April 3, 2016

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com
Twitter: @JoshRosner

UPDATEDi: What is Wrong with the Parrott, Ranieri, Sperling, Zandi and Zigas
Reform Proposal? Everything.

The primary goal of any secondary mortgage market system should be to ensure that, in
adverse economic environments, it can provide liquidity to the primary market in support
of borrowers. If a proposed system results in increased government exposure, or an
inability to fund itself in bad economic environments, then the proposal has failed to meet
its most basic purpose and should be dismissed.

Such a proposal is that put forth by Parrott, Ranieri, Sperling, Zandi and Zigas. It would
place the GSEs support for affordable housing at unprecedented risk, disproportionately
benefit Wall Street TBTF banks over smaller independent and community banks and
increase taxpayer exposures, recreating a model of private gains and public losses that
would significantly increase the federal budget. Finally, the proposal would require new
and comprehensive GSE reform legislation that is highly unlikely to pass.

Oddly, the authors compare their flawed concept to the national highway system, in
which a wider range of commerce is able to move freely across the country because of
the governments stewardship of the infrastructure. This is a false analogy. The highway
system is directly funded by governments, its operating costs dont rise in bad times, it
does not provide unequal access, and recessions do not impact its maintenance costs.
Moreover, there is no risk of highways shutting down during recessions.

A more appropriate design for GSE reform would follow that of the vastly
overcapitalized electric, water, sewer and gas utilities which, because of their social
mission and high operating costs are granted quasi-monopoly status in return for highly
regulated oversight and regulated returns on capital. Utility failures are rare and even in
recession homeowners and renters can turn on the lights and expect them to work.

My proposalii solves for each of these issues in a rational way that reduces TBTF risk;
avoids disproportionately benefitting Wall Street; is far less costly, reduces transition risk
and avoids the need for controversial legislation.

AFFORDABLE HOUSING

Although the authors claim that the new NMRC would have the same obligations to
support affordable housing that the GSEs haveiii they also state, The NMRC will
purchase, pool and securitize only those loans that meet the product features of the
Consumer Financial Protec- tion Bureaus de nition of a Quali ed Mortgage and have a
dollar amount no greater than a limit to be determined by the FHFA. QM loans have

Please refer to important disclosures at the end of this report.

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several consumer focused requirements including a requirement that borrowers debt-to-

income ratio is 43% or less. As example, according to Fannie Mae analysisiv, in a tight
credit market as existed between 2009/2013, fully one-quarter of purchase money loans
made to borrowers at or below 80% or area medium income had DTIs greater than 43%.
If only QM loans move through the sysem, 25% of borrowers will lose access to
mortgage money, starving minorities and other underserved populations. While the
authors have tried to clarifyv that they would remove the DTI requirements from the QM
defintion they fail to engage in an discussion of the implications of doing so.

To change the QM definition would require passing legislation giving the new
government owned corporation the same exclusions from QM that the GSEs receive in
conservatorship. In other words, their plan transfers the catastrophic risk of higher DTI
loans onto the government through the corporation. I think that is worthy of discussion
and do not see how that could be seen as acceptable public policy.

While the PRSZZ plan attempts to put all credit and interest rate risk into private markets,
as we saw with Alt-A and subprime loans during the crisis, the private sector was neither
able nor willing to take those risks in an economic downturn. As a result the proposal
creates real risk to those borrowers most in needvi and dramatically increases the pro-
cyclical nature of the secondary market.vii By its defintion and purpose the secondary
mortgage market is intended to be counter-cyclical, that is to say that when the economy
or markets become less liquid and more risk averse the secondary market is intended to
be able to provide liquidity to lenders so that they can tontinue to make mortgage loans.
Any solution that would reduce the ability of all but the strongest borrowers to access
markets in difficult economic times should be abandoned on that basis alone.

The authors claim to have solved for this pro-cyclicality by creating a Mortgage
Insurance Fund (MIF) which can be used to support the market in bad times. According
to their plan, if the MIF becomes depleted, the regulator would be able to assess fees on
the industry, after a crisis, to recapitalize the fund.viii This is an unworkable solution for
several reasons. First, these costs would unfairly be borne by those institutions that
survived the crisis and remained solvent. Perhaps more importantly, at the same time
these institutions were assessed fees to recapitalize the MIF they would almost certainly
be forced by their primary regulators to rebuild capital. This would result in increased
strains in the recovery, increased regulatory competition and would ensure the costs are
passed on to consumers as higher cost.

