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Secondary market.


Over the years mortgage companies have been able to structure transactions with Fannie Mae and (to a lesser extent) Freddie Mac whereby a lender agrees to accept the risk of foreclosure loss in exchange for a lower agency guaranty expense. Companies who manage this risk wisely are able to profit from lower fees paid to the agency and by keeping servicing losses at a minimum. These types of structured transactions seemed to work very well for the agencies, mortgage companies and the consumers who benefit from more flexible underwriting.

Recent bank/thrift regulatory initiatives appear to threaten this way of doing business. Of primary concern to MBA is the possible reclassification of mortgage "sales" as "financing" with respect to assets sold through Fannie Mae, Freddie Mac and GNMA. Currently, risk-based capital rules for banks define recourse according to the Federal Financial Institutions Examination Council's (FFIEC) instructions to the consolidated reports of condition and income (call report instructions). The call report instructions explicitly provide that: "if the reporting bank is involved in the disposal of its mortgages under any of the GNMA, Fannie Mae or Freddie Mac is to treat the transaction as a sale of mortgages and remove the mortgages from its balance sheet."

It is MBA's understanding that the banking and thrift regulators are considering denying this sales treatment in connection with securitization or swap transactions under Fannie Mae's and Freddie Mac's "regular" servicing option and on GNMA/VA servicing, where servicers have the potential of being responsible for expenses resulting from borrower defaults.

Such a strict interpretation would bring mortgage assets back on the consolidated balance sheet of financial institutions. The institutions will have to set aside capital at the required ratio as a percentage of those assets brought back on the balance sheet even though the servicer merely holds legal title sufficient to service the loans. The amount of capital reserved would be excessive relative to the actual risk of loss based on historical experience.

The ability to securitize and sell loans through GNMA, Fannie Mae and Freddie Mac plays an important role in supporting the flow of capital into housing. By receiving sales treatment and removing the assets from the balance sheet, lenders can replenish their supply of funds, thus increasing the availability of mortgage credit and often reducing financing costs for homebuyers. Moreover, the ability to shift interest rate risk to investors has contributed to the broad range of financial products offered to consumers, such as long-term fixed-rate mortgages and medium-term ARMs. For financial institutions, asset sales and securitizations enhance liquidity and provide valuable tools for effective risk management.

An efficient secondary market is predicated on a number of key factors: the lender's ability to receive sales treatment on mortgage sales; effective management of the recourse risk so as to make acceptance of the risk profitable; and the secondary market agencies' ability to attract servicers to perform the loan administration function on behalf of investors. An excessive capital tax placed on mortgage asset sales will jeopardize this efficiency by reducing the attractiveness of mortgage sales and returns on servicing, thereby reducing the lender's willingness to service loans that are classified as recourse. Moreover, the treatment of asset sales as financings will effectively limit the banking organization's ability to profit from manageable risk-taking.

MBA members, many of which are owned by or affiliated with a bank, thrift or financial holding company, will be directly affected by any change in the treatment of asset sales with recourse for purposes of determining capital and reporting requirements. Clearly, the outcome of the FFIEC's treatment of recourse could have a profound effect on the future of mortgage securitization and off-balance sheet activities like mortgage servicing.

MBA believes that institutions should maintain appropriate levels of capital to protect against risk of loss. However, we respectfully submit that an unnecessarily broad definition of recourse that does not incorporate the realities of the marketplace and generally accepted accounting principles (GAAP) would have serious repercussions on the profitability of thrifts and banks.

MBA believes the regulators should adopt GAAP as set forth in Statement of Financial Accounting Standards No. 77 (FAS 77) for determining when asset transfers are given sales treatment for reporting purposes. GAAP requires institutions to establish loan loss reserves to cover expected losses. In addition, institutions should thoroughly document the basis for reporting the transaction as a sale and for establishing the level of their loan loss reserves. Any regulatory proposals that would treat Fannie Mae/Freddie Mac servicing or GNMA/VA servicing as a financing would result in a grossly excessive capital requirement in relation to the risk associated with the asset. Such treatment would seriously cripple the mortgage delivery system and drive bank and thrift organizations out of the mortgage servicing business. Furthermore, because GAAP provides for the assessment of risk on a case-by-case basis, it more accurately targets the amount of capital that is needed to protect the institution.

Lastly, we have asked the regulators to accept a concept of "limited recourse" and to exempt transactions already undertaken from any changes in recourse rules. A limited recourse concept would allow seller/servicers to structure alternative recourse arrangements with the secondary market agencies. Requiring "prospective" effect only, would allow future transactions to be priced in accordance with the new rules.

Michael Taliefero Vice President
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Title Annotation:Mortgage Bankers Association of America's position on transactions with Fannie Mae and Freddie Mac
Author:Taliefero, Michael
Publication:Mortgage Banking
Date:Oct 1, 1990
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