A federally chartered but privately owned securitization conduit is one form of government participation in the secondary mortgage markets that just might work, according a Financial Economist and Policy Advisor at the Atlanta Federal Reserve Bank.

W. Scott Frame told the Bankers Club of Chicago last week that the futures of Freddie Mac and Fannie Mae are a legislative priority in 2010. He also set out some ideas, which he stressed were his own, for redefining the scope of government involvement in secondary mortgage markets.

Frame said that the intervention of the federal government (shoring up the GSEs financially and placing them into conservatorship when the housing and mortgage markets collapsed) in 2008 was necessary because it calmed investors by effectively guaranteeing the GSEs' obligations and improved the flow of capital to the residential mortgage sector.

The failure of Fannie Mae and Freddie Mac, Frame said, provides an opportunity to redefine the federal government's role in secondary mortgage markets.  One option would be to simply recapitalize the two GSEs and "return them to the wild."  If that is the choice, he said, changes would clearly be needed.  He suggested four....

  1. Significantly increase the GSEs' capital requirements to make them consistent with those of other regulated financial institutions, reducing incentives for large volumes of risk to reside in only two institutions.
  2. Strictly limit the GSE investment portfolios.
  3. Require that federal guarantees for GSE obligations, if any, be made explicit and be priced by the government.
  4. Strip out the GSE's affordable housing mission.  The two corporations have not performed well in this area and it is unclear whether they had any effect on outcomes.  In fact, some analysts speculate that the affordable housing goals may have contributed to the institutions' failure.

According to Frame, an alternative to resurrecting Fannie and Freddie would be to revisit the desirability and structure of government intervention in the secondary market.  It is not clear, he said, that government-sponsored securitization is truly needed for a well-functioning market, but may serve to insulate markets from external shocks and maintain stable access to credit.

One approach would be a Ginnie Mae type of blanket credit guarantee for qualified mortgage pools which would allow the government to control the guarantees and price risks and costs into the federal budget.  However, he said, experience suggests that a government-run operation would be less efficient and innovative and have more difficulty retaining staff than one run by the private sector and would carry the "big government" political onus.

He suggested that a politically palatable alternative could be a hybrid public-private model, but not of the GSE ilk; perhaps privately owned securitizers with access to priced government tail-risk insurance and be subject to safety-and-soundness regulation. This, compared to a full government model, would likely bring greater efficiency and innovation and involve more private capital and a smaller role for government.

Such hybrid public-private models could be created by statute or the charter function placed in the hands of a regulator. The latter model would allow the granting of an unlimited number of charters and create competition among those receiving them. The opposing view is that important standardization and liquidity benefits would be more easily obtained with fewer entities issuing securities.  Limiting the number of participants could also reduce misrepresentation and fraud.

A second issue is whether such entities would be required to be monoline firms (as Fannie Mae and Freddie Mac are today) or whether charters could be granted to affiliates or subsidiaries of other diversified financial institutions such as large commercial banks. Chartering stock-owned financial institutions may expand the safety net and further distort risk-taking incentives.

If the entities are to be monolines, should they be owned cooperatively by originators or as stock firms by public shareholders? Frame said that experience with cooperatives suggests that such institutions have weaker risk-taking incentives, although stock purchase requirements would add to the cost of participation.

Finally, no matter what the number and structure of these entities, he said, we will need a regulator with political independence and broad authorities to limit taxpayer risk.

In terms of risk sharing, some analysts have suggested having the securitizer(s) purchase priced tail-risk insurance from the U.S. government that carries an explicit guarantee. That raises important additional questions about public-private loss sharing on mortgage pools. For instance, what is the threshold at which the government tail-risk insurance is triggered? In instances where this level is below that of the mortgage underwriting standard and securitizers are thus exposed to risk, should some of this credit risk be shared by the mortgage originators, perhaps through a risk retention requirement? Then, he said, perhaps one should consider similar rules for government-sponsored deals that face the same adverse selection problem.

Frame concluded by saying he believed that the most likely outcome will be government chartering of  privately owned securitization conduits that would be required to purchase government tail-risk insurance. Such conduits could actually include Fannie Mae and Freddie Mac—after each is restructured through a receivership process, the Federal Home Loan Banks or possibly even mortgage originators themselves.