The argument that their plan would put a formidable amount of capital in front of
taxpayers, particularly after considering that the mortgages the NMRC will backstop
must satisfy the qualified mortgage rule is misleading. The timing of capital is as
important as the level of capital. Much of the capital they design for would be calculated
and, hopefully, recovered on the other side of a crisis - precisely when there is less capital
available to repay the government.

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PRO-TBTF

They may view the Dodd-Frank Act as perfect or problematic, but few in Washington or
elsewhere would disagree with its intentions to reduce concentration in the banking
industry, diminish the interconnectedness of financial institution and slash systemic risk.
Unfortunately, almost all legislative and policy proposals for secondary-mortgage-market
reform increase those risks. The PRSZZ proposal goes furtherit dramatically increases
those risks.ix

The authors contend that in good times the private-market players should provide the
majority of loans, either through originating mortgages to keep in their portfolios or
through private-label-securitization. This approach guarantees that community banks and
independent lenders, typically more in touch with local market conditions and closer to
their customers, will be disadvantaged as it would create incentives for independent
lenders, who do not have capital market execution capabilities, to become third party
originators who sell their loans to those TBTF banks who have capital market access. As
we saw in the crisis, many of the worst private label securities issued by large banks were
comprised of loans originated by third party lenders which the banks bought to securitize
while failing to inform investors of the weoful conditions of those loans. Currently there
is essentially no private label market and even when there was a PLS market it only
securitized jumbo, Alt-A and subprime loans and it never operated with any unified
standards.

Even beyond the reality that smaller lenders cannot securitize, one has to ask which small
banks originate loans and keep them in their portfolios the answer is very few small
banks and no independent lenders. Even if banks had the balance sheets that would allow
them to portfolio these mortgage loans it is very unlikely that bank regulators would
support an increased use of regulatory capital for real estate lending. After all, an
increased reliance on bank portfolios shifts risk from one implicitly guaranteed part of the
market to another while increasing the risks to regulated financial institutions.

Besides the creation of the Mortgage Insurance Fund, PRSZZ proposes the creation of a
National Mortgage Reinsurance Corporation, a government-owned company that would
sell the non-catastrophic risks into the market while retaining the catastrophic risks. The
authors argue that The sources of private capital in the NMRC system are not too-big-to-
fail, and thus will not be required to hold additional capital to remain going concerns in a
crisis, as would be required of a systemically important financial institution. But this is
inaccurate. While private particpants are not a single institution, they would still be
aggregating more risk to the largest players. That risk would grow and accelerate industry
consolidation due to smaller firms being increasingly unable to grow volumes, retain
servicing or because of their lack of resources - play in the first-loss risk transfer market
with its higher and greatly leveraged returns. Moreover, each of the purchasers of these

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first-loss risk securities is counterparty to large regulated institutions and the result would
require an increase in counterparty capital. Risk, like matter, follows the laws of physics;
it can be neither created nor destroyed only moved around and, in this case, hidden. In
attempting to dismiss these concerns the authors are forced to rely on a politically nave
claim that FHFA [will] act as an ombudsman for mediating concerns of stakeholders in
the system about NMRCs activities. As we have witnessed repeatedly both before and
since the crisis, regulatory capture by the largest firms is real and, in this case, the largest
firms would inevitably yield more power over the regulator as they are more effective at
lobbying and have deeper pockets.

COST, TRANSITION RISK AND TAXPAYER EXPOSURE

Like the Corker-Warner and Crapo-Johnson plans before it, the PRSZZ proposal fails to
assess the costs of the transition from the GSE model to their own. As we have
previously pointed out they they fail to consider the need for the NMRC to hold any
regulatory capital.x More disconcerting and costly is the reality that their approach would
lead to private capital proactively withdrawing from the market at the first hint of
problems and place more risk on the public. This demonstrates both a lack of
understanding of capital market behavior and the increased public costs that would result.
It also recreates an unacceptable model of private gains and public losses.

