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Mortgage Crisis Watch Business and legal issues affecting: loan repurchases | mortgage-backed securities | mortgage insurance

Proposed Legislation Would Replace Fannie Mae, Freddie Mac

The Future of Housing Reform

A bipartisan group of U.S. Senators recently proposed a bill that would replace Fannie Mae and Freddie Mac over the next 5 years. If passed by congress, the legislation would replace Fannie and Freddie with a newly created government reinsurer called Federal Mortgage Insurance Corporation (FMIC), modeled after the Federal Deposit Insurance Corporation. The bill reflects a prevailing view among lawmakers that the two government-sponsored agencies should be phased out while the federal government should continue to play a prominent role in backing U.S. residential mortgage lending.

Despite what we feel is feigned outrage over the lack of quality of most “legacy” mortgage loans, there is little doubt that Fannie Mae and Freddie Mac both were players in the financial crisis. During 2005 and 2006, they increased their purchases and guarantees of risky mortgages, just as the housing market was peaking. Moreover, the two government sponsored agencies combined have received nearly $190 billion in taxpayer-funded injections. As a result the U.S. Treasury now owns roughly 80% of each company. It should be no surprise, therefore, that they are at the center of the debate on housing and mortgage lending reform.

New Architecture

“Housing finance is the only part of financial reform that really was never taken on and we think it’s a good time to set up a new architecture,” U.S. Senator Mark Warner (D-VA) said in an interview with Betty Liu on Bloomberg Television.

The proposed reconstruction of the housing market’s government-sponsored financial infrastructure will likely be a long process, however the window of opportunity to introduce legislation that would replace Fannie Mae and Freddie Mac is open wider now than it has been since any time following the crisis, in large part due to the recovery of the housing markets.

Perhaps equally as important, the bill has won the support of President Obama. “The president strongly supports comprehensive housing finance reform that would forever end Fannie Mae and Freddie Mac’s flawed business model that put the American taxpayers on the hook,” Amy Brundage, a White House spokeswoman, wrote in an e-mail.

The 10% “First-Loss” Provision

The proposed legislation would permit the FMIC to collect premiums from industry participants, while still acting as a safeguard in the event of a crisis by stepping in to insure investors of conventional mortgages from losses, but only after private capital has absorbed the first 10% of the loss. Meanwhile, the FMIC would continue efforts to expand secondary mortgage markets by securitizing mortgages in the form of mortgage-backed securities (MBS) while also continuing Fannie and Freddie’s existing form of multifamily guarantees.

The cornerstone of the bill’s “new architecture” is the first 10% requirement, placing more private capital up front, which acts as a buffer in the event of a crisis. The proposal requires private investors to hold equity capital of 10% of the principal of underlying securities. The bill’s supporters argue that the increased investment by the private sector in advance of any government reinsurance ought to placate taxpayers. We would also think that the first-loss requirement hopefully will act as a self-regulator to curb the risky practices that were all too prevalent prior to the current mortgage crisis.

While politicians seem determined to replace the “too-big-to-fail” housing goliaths, not everyone is supportive. According to Michael Kao, founder of hedge fund Akanthos Capital, “the public-private model is a time-tested model,” which simply needs better regulation and an approach to business that encourages competition from private capital.

We suspect that implementing the 10% first-loss provision may reduce losses for GSEs and ultimately ease the ripple effect of future mortgage buyback demands. Although it may be difficult to gauge when such relief will arrive and when legislation winding down Fannie and Freddie will be passed by congress, one certainty is that housing reform is coming.