Washington is the problem in mortgage finance

It’s August and that means that silly and inexplicable things can happen in Washington, D.C. Last year around this time, the mortgage finance sector got the proverbial two-by-four in the face just as many were trying to go on holiday. We sounded the first warning in The Institutional Risk Analyst a year ago:

“Our friends at Ginnie Mae suddenly floated a request for public comment on a bizarre proposal for new issuer eligibility standards that would crush many government lenders. The announcement came late in the day Friday, meaning that Ginnie Mae buried the request on the website. Indeed, we hear that Ginnie Mae originally planned to release the rule without any request for public comment.”

A lot has happened in a year. The Senate confirmed Sandra Thompson, a veteran of the Federal Deposit Insurance Corp. and Resolution Trust, as Director of the Federal Housing Finance Agency. The Senate also put in place a new president of Ginnie Mae, Alana McCargo, an industry veteran who worked in outward-facing roles for the GSEs, JPMorgan Chase and, most recently, the Urban Institute. 

These two appointments are very good news for the industry after years of neglect by the White House and Congress. The big hope is that these two agencies can move forward together, in concert with the states, to conclude the two issuer eligibility rules that have been hanging over the industry unfinished for years.  But do Thompson and McCargo have sufficient sensitivity to the mortgage industry’s increasingly dire predicament? 

We’ve noted previously that Thompson and FHFA essentially took ownership over both issuer eligibility proposals by including different capital risk weights for conventional and government-insured assets in the FHFA capital proposal. But Thompson cannot act unilaterally on the new standards for non-bank issuers in the conventional market of Fannie Mae and Freddie Mac.  

If Ginnie Mae and the FHFA do not agree on the requirements for government-insured assets (loans and servicing), then the industry faces chaos. A significant divergence between the FHFA and the Ginnie Mae issuer rules could greatly disrupt the secondary market — and that is precisely the outcome that now faces the mortgage industry.

Valuations for Ginnie Mae securities, government- insured loans and mortgage servicing rights (MSRs) could be affected adversely, along with credit ratings by Moody’s, Kroll Bond Rating Agency and other agencies. The threat of reducing operating leverage and therefore profitability could also impact equity market prices for mortgage issuers at a time when many firms are on the verge of insolvency.

The process is complicated by the fact that the two secondary markets are very different. In the conventional market, the GSEs own the loans and allow the private issuers to retain the servicing asset. The GSEs issue the mortgage-backed securities and reimburse the private issuers for expenses incurred servicing delinquent loans. The major risk to conventional issuers is short-term liquidity and, more dire, loan repurchase claims by the GSEs for a manufacturing defect. 

In the government market, on the other hand, the seller/servicers own the government-insured loans and the servicing, and issue the MBS with a guarantee from Ginnie Mae for bond holders. Ginnie Mae cannot reimburse issuers for expenses and thereby provide liquidity to the market. Instead, government issuers are required to finance Ginnie Mae loss mitigation indefinitely until either the loan is modified or foreclosed. 

Ginnie Mae just issued modest changes to the issuer eligibility rules on Aug. 4, but issuers worry that more significant changes are in the offing. Word on the Street is that FHFA and Ginnie Mae could release their final issuer eligibility proposals over Labor Day weekend, hopefully with alignment on capital and liquidity.  But there may be more bad news for the industry there.

The big hope from the industry is a more liberal approach to counting unused lines of credit from banks as part of liquidity calculations. The big worry is that both Ginnie Mae and FHFA may mandate higher margin requirements for to-be-announced securities trades in the secondary loan market. We talked about the FHFA’s proposal regarding TBA margins back in March in this column.

Keep in mind that the SEC and FINRA have primary legal responsibility from Congress for setting margin requirements. The last thing that the mortgage finance industry needs is increased hedging costs, especially when the volatility in the secondary market has already trebled compared to historical market moves. Of note, FHFA has refused to confirm to NMN whether they have discussed their proposal with FINRA or the SEC

Rising margin costs are only one of many threats to the industry in Q3 2022. The big risk is from mounting levels of delinquency, a threat that is pretty much in everyone’s face but is not yet visible in the data. Operators, however, know that a large pile of government loans is headed for default post-COVID. Thompson and McCargo should be actively supporting loss mitigation with additional liquidity for Ginnie Mae issuers.

On Capitol Hill, members of Congress are worried about matters of no consequence, like nonexistent risk from the GSEs as they sit in conservatorship. No less a financial authority than Rep. French Hill (R-Ark.) and nine other Republican committee members, recently sent a letter to FHFA Director Thompson urging oversight of Fannie Mae and Freddie Mac activities.

Instead of making much ado about nothing with respect to imaginary risk from the GSEs, Republican members ought to be encouraging the FHFA to support liquidity for private mortgage issuers as the U.S. economy slips into a recession. Perhaps Rep. Hill and his esteemed colleagues did not get the memo, but the GSEs are essentially stuck in conservatorship indefinitely and are winding down their balance sheets.

Rep French apparently does not understand that without legislation, the GSEs will never exit conservatorship. Indeed, once the GSEs pay down the rest of their corporate debt, Fannie Mae and Freddie Mac will be neutered, mere mortgage conduits with no loan portfolio and an insurance book supported by Uncle Sam. 

As the GSEs exit the world of buying loans for portfolio stage right, the mortgage industry is badly in need of a new source of liquidity. Commercial banks are already stepping back from the mortgage market at the behest of prudential regulators.  In addition to getting the issuer eligibility proposals done, Thompson needs to help McCargo focus on getting sufficient liquidity to help Ginnie Mae issuers financing loss mitigation activities in a real recession. 

In 2020, there were fears of liquidity shortfalls due to COVID forbearance that never materialized. Now we have a Fed-induced recession coming, with delinquency rising in full view of lenders, and not nearly enough fear and loathing on the part of the FHFA and Ginnie Mae. There is a reason why federal bank regulators are pressing the top banks to raise capital and sell, yes sell, risk assets like one- to four-family mortgages. We talked about the faulty Fed bank stress tests in our last comment.

Immediate steps by the FHFA to bolster liquidity for Ginnie Mae issuers ought to include reopening the Federal Home Loan Banks to bona fide insurance subsidiaries of independent mortgage banks. And both Thompson and McCargo need to get the issue of liquidity for government loans and Ginnie servicing assets front and center with the Treasury, Federal Reserve Board and the White House now — before we have a liquidity problem later this year or in 2023.