A new blueprint for the secondary mortgage market: congress will soon take up the issue of what to do once the conservatorship of Fannie Mae and Freddie Mac is over. A hand-picked group of mortgage finance experts called the Council on Ensuring Mortgage Liquidity has some suggestions.

Since the creation of Fannie Mae in the 1930s, the federal government has played a key role in providing stability to the secondary mortgage market. Following the single-family housing woes and credit crunch of 2007, that role changed dramatically as the federal government stepped in to take over and prop up Fannie Mae and Freddie Mac. * The two organizations collectively hold $280 billion in private-label mortgage-backed securities (MBS) and $400 billion in whole loans, and have guaranteed more than $4.5 trillion in MBS. It is generally agreed that they cannot return to business as usual, but the question of how to fill their large shoes remains open. * The Mortgage Bankers Association (MBA) and its Council on Ensuring Mortgage Liquidity (see sidebar for a list of council members) have taken a deep and deliberate look at this question, and have come up with a recommendation--one that has garnered the attention of the White House, The Wall Street Journal, Congress and CNBC.

The council

MBA's Council on Ensuring Mortgage Liquidity has been at work on these issues since its formation in October 2008.

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On Nov. 19, 2008, the council hosted a summit on the future of the secondary mortgage market and the government-sponsored enterprises (GSEs). The summit brought together leading thinkers from industry, academia and regulators to discuss what fundamental elements would be required for a functioning secondary market.

The discussion led to the report Key Considerations for the Future of the Secondary Mortgage Market and the Government Sponsored Enterprises. The document was released in January 2009.

The council's second task was to develop a set of guiding principles that would help it and others assess recommendations about the future of the secondary mortgage market. The report Principles for Ensuring Mortgage Liquidity was released by MBA in March 2009.

As the policy spotlight turned to the futures of Fannie Mae and Freddie Mac, the council took up the question of what an appropriate future government role in the core secondary mortgage market might look like. Its recommendations and reports can be found at www.mortgagebankers.org/ceml.

The recommendation

"At its heart, the recommendation from the council and the MBA simplifies and clarifies the roles of the private sector and the government: establishing a durable framework for promoting residential mortgage market liquidity while protecting the taxpayer from risk," says Michael Berman, CMB. Berman is president and chief executive officer of Boston-based CWCapital, chairman-elect of MBA and the chairman of MBA's Council on Ensuring Mortgage Liquidity.

The centerpiece of MBA's recommendation is the creation of a new line of mortgage-backed securities. Each security would have two components--a loan-level guarantee provided by privately owned, government-chartered and regulated mortgage credit-guarantor entities (MCGEs) and a security-level guarantee "wrap" provided by the federal government (see Figures 1 and 2).

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"Under the recommendation, the assessment, mitigation, pricing, guarantee and holding of capital against mortgage risks would be left with the private sector, with private investors taking on the risks associated with single-family and multifamily mortgages in exchange for market returns," says Berman.

"At the same time, and in order to attract a range of investors to mortgage-backed securities covering the core of the mortgage market, the government would provide a credit backstop in the form of an explicit guarantee of certain mortgage-backed securities. The government guarantee would be backed by a risk-based insurance fund, by strong regulation of the providers of the underlying loan-level guarantees and by limits on the types of mortgage products covered."

Given the fragile state of the capital markets, the importance of keeping Fannie Mae and Freddie Mac functioning efficiently in the current environment is also recognized. The council envisions the existing GSEs continuing to support the secondary mortgage market for as long as it takes to attract private capital back to the market. "That could take a long time--years, not months," says Berman. "So patience and transition are critical." To assist this transition, the recommendation sees key roles in the new paradigm for the people, systems, documents and relationships of Fannie Mae and Freddie Mac.

"The recommendations represent a clear, concise and workable approach to ensuring liquidity to the mortgage market," says John Courson, MBA's president and chief executive officer.

"The proposed framework balances the government's ability to ensure liquidity with the need to protect taxpayers from credit and interest-rate risks associated with mortgage finance." MBA's Residential/Single-Family Board of Governors (RESBOG), Commercial Real Estate/Multifamily Finance Board of Governors (COMBOG) and board of directors have all signed on to the council's recommendations.

Need for private investors to assess, mitigate, price and bear risks

Under the plan, a new set of institutions--mortgage credit guarantor entities (MCGEs)--would purchase mortgages and issue mortgage-backed securities supported by those mortgages. The MCGEs would provide loan-level guarantees on the mortgages and would manage their credit risk using combinations of risk-based pricing; originator retention of risk, such as lender representations and warrants; private mortgage insurance (PMI) or other risk-sharing arrangements.

