The Acting Director of the Federal Housing Finance Agency (FHFA) said this week that risk management is not the only relevant consideration in reforming the nation's housing finance system. 

Edward J. DeMarco, speaking to the 12 Annual Risk Management Convention, said, however, that the characteristics of the government's role in housing and the reform framework that is eventually put in place will define the degree of certainty market participants have regarding their own risk exposure in housing finance.

"The credit policies and guarantees put in place during the GSE reform process will ultimately dictate private investor demand for mortgage-backed securities", says MND's Managing Editor Adam Quinones. "That in turn will determine the level of mortgage rates relative to benchmark yields."

Despite their conservatorship status, DeMarco said, the government sponsored enterprises (GSEs) Freddie Mac and Fannie May remain at the center of the country's housing finance system, but that will have to change.  The longer the future structure of the system remains uncertain, the more the operational risks of conservatorship will continue to emerge.   Improving and simplifying the operations of the GSEs is part of FHFA's duty to preserve and conserve assets and is consistent with the notion of their "wind down," but the ultimate transformation of the GSEs and their market functions will largely depend on actions of Congress and the Administration.  This leaves FHFA with the responsibilities of conservatorship while the long term course is determined. 

DeMarco said it is important to keep the GSEs focused on their existing core business rather than venturing into new product lines or businesses but they must still looking beyond a holding pattern.  To this end FHFA is working with the GSEs to make long term improvements in the functioning of the system which will pay dividends without regard to the form the system ultimately takes.  For example, last May FHFA directed the GSEs to develop uniform standards for data reporting on mortgages and appraisals.  This will allow identification of potential loan defects at the front end of the mortgage process which should reduce repurchase risk.  Standardizing terms and data reporting protocols will decrease costs and will allow new industry participants to utilize industry standards rather than having to develop their own proprietary systems.

More recently FHFA announced the Joint Servicing Compensation Initiative to consider alternative compensation models for single-family mortgage servicers.  The goals are to improve service for borrowers, reduce risk to servicers, provide flexibility for guarantors to better manage non-performing loans, and promote continued liquidity in the To Be Announced mortgage securities market.

The White Paper on housing finance developed recently by the Departments of Housing and Urban Development and Treasury recommends a gradual transition to greater private capital participation in housing finance and greater distribution of risk to non-government participants.  While a lot of steps have been taken, the White Paper envisions that FHFA will further strengthen the GSE's underwriting standards and improve the risk sensitivity of their pricing.  It also calls for a finding ways to bring greater private capital to the mortgage market such as increased down payments, expanded private sector risk-sharing and further adjusting pricing to reflect what would result in a more purely private-sector operated market.

The Acting Director said that his agency's statutory responsibility to "preserve and conserve the assets and property" of the GSEs leads to the question "what are we preserving and conserving, why, and for whose benefit?  The GSE's assets fall into four broad categories:

  • The legacy, pre-conservatorship book of business, including investments, mortgages owned, mortgages guaranteed;
  • The post-conservatorship book of new business.
  • The business platforms, operations, and processes;
  • The human capital; people who run the business, manage the risk and support the operations.

The "why" of doing this, DeMarco said it was to protect taxpayers from further losses, ensure market stability and liquidity; to give lawmakers options for the future, and to protect the future value of the GSE's intangible assets for future utilization and value to taxpayers and markets.  "Even though we do not know the future of the companies," DeMarco said, "it makes no sense to diminish, denigrate, or erode their tangible or intangible assets."

FHFA must acknowledge the preserving and conserving the assets entails many risk management challenges.  The legacy book of business must be protected from further credit losses and FHFA and the GSEs are focused on effective loss mitigation strategies to avoid foreclosure where practical and use loan modifications and other loss mitigation alternatives.

In managing the risk of the post-conservatorship book of business the challenge is establishing appropriate underwriting standards and risk based pricing.  Much of this has been done but further refinements will continue to be a challenge, especially since government supported mortgage activity constitutes nearly the entire market today.

There are multiple risk management challenges in the GSEs business platforms, operations, and processes as shortcomings in those areas contributed to the conservatorship in the first place.  It is difficult to control for the future when the fate of the companies is unknown; thinking about whether and how to invest in and develop infrastructure and operations presents some unique challenges.  DeMarco said participants need to continue to develop and maintain the infrastructure supporting securitizations but some long term investments in overhauling information technology or other infrastructure may not be appropriate.  Finding the balance is key.

What may have happened with past management of the GSEs, DeMarco said is in the past.  Today it is necessary  to address the uncertainty felt by GSE employees.  They know the company will probably cease to exist at some point yet there is critical work to be done.  FHFA has sought to establish an appropriate and competitive compensation system and while employees appreciate both the importance of their role and being suitably compensated, the opportunity costs to some will become greater over time.  Thus recruiting and retaining executives and staff is one of FHFA's principal risk management challenges.

There is also the issue of the public debates about the GSEs and their future and how those play out among employees.  DeMarco said Congress's review of the advancement of legal fees to some officers was appropriate but also generated uncertainty that commitments made to employees are subject to change ex post.  As conservator, he said, FHFA has an obligation to ensure these commitments are appropriate to the goals of the conservatorship and are fulfilled to the extent FHFA's authority permits.

Time, the Director said, is not on our side.  A lengthy transition is probably inevitable but we need to begin moving ahead now to determine the future of the nation's housing finance system.