Unfinished Business: Reform of Mortgage Market, Part II
The potential pathways forward. Will the Trump administration fix the mortgage market?
There is no question the Trump administration wants to make changes to the financial system. (What is not clear is where this issue fits in the long list of other priorities, such as health care, immigration, trade issues, etc.) There are two separate issues that need to be addressed: the Dodd-Frank regulations and reforming the Government Sponsored Enterprises (GSEs). President Trump has talked about the need to “dismantle” the Dodd-Frank regulations. Treasury Secretary Steven Mnuchin has some views on these issues as well.
With the president’s background in real estate, the Trump administration is likely to seek more clarification on the Put Back Clause, so that the originator of a loan is at risk only if there was major mistakes or lack of oversight in placing a mortgage and then selling it to a GSE. Fannie Mae recently took steps to revise the Put Back Clause as well, to insure it only happens when there is a serious error in the mortgage origination. These changes could happen in 2017, since they can be done through regulation changes rather than legislation. These changes should bring banks back into the origination process, but slowly at first. Banks do not believe the changes yet.
Steven Mnuchin has said that reforming Fannie Mae and Freddie Mac is one of his top 10 priorities. (He did not say if it is number 1 or number 10, however.) In his hearings, he made it clear that he does not want to recapitalize the GSE as is. Under the current management goals, Fannie Mae will have zero capital by the end of 2018. They are as one critic suggested, “zombie companies.”
The Obama administration and Secretary Clinton would have favored maintaining the GSEs as extensions of the government. Mnuchin will clearly favor moving the GSE away from the government corporate model towards a more private model. But with over $4 trillion in assets, the transition from the current GSE model to a private market will take some time. The big question will be how far to a completely private mortgage market any Republican legislation will shoot for.
The GSE’s portfolios are in excellent financial shape (see rates graph below), so making the shift towards a private company seems possible. They are profitable, but they still need to rebuild their capital reserves. The move back to a private company will also be complicated by outstanding lawsuits from investors claiming the 2012 decision to take all of the profits was illegal.
Here are some of the options that will get attention over the next year, which have been proposed already:
- In 2014, a bill with bipartisan support was introduced by Sen. Crapo (R) of Idaho and Sen. Johnson (D) of South Dakota. The bill aimed to wind down the current GSE companies and shift the securitization role into a privately owned structure. The idea was for the government to provide guarantees in certain conditions, but for private investors to take some of the initial losses from a mortgage pool. The bill was not enacted, but Sen. Crapo is currently in a key position to try again.
- An earlier effort, that was strictly a Republican bill in the House, was more aggressive and wanted to move to a completely private mortgage security market. This effort was led by Texas Congressman Hensarling (R), who is now the Chairman of the House Financial Services Committee. He prides himself on having a comprehensive approach to fixing the Fannie Mae and Freddie Mac problems. This approach is supported by analysis done at the American Enterprise Institute.
- The administration will have to take another look at what has happened with the surge in FHA loans as well. The growth and the lack of capital reserves does create some serious risks if there is another serious economic downturn. Unfortunately, there has been very little analysis on what will happen on this issue.
Here are some of the changes that this effort will create:
- ● Depending on how the debate is pursued, it could create more uncertainty in the next two years in the mortgage market.
- ● Lending standards could clearly be adjusted to reflect a higher risk tolerance for a more private company that is well capitalized. But the higher risk would be reflected in higher mortgage rates. The private firm would have to borrow at rates comparable to corporate interest rates, not long-term government rates.
- ● A long-term (30- or 15-year) fixed rate mortgage with no pre-payment penalty would probably disappear. Many analysts (particularly at the American Enterprise Institute) think this would be a good thing.
- ● The adjustment would try to separate the role of the mortgage firms from the political goals of improved housing affordability and increased home ownership for low-income households.
- ● Major changes in lending standards for FHA loans could have an impact on first time buyers, as this has been the key source for low down-payment loans.
Change is coming, but it is not likely to be fast. For now expect lending standards to remain near current levels this year. There is likely to be easing in the Put Back Clause for mortgage originations. However, as we progress through 2017 and see how the Trump team’s plans evolve, we will adjust our outlook. As mentioned earlier, it is just too early to know exactly how the reforms will progress. It is however clear that the likely reforms under this administration will be very different than if Hillary Clinton had been elected president. Keep tuned in.