U.S.

Mortgage Finance Reform Efforts And The Potential Credit Implications

Primary Credit Analysts: Jeremy Schneider, New York (1) 212-438-5230; jeremy.schneider@standardandpoors.com Sharif Mahdavian, New York (1) 212-438-2412; sharif.mahdavian@standardandpoors.com Lawrence R Witte, CFA, San Francisco (1) 415-371-5037; larry.witte@standardandpoors.com Monica Perelmuter, New York (1) 212-438-6309; monica.perelmuter@standardandpoors.com Devi Aurora, New York (1) 212-438-3055; devi.aurora@standardandpoors.com Matthew B Albrecht, CFA, New York (1) 212-438-1867; matthew.albrecht@standardandpoors.com Ron Joas, CPA, New York (1) 212-438-3131; ron.joas@standardandpoors.com Blake Mock, New York (1) 212-438-7278; blake.mock@standardandpoors.com

Table Of Contents
The Implications For Available Loan Products What Is The Potential Impact On Affordable Housing? How Banks Could Be Affected The Implications For Mortgage Loan Servicing And Origination The Potential Effects On Private Mortgage Insurance Steps Forward

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U.S. Mortgage Finance Reform Efforts And The Potential Credit Implications
As the recovery in the U.S. housing market continues to strengthen, with property prices rising and home sales increasing, mortgage finance reform is taking center stage for many legislators in Washington. There seems to be a bipartisan commitment to encourage private capital support for the U.S. housing market while winding down Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that hold dominant positions in the mortgage market. In this article, we comment on the potential credit implications of these mortgage finance reform efforts on several market sectors. (Watch the related CreditMatters TV segment titled, "U.S. Housing Finance Reform: The Potential Credit Impact On Financial Institutions And Mortgage Insurers," dated Oct. 28, 2013.) As it stands, lawmakers have presented three notable proposals this year (see table). The Housing Finance Reform and Taxpayer Protection Act, introduced by Senators Corker and Warner (the Corker-Warner bill), seeks to restructure the government's role in housing finance but maintain its role as a lender of last resort. The Protecting American Taxpayers and Homeowners Act (PATH), introduced by Representative Hensarling, seeks to reduce the government's role significantly, limiting it to an oversight function and extending financial support only through Ginnie Mae. And the Federal Housing Administration Solvency Act of 2013, introduced by Senators Johnson and Crapo, seeks to recapitalize and reshape the FHA's role in housing. The House (PATH) and Senate (Corker-Warner and FHA Solvency Act) versions are intended to promote homeownership while minimizing the burden on taxpayers by returning private capital to the mortgage market. Notably, Corker-Warner and PATH plan to wind down the GSEs within five years, and each proposal has the potential to affect various market segments and participants differently. U.S. Mortgage Reform Proposals
Date introduced June 2013 Bill Housing Finance Reform and Taxpayer Protection Act of 2013 (Corker-Warner) Key provisions Wind down Fannie Mae and Freddie Mac and replace the Federal Housing Finance Agency (FHFA) with a new Federal Mortgage Insurance Corporation (FMIC), an independent agency charged with supporting the mortgage market and providing reinsurance on eligible mortgage-backed securities (MBS). These MBS would have an explicit full-faith-and-credit federal government guarantee. Requires GSE loans in the interim and eventual FMIC-insured loans to comply with Qualified Mortgage (QM) definitions and decreasing conforming loan limits as well as certain requirements related to down payment, private mortgage insurance, maximum amount, and other conditions as determined by the FMIC. Mortgages that do not meet the eligibility criteria may receive a guarantee for a limited time under exigent circumstances. FMIC-approved issuers could issue guaranteed MBS, but an MBS would require a private market holder to be in a first-loss position sufficient to cover at least a 10% decline in the face value of the security, reducing potential taxpayer exposure. The FMIC would develop standard securitization agreements to establish the contractual terms and continue FHFA's current efforts to develop a common securitization platform. Wind down Fannie Mae and Freddie Mac over five years by removing their charters and replacing them with an FHFA-regulated National Mortgage Market Utility that would facilitate private market mortgage securitization without a government guarantee by setting common voluntary underwriting and disclosure practices. Requires GSE loans in the interim to comply with QM definitions and decreasing conforming loan limits, set guarantee fees to levels comparable to private market costs, engage in private capital risk sharing transactions and prevent purchases of loans from jurisdictions that have utilized eminent domain procedures. Would reform FHA by making it an independent agency and taking steps to improve its finances such as increasing borrower down payments, tighten borrower eligibility requirements and increasing insurance premiums while reducing coverage over time. Would direct financial regulators to implement regulations to create an oversight framework for covered bonds in which original lenders maintain primary liability for the issued debt.