"It is a balancing act," says John Johnson, CMB, president and chief executive officer of Mortgage America Inc., Birmingham, Alabama. "A government backstop of the mortgage backed securities is essential, but you need to have private industry--private capital--taking on the primary risks and the concomitant rewards of the market. The market is too diverse and too dynamic for the government to do that effectively."

The MCGEs would be privately owned, mono-line institutions focused solely on the mortgage credit guarantee and securitization business. The MCGEs' loan-level guarantees would be backed by their own private capital, which would be overseen by a strong regulator. None of the corporate debt or equity issued by the MCGEs would be guaranteed, either explicitly or implicitly, by the federal government.

Unlike today's GSEs, the MCGEs would hold only de minimis portfolios of mortgage assets. The portfolios' purposes would be to support securitization by allowing the MCGEs to 1) aggregate allowable mortgages for securitization; 2) manage loss mitigation through foreclosure, modifications and other activities; 3) incubate mortgages that may need seasoning prior to securitization; 4) develop new mortgage products through a strictly limited level of research and development prior to the development of a full fledged securitization market; and 5) fund highly structured multifamily mortgages that are not conducive to securitization. As a result, the MCGEs would take minimal interest-rate risk, with private MBS buyers bearing that risk instead.

Another key aspect of the plan is that the MCGEs and the federally related securitization guarantee would support only "core" mortgage products, with well-understood, well-documented risk characteristics. Subprime, alternative-A and other similar mortgage products would still have a home in the fully private market, but would not be a part of the core market supported by the MCGEs. Any new loan types proposed by the MCGEs would require approval by the regulator and the government guarantor (GG).

Need for a federal credit wrap to attract a range of investors

In order to attract the range of investors needed to fund the $12 trillion single-family and multifamily mortgage markets, the council and MBA recognized the need for an investment vehicle that is liquid, clearly defined, simple to understand and backed by quality regulation.

"It is absolutely critical that we have the full faith and credit of the federal government behind mortgage-backed securities," says Robert Gaither, senior vice president, government lending executive, Bank of America Home Loans, Calabasas, California. "That has been demonstrated by the recent rise of FHA/VA [Federal Housing Administration/Department of Veterans Affairs] lending and Ginnie Mae issuance. In times of illiquidity, you have to have an instrument that will perform in tandem with where Treasuries will perform."

To accomplish this, the recommendation calls for a new line of mortgage-backed securities. Each security would have a security-level, federal government-guaranteed "wrap" like that on a Ginnie Mae security. The GG securities would carry a government guarantee of timely interest and principal payment, would explicitly carry the full faith and credit of the U.S. government, and would be sup ported by a federal insurance fund similar to deposit insurance.

The GG would support only those types of loans needed to keep the secondary market for core mortgage products liquid and functioning through all environments, with the government guarantor itself responsible for determining eligible mortgage products. FHA, VA, Rural Housing Service (RHS) and Ginnie Mae would continue to play critical roles in providing government credit support for affordable housing, while the fully private market would provide financing for mortgages that fall outside of core loan types.

Similarities to and differences from the current model

The recommendation bears important similarities to and differences from the pre-conservatorship Fannie Mae and Freddie Mac models (see Figures 1 and 2).

Unlike the previous model, liquidity would be promoted through an explicit government guarantee of mortgage-backed securities, rather than implicit guarantee of the private companies issuing MBS. Also, the mission of the MCGEs would be explicitly limited to ensuring liquidity in the core mortgage market through the issuance and guarantee of mortgage-backed securities. This would limit risks and provide ample room for the fully private markets to operate.

As with the GSEs, the MCGEs would assess, price, mitigate, guarantee and hold capital against mortgage credit risks, but the products covered would be limited to only core mortgage products and subject to double approval by the regulator and the GG, rather than left open to the management of the MCGEs.

"The key to the MCGEs is that they take on the initial credit risk at the loan level," says Garry Cipponeri, senior vice president at New York-based Chase. "The key for security investors is the government guaranty at the bond/security level, which is backed by the full faith and credit of the U.S. government. During last year's meltdown with Fannie Mae and Freddie Mac, Asian and other large investors made it clear that they were no longer comfortable with the long-standing implicit guarantee," he says.

The MCGEs would hold only de minimis portfolios in support of securitization, rather than large investment portfolios like those of Fannie Mae and Freddie Mac. As a result, essentially all of the interest-rate risk would be passed on to MBS investors with no opportunities to seek arbitrage profits. The capital requirements of the MCGEs would be overseen by a strong regulator and would not be clouded by interest rate risk and liquidity risk of large investment portfolios.

Affordable-housing objectives that had been placed on the GSEs would, in the new model, be achieved largely through FHA, Ginnie Mae, RHS and other explicit federal tax and spending programs.

Any affordable-housing role for the MCGEs would be carefully defined and would supplement, but not weaken, their primary functions. This would include 1) affordable multifamily rental housing; and 2) if the regulator and GG agree to define "core products" to include affordable single-family products, then risk-based pricing and transparency would be included in order to avoid market distortions.

