While regulators in Washington agree there’s a need to draw private capital back into the market, no consensus has developed on how to do so.
To entice investors, Ed DeMarco, current acting director of the Federal Housing Finance Agency, proposed two broad approaches designed to replace Fannie Mae and Freddie Mac.
“In each approach, private investors would be compensated for pricing and bearing mortgage credit risk ahead of a government guarantee, if such a guarantee exists at all,” DeMarco said Thursday.
The issuer-based approach is associated with a financial institution guaranteeing principal and interest repayment to investors.
In this model, the issuer’s guarantee would be backed by shareholders’ capital and would assume a further credit enhancement in the form of a government guarantee on the securities issued.
“This type of structure requires a significant amount of regulatory safety and soundness oversight to protect against the moral hazard associated with providing a government guarantee,” DeMarco explained.
He added, “It also relies heavily on federal regulators rather than private investors to measure risk and set the capital needed to absorb losses across a wide array of possible economic environments. While such an outcome has certain merit and some attractive features, a number of issues need further exploration.”
Mortgage-backed securities issuers in such a structure would have concentrated and undiversified exposure to residential mortgage credit risk.
However, the acting director questions whether that is an appropriate way to structure a key component of the finance system and would it also pose systematic risks.
In the securities-based approach — as opposed to credit risk being absorbed by the equity of the securities issuer — credit risk would be absorbed through capital markets, DeMarco stated.
“To a large degree, this is what the old private-label MBS market did. We know that even though the old private-label MBS market functioned in a way to distribute credit risk, in the end it was not durable and led to a misallocation of credit risk in its own right,” he said.
He added, “But was the problem with the concept or the lack of infrastructure, standards, and rules to govern the market? In my own view it was not the concept, but the lack of an appropriate infrastructure.”
From an investor’s perspective there are a number of key areas in the securitization process where it’s important to have the ability to enforce rights if private capital is accepted to price credit risk.
Some of the areas include standard data definitions, loan quality assurance, servicing standards and protocols and data disclosure.
“What the securities-based approach would be establishing is a market infrastructure for the pricing and capitalizing of mortgage credit risk. If such an approach were established, it would allow for the broader disposition of credit risk across capital market investors, as opposed to the equity investors in the issuer-based approach,” DeMarco explained.
In either approach, the point is to pool capital sufficient to bear mortgage credit risk while pricing such risk.
“The approaches differ from each other in the institutional and regulatory frameworks required and in the potential systemic risk that may result. In either approach, an ultimate government backstop could be deployed, although the securities-based approach has more flexibility in how that might be done,” the acting director explained.