July 2013

Protecting American Taxpayers and Homeowners ACT of 2013 (PATH)

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U.S. Mortgage Finance Reform Efforts And The Potential Credit Implications

U.S. Mortgage Reform Proposals (cont.)

August 2013 FHA Solvency Act (S.1376) (FHA) FHA reform, including strengthening underwriting guidelines with standards similar to QM. Requires re-evaluation by the GAO of maximum insurable amounts with minimum premiums reviewed annually by FHA and raises the current 2% capital reserve ratio to 3% over 10 years.

The Corker-Warner proposal provides for a greater government role than PATH does, particularly with the formation of a Federal Mortgage Insurance Corp. (FMIC), which would, in our view, effectively serve as a partial replacement for Fannie and Freddie guarantees. However, a condition of the Corker-Warner proposal, under which private investors would absorb a so-called 10% first-loss from defaults, would aim to lower the burden on a federal backstop. We believe that this 10% first-loss piece could provide sufficient protection in the most stressful scenarios to taxpayers, provided the pool reflects high-quality underwriting standards and resulting low loss expectations. However, that protection might be somewhat modest in a pool containing loans that have been underwritten to less-stringent credit standards. For example, Standard & Poor's expected loss for an archetypical pool of mortgage loans under a 'AAA' level of stress (commensurate with what was experienced during the Great Depression) is 7.5%. The archetypical pool assumes 30-year fixed-rate loans with FICO scores of 725 and equity of 25%. Higher risk variations from the archetypical loan characteristics would correspondingly increase the loss expectation. Therefore, another consideration is what type of stress event would be presumed to correspond to the 10% figure in terms of determining this threshold; would it be a 'AAA' level of stress? Even loans that otherwise qualify for QM/QRM risk retention treatment but contain more historically average loan characteristics could have substantial losses in a stressful economic environment. Regardless of what the sizing of the first-loss piece is, one question that remains is how the loss would be funded. Bond insurers have historically participated as a guarantor in many non-agency securitizations. However, the projected size of the loss piece would create capital requirements that are high in the near term relative to the current capacity in the marketplace. The bond insurance industry has not recovered from the significant losses suffered during the recent housing crisis and currently has a limited number of participants. Furthermore, the barriers to entry can be high. Once the market has more clarity around the likely market structures for private capital to assume credit risk, we would expect that investors would begin to coalesce around solutions and a market would begin to build. But that could take time, and regardless of how the loss piece is funded, the key question is how much it will cost. PATH, meanwhile, assumes that private capital would play an even larger role. Standard & Poor's Ratings Services believes that an investor base large enough to absorb the resulting volume of non-guaranteed mortgage-backed securities (MBS), in which loans are bundled and sold, could be hard to come by, particularly in the short term. We also expect that, based on our observations in the non-agency market today, borrowing rates would need to rise materially from current levels to draw the requisite private participants. PATH also contemplates a significantly expanded role of the Federal Home Loan Banks in aggregating loans from smaller originators. It also contemplates the creation of an oversight framework for a U.S. covered bonds market. While covered bonds, in which the lender maintains primary responsibility for repaying issued debt, have been an effective financing tool in Europe, the U.S. market has been hampered by investor uncertainty over recourse to the related mortgage pool in the event of issuer default.

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U.S. Mortgage Finance Reform Efforts And The Potential Credit Implications

In terms of the GSE wind-down, both Corker-Warner and PATH call for the U.S. Treasury to assume the outstanding obligations of the entities as they're wound down. We believe this is important and necessary for the government and regulators to retain credibility with investors and other market participants. In the following discussion we review implications for loan originations as well as the impact on select market sectors.

