Opinion

Securities-Level Backstop Threatens Taxpayer Protection

In April, Treasury Secretary Steven Mnuchin clearly stated: “… [w]e can’t put taxpayers at risk. We can’t have a system where we have a bailout of housing finance.” But some market participants are expected to ask for precisely that this week at a hearing of the Senate Banking Committee. They will ask that the federal government provide an unlimited full faith and credit guarantee on mortgage-backed securities issued by Fannie and Freddie (or on MBS issued by one of the untested guarantors they repeatedly propose). This request provides a windfall to large banks that purchase and lend against MBS.

Recently we published “Blueprint for Restoring Safety and Soundness to the GSEs.” This blueprint provides a clear path to building $155 billion to $180 billion in first loss private capital, through retained earnings, public stock offerings and contributions from existing investors. We emphasize that Fannie and Freddie should be subject to enhanced capital requirements, which are consistent with large financial institutions, but customized to fit their role as single-purpose mortgage guarantors. We recommend that existing government support, which takes the form of a combined $258 billion in undrawn backup lines, be reduced dollar-for-dollar as private capital is raised, with a floor of $150 billion, or such amount established by the safety and soundness regulator. This approach puts substantial private capital in front of the taxpayer, while increasing the claims-paying resources that provide credit support to GSE debt investors.

The blueprint for GSE reform plainly states that, “… [w]hile we believe market stability can be maintained utilizing the existing PSPA [the Treasury’s preferred stock backup line], and in fact winding-down that PSPA over time, nothing in our plan would preclude new legislation to restructure this support into a full MBS guarantee, should Congress ultimately enact any such legislation.” The blueprint is compatible with a full MBS guarantee. Having said that, we don’t believe that such a guarantee is needed.

There is no question that MBS investors prefer a full faith and credit guarantee of GSE MBS. In addition to a reduction in already limited credit risk, such an arrangement would give MBS investors substantial regulatory advantages that would improve the trading price of fully guaranteed securities. Ginnies on average trade about one-and-a-quarter points richer than Fannies and Freddies for the same coupon.

Under Basel III, Fannie and Freddie securities are assigned a 20 percent risk weighting, whereas Ginnie Mae MBS – which benefits from an unconditional guarantee — is assigned a 0 percent risk weighting. This means that banks do not need any capital held against investments in Ginnie Mae bonds. There is almost $1 trillion of Fannie and Freddie MBS on the call reports of U.S. banks. Extending a full guarantee to existing GSE obligations, which is one option being discussed, would eliminate today’s 20 percent risk-weighting and provide $200 billion in risk-weighted asset relief to U.S. banks. Ginnies are also assigned no haircut by banks in determining their liquidity coverage ratios, whereas Fannie’s and Freddie’s are assigned a 15 percent haircut.

Guaranteeing only MBS and not unsecured agency debt has the potential for increasing funding costs in a market that currently has $700 billion outstanding. This could hamper the GSEs’ ability to carry out their core functions. This debt provides financing to (1) buy mortgages at the cash-window (a great service and benefit to smaller banks and originators), and (2) to repurchase delinquent loans from MBS trusts (maintaining the steady prepayment characteristics that are important to the market). Providing no catastrophic support for this unsecured agency debt would hamper the GSEs ability to support small lenders and maintain stability in the markets.

Some argue that foreign investors will demand an explicit and unlimited guarantee to buy GSE MBS. These investors have never benefitted from such a guarantee, and certainly don’t have one now. Today they have the benefit of explicit but limited government support provided by the Treasury’s backup line. Based on MBA forecasts and conservative growth assumptions, the overall outstanding amount of Fannies and Freddies should be constant or even fall over the next several years.

Today we enjoy some of the lowest mortgage rates in modern times with the support of both domestic and foreign MBS investors. We believe that the current explicit, but limited, government support can and should be maintained. We note that the blueprint provides substantially more explicit credit support than MBS investors have ever enjoyed.

Some proponents of a securities-level guarantee suggest the U.S. government fully guarantee the $4.4 trillion of Fannie and Freddie legacy MBS. In the absence of such a guarantee, legacy securities could trade at a discount to new fully guaranteed MBS. This could have unintended consequences on the TBA market. We estimate the market-based fee that would be needed could be 25 basis points or more on the full notional amount of the legacy MBS to compensate for this increased risk, or approximately 5 basis points if Fannie and Freddie raise first-loss private capital to the 3.25 percent level as outlined in the blueprint. Just giving this guarantee away for free would result in a sizable transfer of wealth to MBS investors.

The blueprint provides a straightforward path to build substantial protection for taxpayers, while maintaining the 30-year mortgage and TBA markets. The blueprint is fully compatible with an unlimited and explicit guarantee, but we believe that stability in the mortgage market can be maintained with reduced government support. This approach would help Mnuchin meet his goal of not putting taxpayers further at risk, while ensuring the continued availability of the 30-year mortgage.

 

Landon D. Parsons is a senior adviser in the Financial Institutions Advisory Group at Moelis & Company LLC. The views expressed in this op-ed are those of the author and not necessarily the views of Moelis, which disclaims any liability to any person who reviews this op-ed. Moelis is a financial adviser to certain non-litigating preferred shareholders of Fannie Mae and Freddie Mac.

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