The goal of the PRSZZ plan recognizes that rather than winding the current system
down and starting largely from scratch, we would merely accelerate the steps that FHFA
already has under way to synchronize and de-risk the current GSEs, which would then
form the structure for the government corporation to replace them. This may sound
workable but it is not. It ignores that the GSEs continue to have debt-holders, preferred
and equity holders who would need to be remunerated. Calculating these costs and
apportioning the claims would be a costly, lengthy and complicated process, requiring the
appointment of a trustee or receiver, and also creating significant new risks that many
more lawsuits by those investors will be filed. During this period of uncertainty the GSEs
would continue to lose key personnel and risk an acceleration of those departures as a
result of employees going from a market based compansation structure to a government
pay scale.xi

In considering the impact of moving the new corporations onto the government budget
the authors ignore that the costs will rise dramatically in bad economic times even if the
government is eventually able to recoup its outlays.xii While the authors agree that the
debt issued to support the portfolio of the NewCo would count toward the Treasurys
debt limitxiii they fail to acknowledge that it would be politically impossible to sell that
idea to Republicans. Placing another $5 trillion of debt on the government debt limits is
politically unworkable, even if only on a temporary basis. Furthermore, in supporting
claims that the impact of moving the federal governments backstop onto the budget
would be modest, PRSZZ is forced to rely on accounting machinations.xiv

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LEGISLATION WOULD BE REQUIRED

A significant criticism of the GSEs business model and their increasing instability,
between 1995 and the crisis, was their ability to influence legislators and capture
regulators in an effort to expand their business without adequate consideration of credit,
operational, liquidity or reputational risks. It is therefore an imperative to ensure that
these elements are not reintroduced in any new system. Unfortunately, the PRSZZ
proposal only transfers those unacceptable powers from the GSEs to the largest primary-
market financial institutions while transferring key risks directly to the government. This
system of public losses and private gains has little chance of finding adequate support on
Capitol Hill.

Claims that as a government corporation, it would be motivated neither by profit nor

market share, but by a mandate to balance broad access to credit with the safety and
soundness of the mortgage market sound eerily familiar. After all, that was a key
justification for the passage of the 1992 GSE regulatory legislation. It became the basis of
the GSEs lobbying power and political support - by wrapping itself in the American
flag while promoting a distorted version of homeownership.

These future risks of politicization can be seen in the authors own words. The system
proposed could accommodate either a large or a small government footprint, with the size
controlled by adjusting these loan limits.15 This will allow policymakers to signi cantly
reduce the governments share of the market when purely private lending channels are
healthy enough to serve much of the countrys borrow- ers adequately, and scale it up if
and when they struggle. Replacing the GSEs with a system that recreates the
politicization of the 1995-2007 GSE model or the risk of capture will not likely find
significant support from rational legislators. The suggestion that The NMRC will be
required to meet duty-to-serve and afford- ability goals de ned by the FHFA, the same as
Fannie and Freddie must do today. And like the GSEs, to help meet these obligations, the
NMRC will price its g-fees in a manner that subsidizes lower wealth borrowers who are
creditworthy but may not be able to afford a mortgage loan otherwise. In addition to this
subsidy, the NMRC will charge an explicit 10 bps affordability fee that will be used to
fund initiatives to support access and affordability for homeownership and rental
housing demonstrates a further level of political tone-deafness. Rather than creating a
hard-wired and non-manipulable means to support affordable housing, as I do in my
proposal, this proposal would create a new system that is sure to be manipulated by the
political ideology of any future FHFA Director.

Clearly the authors of the paper have faile in attempting to reach the goals of meaningful
GSE reform. Specifically, they fail to create a system that avoids future politicization of
the system, ensures proper protections for the public, apportions losses on private lenders
and investors, reduces systemic risk, reduces concentrations of lending in the largest

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firms or supports affordable housing loans to qualified borrowers. At core, the goals of a
secondary mortgage market are to create a counter-cyclical mechanism to ensure
mortgage lending will continue when economic circumstances lead private market
players to pull back from lending and risk-taking.