Need for a smooth transition

Getting from the current state to any future state will require a great deal of planning. "The council spent a lot of time talking about the importance of the transition," says David Roberts, CMB, president and chief operating officer of Grand-bridge Real Estate Capital LLC, Charlotte, North Carolina.

"The issue is dealt with in the council's Key Considerations document, in its principles and in its recommendations. The new model won't arrive overnight. With so many players and so many issues, we need to make sure the transition helps stabilize the market, not disrupt it," he says.

To that end, the council and MBA recommend that the infrastructures of the existing GSEs be used as a foundation for one or more of the new MCGEs. Fannie Mae and Freddie Mac have people, systems, documents and relationships that would prove instrumental to a new MCGE, and their transfer would help smooth the transition from the existing system to the future.

Likewise, historical performance data and other information from Fannie Mae and Freddie Mac would be made available to market participants--including originators, the MCGEs, regulators, rating agencies, investors and providers of credit support. The transparency and historical insights from such information would help the entire market function more smoothly. The council also notes that a good bank/bad bank approach should be considered for the resolution of the existing GSEs.

The coming debate

The MBA recommendations come as the heat is being turned up on the debate over the future of the GSEs.

In June 2009, MBA Chairman-Elect Berman testified at a hearing of the House Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises. Beginning this fall, both the House and Senate are likely to begin a new slate of hearings on the topic. These hearings will serve as a key vehicle for members to refine their thinking about what the secondary mortgage market should look like in the aftermath of the conservatorship of Fannie Mae and Freddie Mae.

"The question of how to resolve the conservatorship will be a key link in the thinking of members of Congress about what the market should look like in the future," says MBA's Courson. "The recommendations developed by the Council on Ensuring Mortgage Liquidity and endorsed by MBA lay a strong foundation for that thinking."

The next major milestone comes in February 2010, when the administration releases its budget request for 2011. That request will include a description of the administration's plans for Fannie Mae and Freddie Mac.

From there, Congress is likely to take up the issue with increased intensity, with a legislative proposal expected to be developed and moving forward in 2010. Of course, with financial services regulatory reform and other broad legislative efforts also in the mix, the course and timing of the debate are inexact and highly subject to change.

"MBA will continue to be an active participant in the debate, working closely with the administration, members of Congress and others," notes Courson. "With the recommendations from the council and the MBA as a starting point, we need to ensure that the secondary mortgage market is fixed, and that it is fixed right."

Members of MBA's Council on Ensuring Mortgage Liquidity

Council Chairman

Michael Berman, CMB

President and Chief Executive Officer, CWCapital Chairman-Elect, Mortgage Bankers Association

Council Members

Richard A. Aneshansel

Executive Vice President and Chief Financial Officer, Finance

U.S. Bank Home Mortgage

Jon K. Baymiller

Executive Vice President

AmTrust Bank

Phillip W. Bracken, CMB

Executive Vice President

Wells Fargo Home Mortgage

Garry Cipponeri

Senior Vice President

Chase

Timothy C. Dale, CMB

Executive Vice President

BB&T

Peter F. Donovan

Senior Managing Director

CBRE Capital Markets

Robert Gaither

Senior Vice President, Government Lending Executive

Bank of America Home Loans

S.A. Ibrahim

Chief Executive Officer

Radian Guaranty Inc.

Curt G. Johnson

Vice Chairman

First American Title Insurance Co.

John B. Johnson, CMB

President and Chief Executive Officer

Mortgage America Inc.

Richard D. Jones

Partner

Dechert LLP

David H. Katkov

President and Chief Operating Officer

PMI Mortgage Insurance Co.

Rodrigo Lopez, CMB

President and Chief Executive Officer

AmeriSphere Multifamily Finance LLC

Regina M. Lowrie, CMB

President and Chief Executive Officer

Vision Mortgage Capital LLC

Peter F. Makowiecki

President and Chief Executive Officer

MetLife Home Loans

Phoebe Moreo

Partner

Deloitte & Touche LLP

Kieran P. Quinn, CMB

Vice Chairman

Walker & Dunlop Inc.

Diana Reid

Executive Vice President

PNC Real Estate Finance

David A. Roberts, CMB

President and Chief Operating Officer

Grandbridge Real Estate Capital LLC

Theodore Tozer

Senior Vice President, Capital Markets

National City Bank

Bruce W. Williams

Chairman and Chief Executive Officer

HomeStreet Bank

Michael W. Young

Chairman of the Board, Cenlar FSB

Vice Chairman, Mortgage Bankers Association

Jamie Woodwell is vice president of commercial real estate research for the Mortgage Bankers Association (MBA) in Washington. D.C. He can be reached at [e-mail].