The Implications For Available Loan Products

Both Corker-Warner and PATH assume the continued availability of 30-year fixed-rate loans. While the 30-year fixed rate mortgage with no prepayment penalty has been a staple in the U.S. (though not outside the U.S.), it has also been largely funded through securitization. In many other regions, because of the nature of the loans offered, banks can hold mortgages on their balance sheets because the more frequent repricing of the loans better matches the duration of their liabilities, such as customer deposits. For example, although the market in Denmark offers something comparable--long-term, fixed-rate loans that are based on callable 30-year bonds--shorter refinancing periods (typically one year) have become predominant in the past few years. Elsewhere, mortgages typically are subject to being repriced more frequently, though the amortization periods associated with them might be just as long or longer. The Canadian market has home loans with 25-year amortization periods that are repriced every five years, and in Sweden, the bulk of lending is interest-only, and amortization would only apply to those with loan-to-value ratios above 75% over 10 to 20 years. The 30-year fixed-rate mortgage has contributed significantly to housing affordability in the U.S. And while some market players have looked at current rates on jumbo mortgages (those that exceed conforming-loan limits) and suggested that the private market could support mortgage interest rates below 5%, we think this view is distorted. Jumbo mortgage rates carrying the lowest interest rates, for the most part, are limited to a narrow set of borrowers who have FICO credit scores above 750 and equity of roughly 30% in their homes. We don't believe that these same rates would be available to average prime borrowers, such as those with credit scores of 725 and 25% equity in a property. Historically, the 30-year fixed rate on conforming loans has been below fixed jumbo rates. However, the two rates recently flip-flopped due to the superior credit quality associated with recent jumbo mortgages, uncertainty about when the Federal Reserve will scale back its program of bond purchases, and increasing GSE guarantee fees. All told, this suggests that there will be a jump in the 30-year fixed mortgage rate if the associated costs of supporting average loan products are borne to a greater degree by private lenders in the market. Also, we note that when the private market had a mortgage-market share of 50% from 2004-2008, there was a sharp increase in the number of adjustable-rate loans. This large share of adjustable-rate mortgages during an expansion in the private market suggests that as the private market increases, availability of the 30-year fixed rate mortgage may decrease.

What Is The Potential Impact On Affordable Housing?

Although the significant losses that the GSEs incurred in 2007-2011 resulted in conservatorship, the government role in Housing Finance Agencies (HFAs) that serve largely low- to moderate-income first-time homebuyers had a different

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U.S. Mortgage Finance Reform Efforts And The Potential Credit Implications

experience. In fact, HFA loans have performed better than affordable loans issued through other channels. Both Corker-Warner and PATH increase down payment requirements to 5%--higher than the 3.5% under many current affordable single-family loans that HFAs offer. Because many HFAs provide down payment assistance, the increase in down payment requirements could mean additional costs to the HFAs when making up the difference. The additional costs could decrease their participation in the affordable housing market, thus limiting availability. In 2012, affordable single- and multi-family housing loans accounted for $267 billion of the GSE loan production. Corker-Warner would assess a fee of 5-10 basis points on all loans to establish trust funds that would be available for housing and other purposes. It is estimated that the fees generated for the trust funds would be less than $1 billion annually. This figure is substantially below the current affordable housing support provided by the GSEs and could significantly reduce the activity of HFAs and other municipal issuers, in our view, reducing housing opportunities--both ownership and rental--for many working- and middle-class households.

How Banks Could Be Affected

The Corker-Warner proposal would likely have a limited impact on banks that Standard & Poor's rates. Similar to the status quo, servicers and aggregators of eligible mortgages would have to get approval to participate in government-sponsored programs. In this scenario, bigger banks could have an advantage if the approval process were strict and carried onerous minimum financial requirements. The PATH proposal, meanwhile, could have a larger effect on banks. Notably, the plan proposes a delay in the U.S. implementation of the Basel III capital rules to ease the regulatory burden on community financial institutions. It also proposes a number of other regulatory changes, including further delays or the repeal of rules mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Generally, we have a favorable view of the convergence of global bank regulatory standards, including Basel III, which requires higher minimum capital levels and more scrutiny on funding and liquidity. We believe that there could also be a shift between bank and nonbank lending, as certain entities might not have the ability to hold loans on their balance sheets. So-called warehouse lending, in which lenders extend credit to loan originators, might also be affected, and less liquidity and certainty in the market typically have pricing implications.

