding companies. And, the FDIC has initiated a temporary liquidity guarantee for new bank-issued debt. Together, these events have resulted in the provision of various explicit and “effective” government guarantees for a large cross section of the United States domestic debt market.

These developments have directly affected Treasury’s borrowing needs as well. The fiscal stimulus payments distributed earlier this year along with other actions to aid credit markets and promote economic recovery have added to our borrowing needs in a compressed period of time. In addition, the slowing economy and potential responses to this downturn will cause the government’s borrowing needs to increase further.

The Office of Management and Budget (OMB) deficit estimate for fiscal year 2009 was $488 billion in mid-July, very similar to private sector estimates at the time. In February 2009, OMB will release the Annual Budget with the Administration’s revised fiscal year 2009 deficit forecast as well as the five year outlook. In the meantime, private sector estimates of the budget deficit have risen given the possibility of further economic deterioration and subsequent spending on economic recovery programs.

While there is generally variation in market participants’ deficit estimates, this year the range is wider than in recent years. At this point, most estimates fall within a $500 billion range – nearly the size of last year’s entire deficit. More importantly to investors, estimates of net marketable borrowing vary commensurately. Recent market estimates have suggested $1.5 trillion in net marketable borrowing in fiscal year 2009, with some raising the possibility of net marketable borrowing in excess of $2 trillion. While this uncertainty remains, it is our responsibility as debt managers to as transparently as possible meet these borrowing needs in the least disruptive manner.

We have responded to the increases in the government’s borrowing needs in a traditional yet aggressive manner, following our principles of first increasing issuance sizes, then considering changes in frequency, and finally, considering additions to the auction calendar. This past year, we significantly increased issuance sizes of regular bills and coupons and increased issuance of cash management bills, some long-dated, to bridge low points in our cash balance. In June, we resumed issuing a monthly 52-week bill.

In addition, to address evolving challenges in a clear yet timely manner, we have issued statements regarding debt management decisions between quarterly refundings. For example, in early October, after passage of the Emergency Economic Stabilization Act, we alerted the market that we were considering significant changes to the offering calendar, including a reintroduction of the 3-year note in November.

Just two days later, Treasury took the extraordinary step of announcing the unexpected, off-cycle reopening of four off-the-run 10-year notes. This action provided needed funds while also helping to clear the unprecedented volume of settlement fails in the Treasury financing market. The subsequent November quarterly refunding statement made clear that unscheduled reopenings would remain the exception, as they are in general contrary to Treasury’s policy of regular and predictable issuance.

The statement also made evident that further improvements in resolving settlement fails would have to derive from private sector changes to trading conventions; otherwise, regulatory measures would need to be considered. Since that time, fails to deliver have declined from nearly $800 billion to less than $150 billion – a massive reduction in a very short period of time and another sign of increased efficiencies in our debt markets.

At the November refunding, we reintroduced the 3-year note to be issued on a monthly basis, added a regular second reopening of the 10-year note, and switched to quarterly new issue 30-year bonds. We also stated that we would continue to monitor projected financing needs and make adjustments as necessary, including, but not limited to, the reintroduction or establishment of other benchmark securities.

Marketable borrowing needs of $1.5 trillion can be managed with traditional approaches: increasing issuance sizes and frequencies, issuing cash management bills to bridge low points in our cash balance, and adding or reintroducing securities as necessary. Nonetheless, given the broad range of deficit estimates, Treasury needs to be prepared to meet additional financing needs if necessary. This challenge may require novel approaches to debt management. Should new approaches be adopted, Treasury would continue to strive for transparency and predictability, communicating any changes in as cogent and unambiguous a way as possible.

Market participants have proposed several ideas for addressing significant growth in net marketable borrowing needs. Some of the more conventional approaches include issuing a 7-year note on either a quarterly or monthly basis, potentially as early as February, and reopening the quarterly new issue 30-year bonds. More generally, extending the average length of the debt, given the current cyclical and future secular shifts in borrowing needs, has been suggested. While proposals such as the introduction of longer dated bonds have been raised, we need to be cognizant of the limited capacity to raise funds from such instruments and the ability of the market to effectively digest the risk inherent in the types of securities.

Other ideas that have been suggested to Treasury include introducing additional cycles of existing maturity debt such as bi-monthly 52-week bills, 2-year notes or 5-year notes. Debt repurchases for cash management purposes and a regular schedule of off-cycle reopenings of longer-dated securities have also been suggested and continue to be reviewed.

Treasury debt management requires constant reevaluation of our issuance calendar and available tools as we seek to finance the government’s expenditures at the lowest cost of financing over time. However, we do not time the markets. We issue debt in both a low and high interest rate environment which helps keep the market for Treasury securities deep and liquid and enables us to attract capital in even the most challenging financial market conditions. This certainty of supply results in a premium for Treasury securities which in turn reduces our borrowing costs over time.

Increasing demand for Treasuries has been aided by the decline in risk appetite by both traditional and non-traditional Treasury market participants and thus far the increase in Treasury issuance has been easily absorbed. The growth of Treasury and government-guaranteed debt will act as a catalyst for the return of smooth functioning credit markets and economic recovery, both of which will gain momentum as risk appetite returns.

As we move forward in thinking about how to potentially raise a significant amount of debt over a relatively short period of time, we recognize that we may need to progress beyond the conventional means of the past, particularly if our borrowing needs do indeed reach the upper end of market estimates. Nonetheless, as we continue to issue debt to finance the government’s initiatives to facilitate credit market and economic recovery, we must remain aware of the possibility of a rapid increase in risk appetite if the economic outlook becomes less negative, as well as any structural shifts in the economy.

At the same, we will need to be mindful of the effects any decisions may have on the volatility of our cash balances and the maturity structure of the debt, and uncertainty surrounding the fiscal outlook. We encourage market participants and others to share their ideas and suggestions with us regarding how Treasury might most appropriately raise the funds necessary, given the constraints and uncertainty we face.

Thank you.