Concerns Regarding GSE Multi-Guarantor Model
Community Home Lenders Association (CHLA)
February 21, 2018
Last July, CHLA and 5 other associations representing small mortgage lenders testified before the Senate Banking Committee on GSE Reform. All six groups opposed chartering new guarantors in addition to Fannie Mae and Freddie Mac. [LINK: https://bit.ly/senateGSEreform] The groups raised concerns about creating more TBTF entities, vertical integration, and adverse small lender impact (pricing disparities, cost of interfacing with multiple guarantors, access to a cash window, and reduced ability to securitize loans).
CHLA first released a GSE reform plan in September 2015. The main components of the plan were to: (1) codify numerous reforms that have taken place to date, (2) recapitalize Fannie and Freddie under a Utility model in which they provide a foundation for loan securitization, and (3) reduce taxpayer risk through back-end credit risk sharing, private capital in Fannie and Freddie, and a Mortgage Insurance Fund funded by loan fees. This model accesses private capital, to foster market discipline. It provides for competition, but at the loan origination and credit risk transfer (CRT) level. CHLA urges Congress to pursue this reform approach.
In contrast, other plans reject the Utility model in favor of emphasizing competition at the guarantor level. Such plans authorize or require many new guarantors, potentially shrinking or eliminating Fannie and Freddie, and some cases using GNMA as the federal backstop. This approach raises concerns – about the impact on fully serving low- and moderate-income homebuyers; about transition risk of wholesale changes; about heightened GNMA counterparty risk requirements; and about competitive small lender access.
When GSE reform takes place, strong legislative language is needed to protect small lenders from direct or indirect practices which exclude smaller lenders, use volume discounts, or employ other discriminatory practices. Equally important is strong, effective regulation that ensures compliance with these requirements.
However, even if such protections are included in GSE reform legislation, any bill that creates multiple new guarantors, based on competition (as opposed to a Utility Model) would create incentives and opportunities that are harmful to smaller lenders. Examples include: (1) Vertically integrated Wall Street banks could use their secondary market abilities to gain an advantage in the primary market, (2) Investment banks and other large aggregators could turn mortgage bankers into loan correspondents, and (3) Guarantors could exclude smaller lenders or find direct or indirect ways to discriminate against them. Ultimately, the preservation of a competitive cash window and the ability of small and mid-sized lenders to securitize loans would be at risk.
CHLA does not claim all these adverse developments would necessarily occur under a multi-guarantor model instead of a Utility model. However, they are all risks that would be magnified by this approach.
Following are foreseeable outcomes of this approach with respect to a cash window and securitization:
RELIABILITY OF A COMPETITIVE CASH WINDOW
IN FULLY MEETING ALL SMALL LENDER DEMAND
The mere inclusion of statutory language in a GSE reform bill does not by itself make this a reality. It is essential that Fannie Mae and Freddie Mac be permitted to recapitalize pursuant to a Utility Model, with both the resources and a mandate to continue to provide a cash window to all qualified seller-servicers under competitive terms and conditions. Having two GSEs has provided a significant degree of competition, while limiting guarantors to these two has reduced the risks of a race to the bottom in credit quality to maintain market share we witnessed last decade in the subprime market and to some degree with Fannie and Freddie.
However, proliferation of guarantors, based on the principle of competition, would create cash window risks:
- COMPETITION-BASED MODEL IS INCONSISTENT WITH UTILITY MODEL Proliferating guarantors under a competition model creates incentives for cherry picking higher FICO borrowers, volume discounts, and other practices that undermine a competitive cash window.
- VERTICAL INTEGRATION UNDERMINES CASH WINDOW. Proposals that allow banks or investment banks to have stakes in new guarantors (or form cooperatives) create incentives for the guarantor to cater to stakeholders instead of providing a broad cash window. Even allowing small ownership positions could easily result in investors exercising control over guarantor practices.
- REGULATING CASH WINDOW REQUIREMENT. The proliferation of guarantors reduces the ability of the federal regulator to effectively monitor and enforce any cash window requirement.
- PROLIFERATION OF GUARANTORS RAISES INTERFACE COSTS. Developing IT and other interfacing capabilities with a larger number of guarantors could be prohibitively costly for smaller lenders without the loan volume and economies of scale larger lenders have. This increases the risk that a small lender could find itself relegated to dealing with 2nd tier guarantors that are providing less competitive cash window pricing than other more dominant guarantors.
REDUCING SECURITIZATION OPTIONS FOR SMALL/MID-SIZED IMBs:
Currently, small and mid-sized lenders with servicing capabilities can effectively compete with larger lenders by securitizing pools of mortgage loans, using the Fannie or Freddie guarantee to competitively execute their securitization through a large number of securities broker-dealers (that don’t have conflicting GSE roles such as acting as a guarantor or providing up-front risk sharing). Maintaining competitive direct securitization options for small and mid-sized mortgage lenders is critically important not just to these lenders – but also to consumers, because of enhanced competition. Moreover, a competitive securitization market has been a critical factor in prodding Fannie Mae and Freddie Mac to be more competitive with cash window pricing.
A multi-guarantor GSE reform model creates significant risks to achieving these securitization objectives. Following are adverse developments that could take place under a competition-based, multi-guarantor model:
- COST OF INTERFACING. Smaller lenders could not competitively absorb the cost of interfacing with a proliferating number of GSE guarantors.
- VERTICAL INTEGRATION. A Wall Street Bank holding company (e.g. Wells Fargo, JP Morgan Chase) could make a small investment in a guarantor and exert influence over its business plan so that the guarantor only guarantees loans for that bank or for similarly situated large banks.
- BREAKING BOUNDARIES BETWEEN SECONDARY AND PRIMARY MARKET. An investment bank or aggregator could invest in a guarantor and exert influence over its business plan so that the guarantor or investment bank would gain a competitive advantage in the primary origination market, potentially carving out profits from the loan origination part of the transaction.
- LENDER RECOURSE. Guarantors could require lender recourse, particularly under a GNMA approach – a requirement that most small and mid-sized lenders might not be able to meet.
- UP-FRONT RISK SHARING. Guarantors could require lenders to obtain up-front risk sharing prior to providing a guarantee, which would be difficult or impossible for small/mid-sized lenders.
- DISCRIMINATION ON DU/LP WAIVERS. Guarantors’ could guarantee or purchase loans written to standards of other guarantors [LP/DU type waivers] – but only for larger lenders.
- USING COUNTERPARTY RISK TO EXCLUDE SMALLER LENDERS. Guarantors could exclude small and mid-sized lenders based on their “unacceptable” counterparty risk – while accepting most banks, since they have an FDIC (taxpayer) backstop.
- SERVING CORRESPONDENT MARKET. Guarantors could use a business model in which they only deal with large bank/correspondent lenders, excluding small and mid-sized lenders.
- APPROVING ONLY LARGER LENDERS AS ELIGIBLE SELLER/SERVICERS. Finally, depending on bill text, even with G Fee parity in the bill, guarantors could elect only to approve larger lenders as eligible seller/servicers for their loans.
- TRANSPARENCY. A model based on competition with multiple guarantors is less likely to be transparent than a Utility model with just Fannie and Freddie. This has been an important issue for equal treatment for smaller lenders – e.g., as FHFA has recently pushed for full G Fee parity with respect to buy-up/buy-down grids, a less transparent issue than G fee cash window pricing parity.