The Implications For Mortgage Loan Servicing And Origination

We believe that each of the bills makes a serious attempt at building or enhancing the operational infrastructure required to originate, service, and liquidate home loans. However, there are few specifics. Both PATH and Corker-Warner seek to create standard origination and securitization platforms through the oversight of the National Mortgage Market Utility and FMIC entities. Nevertheless, to date, the FHFA has struggled to bring the GSEs onto a common platform, with Fannie's Desktop Underwriter and Freddie's Loan Prospector continuing to operate as separate and distinct automated underwriting systems. Under Corker-Warner, the office of underwriting (part of FMIC) would be responsible for determining the platform. But this could take time, causing uncertainty in the origination market in terms of just what type of system would apply. Lenders might be less likely to make investments in systems

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and technology if the platform is likely to change. In addition, each GSE currently has different servicing standards. No matter which bill, if any, passes, servicers may have to service legacy assets on legacy systems and new assets on new systems, which would be more expensive as legacy asset balances decline. Because agency assets typically include 30-year mortgages, servicers might have to maintain and invest in legacy systems during the GSE wind-down period and beyond. In our opinion, regardless of what type of GSE reform is passed, the longer the timeframe to determine the origination and servicing systems, initial and ongoing reporting requirements, and underwriting and servicing standards, the more uncertainty the market will face. Servicers have been facing uncertainty for the past few years, as the market waited for the Consumer Financial Protection Bureau (CFPB) to issue final servicing rules. While some servicers implemented changes to their processes and systems based on the servicing alignment initiative (the FHFA led effort to establish consistencies in servicing certain delinquent loans), consent orders, and national mortgage settlement agreements, other servicers waited until the final rules were issued. Such changes typically involve substantial investments in staffing, training, technology, and internal controls. Lenders are now implementing QM rules into their systems in anticipation of the January 2014 effective date. We believe that lenders, servicers, and, ultimately, borrowers would benefit from quick and thoughtful decisions following the adoption of any reform.

The Potential Effects On Private Mortgage Insurance

The new legislative proposals seek to retain private mortgage insurance as an absorber of risk. For instance, PATH calls for greater constraints on the FHA's ability to provide mortgage insurance. As a result, the FHA would likely continue to cede market share to the private mortgage insurers (MIs), a trend that began in 2010. While Corker-Warner doesn't address the role of the FHA, it removes the requirement for a 20% down payment, which would have limited private MIs' ability to write new policies and explicitly calls for private MI participation. Both proposals come after the sector suffered significant strain in recent years. In particular, a decline in underwriting standards before the credit crisis resulted in a mortgage market full of riskier loans. The ensuing economic problems in the U.S. caused these high-risk loans to default in unprecedented numbers, leading to the insolvency of several participants and to most of the remaining companies' capital being impaired. However, the return of stricter origination standards among lenders and the soon-to-be-instituted QM standards from the CFPB are a paradigm shift in the industry that could prevent the reintroduction of the aforementioned riskier products. Despite the momentum of the recovery that the sector is enjoying, questions remain about the extent and nature of the future participation of the MIs. Still, mortgage insurance as a means of luring private capital continues to see acceptance more broadly. For example, Fannie recently awarded National MI a $5 billion mortgage pool insurance contract. Furthermore, the current proposals appear not only as if they would be favorable to MIs' ongoing participation but would also likely result in an expansion of the business. We believe the combination of diminished participation by the FHA and increased quality of business should bode well for private MIs. As well, increased MI participation allows for an increase in private capital available to absorb credit losses.

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Steps Forward
The pace of reform depends largely on the status of the U.S. housing market. Since last year, home prices have been steadily climbing. In fact, the S&P/Case-Shiller 20-City Composite Home Price Index increased 12.4% year-over-year in July, and our forecast for the full year remains at 11%. Housing starts have also been climbing since 2009. Still, we note that, even with strong recent gains, prices remain 23% below their 2006 peak. And uncertainty about when the Fed will begin tapering bond purchases has raised borrowing costs, which could deter some buyers. Nonetheless, with the housing recovery aiding an economic rebound, talk of mortgage finance reform has increased and Congress seems intent on moving forward. If and when mortgage finance reform does come to fruition, it will likely become apparent that five years is a relatively short time to transition from a market supported by very little private capital to one where private capital bears a substantially greater portion of the mortgage credit and market risk.

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