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i
Note: My prior version of the paper included two quotes from an earlier version of the
paper the authors prepared. I have adjusted the quotes in this version. Neither quote has
any impact on the arguments I had presented or the failings of the authors paper. I have
also added commentary on the implications of changing the definition of a Qualified
Mortgage and have also concluded the paper with specific structural shortcomings of
their paper.
ii
Paper available at: https://www.scribd.com/doc/293324382/12-15-2015-GSE-PAPER-
Something-Old-Somethng-New-Something-Borrowed and Summary available at:
https://www.scribd.com/doc/298963712/GF-Co-GSE-Reform-Presentation-Something-
Old-Something-New
iii
A More Promising Road to GSE Reform (hereafter Promising Road), Jim Parrott
Lewis Ranieri Gene Sperling Mark Zandi Barry Zigas, Economy.com, March 2016,
available at: https://www.economy.com/mark-zandi/documents/2016-03-22-A-More-
Promising-Road-To-GSE-Reform.pdf
(See: the NMRC will be required to meet duty to serve and affordability goals defined
by the FHFA, the same as Fannie and Freddie must do today. And like the GSEs, to help
meet these obligations, the NMRC will charge a g-fee that subsidizes higher-risk
borrowers who are credit-worthy but may not be able to afford a mortgage loan
otherwise.)
iv
Fannie, Freddie Say Overhaul Would Boost Mortgage Rates
Companies Outline Concerns on Senate Bill to Replace Them, Nick Timiraos, Wall
Street Journal, April 25, 2014, (See: Related Documents - Fannie Memo 1) available at
http://online.wsj.com/public/resources/documents/042514FannieAddendum.pdf
v
A More Promising Road to Reform, Mark Zandi, Urban Institute, April 6, 2016,
April 7, 2016 available at: http://www.urban.org/policy-centers/housing-finance-policy-
center/projects/housing-finance-reform-incubator/mark-zandi-more-promising-road-
reform (see Note 1: We would not preclude loans on the basis of debt-to-income ratio.
For more on this topic, see What is a Qualified Mortgage, by the Consumer Financial
Protection Bureau, updated February 8, 2016.) Note: The CFPB document cited states
What is a Qualified Mortgage? Answer: A Qualified Mortgage is a category of loans

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that have certain, more stable features that help make it more likely that youll be able to
afford your loan. Generally, the requirements for a qualified mortgage include:...A
limit on how much of your income can go towards your debt, including your mortgage
and all other monthly debt payments. This is also known as the debt-to-income ratio.
vi
Promising Road (See: The key function of the secondary mortgage market, namely
the taking of interest rate and credit risk, would be handled by the private sector.)
vii
(See: NMRCs g-fee will vary depending on the cost of private capital, which in turn
will fluctuate with the perceived risk in the market. Mortgage rates will thus be lower in
the new system than in the current system in the good times and higher in the bad
times.)
viii
Promising Road (See: If the MIF is depleted during a crisis, the FHFA would have
the authority to make up any shortfalls in the fund by increasing gfees to a level greater
than that needed to cover the prevailing credit risk when economic conditions
normalize.)
ix
Promising Road (See: In normal times, we would expect lending backed by
portfolio lenders and private-label securities investors to serve the majority of the
nations mortgage needs, allowing the government-backed channel to retreat to a more
conservative role. It will only take on a larger role in the market if and as the purely
private lending channels dry up.)
x
Promising Road (See: In a time of acute stress, these investors will either be
unwilling to provide capital at all or require such a high return that it would cause
guarantee fees and mortgage rates to spike, exacerbating the financial stress. To ensure
that this doesnt happen in the new system, the NMRC would have the flexibility to scale
back its risk transfers when private capitals required return rises above a pre-defined
threshold that defines a crisis)
xi
Promising Road (See: The uncertain impact that the transition to the proposed
system would have on employee retention is also an issue.... While there are no
limitations on employee compensation in a government corporation per se, Congress
would be unlikely to stand by silently if the NMRC paid its executives million dollar
salaries.)
xii
Promising Road (See: Lastly, transitioning to this system would move the role of
the federal government in backstopping the market onto the federal budget. But the
impact would be modest, since the NMRC will set its gfee based on returns consistent
with those charged by private capital)
xiii
Promising Road (See: The debt issued by NMRC to support its portfolio would
likely count towards the U.S. Treasurys statutory debt limit, although the impact on the
nations debt load would be inconsequential.)
xiv
https://www.cbo.gov/sites/default/files/112th-congress-2011-2012/reports/06-02-
gses_testimony.pdf The practice of using different accounting methods for similar
federal obligations can cause confusion, make it difficult to accurately compare costs
between programs, and create an incentive to rely more on programs or activities that
have relatively low bud- getary costs even if their full costs to taxpayers are higher.

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Providing an illustration, CBO recently compared the estimated cost of FHAs single-
family mortgage insur- ance program on a FCRA versus a fair-value basis.5 The two
approaches yield very different estimates. Under the FCRA methodology, the FHA
program would produce budgetary savings of $4.4 billion in fiscal year 2012. On a fair-
value basis, in contrast, the program would have a cost of $3.5 billion in 2012. The
inconsistent treatment of the GSEs and FHA also implies that a mortgage that generates a
budgetary cost when it is guaranteed by Fannie Mae or Freddie Mac could show
budgetary savings if FHA provided the coverage instead.

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