The End of White Picket Finance: Reform and Reality in the US Mortgage Market July 5, 2011

Executive Summary: The $11 trillion mortgage market, which has been fostered and supported by the government for 80 years, stands to undergo sweeping reforms. The way homes have been financed for 40 years could change drastically over just a few years. We stand at the cusp of the largest privatization scheme in history. Its impacts will be far reaching across markets. For investors, trillions of dollars are at stake.

A cornerstone of the American Dream is the ability to purchase a home. For generations, homeownership has been considered a smart choice. A home has meant security, prosperity, and financial safety. Once upon a time, the dream of homeownership was once reserved only for the wealthy. New government programs and institutions, over the last half century, however, democratized mortgage credit, ushering in a unique era of White Picket Finance. The promise of a home became a reality for more and more Americans. Home prices seemingly never went down. For decades, our culture s faith in homeownership appeared vindicated. The financial crisis has since changed everything. Financing the American Dream has turned out to be an unsustainable nightmare. Since the Great Depression, the US government has been the force and direction of America s home finance markets. It has founded agencies to facilitate the delivery of credit and enacted special programs to promote homeownership. It kick-started the securitization market which allowed average American households to tap sovereign borrowing rates at 30 year terms. The aggregate government effort and intervention has afforded the average American a net housing subsidy that has drastically reduced the cost of homeownership. A subsidy is any form of financial assistance that lowers the cost of a product or economic activity. Lowering the effective cost of a product makes it more affordable to more people. Policymakers use subsidies to further policy goals. Homeownership is exemplary in this respect. In America, we want people to own homes. The formation of households is the formation of healthy and stable family units. In short, American families are not just helping themselves; they are helping the entire nation. But subsidies also have a dark side. They make market behaviors that are in reality expensive appear cheap. Subsidies distort the incentives of individual actors and thereby distort markets. With housing, their impacts can burrow deep, obfuscating their true costs. The massive housing subsidy enjoyed by American households has gradually snowballed to an unsustainable size. What was once small has become large. Between Freddie Mac and Fannie Mae (Government Sponsored Enterprises or GSEs ) alone, the US government today guarantees $5.5 trillion in residential mortgage debt.1 That s larger than China s 2010 GDP and almost what America will spend on our military over the next seven years combined.2 The magnitude of the guarantee was always known, but the financial crisis has since exposed the magnitude of its costs. For the GSEs, the bill could be as large as $400 billion.3 Total costs to taxpayers will depend on the recovery of the housing market. Sadly, the housing subsidy ended up financially crippling the very populations middle-class homeowners and taxpayers that it was meant to help. Most importantly, the crisis has illuminated the unsustainability of the housing subsidy. The recent economic and social misery inflicted by the aftereffects of the bubble has now culminated in a new1

Initially, the Treasury committed $100 billion in bailouts to each GSE. In December 2009, the Treasury agreed to provide through 2012 an unlimited amount of capital to Freddie Mac and Fannie Mae. At present, this capital line has been utilized to cover guarantees and other obligations of both companies, but the Treasury has the right and ability to sever these capital lines. What remains of the original $400 billion in capital support will support the entities after 2012. The structure of the bailout supposedly incentivizes the GSEs to recognize more losses up front. Through the third quarter of 2010, the GSEs combined had drawn down just over $150 billion. 2 World Bank data and Talkot estimates from linear trends. 3 Peter J. Wallison s 2010 estimate.

Talkot Capital | The End of White Picket Finance

found political ardor to fix a lopsided and broken mortgage finance system. Regulators and legislators are now proposing far-reaching reforms to withdraw the very subsidies that helped grow the US mortgage market into one of the largest credit markets in the world. Many of these subsidies have been in place for many decades. Now the aim of legislators is privatization. On February 11, the Treasury and Housing and Urban Development (HUD) issued a special report to Congress titled Reforming America s Housing Finance Market (The White Paper). It examines the history of government support of the housing market and addresses the fundamental flaws in our housing finance infrastructure. Its core conclusions seem to agree with the now pervasive opinions of most regulators and legislators that the housing subsidy, which has been integral to American homeownership for so many decades, is no longer tenable. The American taxpayer can no longer be the primary financer and insurer of the national housing stock. The private sector must instead provide the bulk of American mortgage credit and stand in a risk position to assume possible losses. To achieve this end, The White Paper calls to slowly wind down the two mortgage giants Freddie Mac and Fannie Mae in a vision of a narrower government role providing: (1) oversight; (2) consumer protection; (3) assisting low- and moderate-income homeowners and renters; and (4) support and stability to markets in crisis. The White Paper is clearly not a hard guideline for reform, but it s significant in its desire for change and its imagination of a housing finance system vastly different from the one we have today. Given the politics surrounding housing market reform, outcomes are difficult to predict. But whatever the particulars, it is clear that the upcoming transition from public to private will require entirely novel finance architectures. The scope of reforming the housing subsidy rivals the sweeping reforms that followed the 1929 crisis that created landmark institutions like the SEC, FDIC, and FHA. And today, the stakes could not be higher. Any slip up in the changeover could threaten already fragile real estate markets, vulnerable bank balance sheets, and a weak economy. For legislators, managing the short-term impacts of implementing these longer-term reforms will be an incredibly complex process. The obstacles are many and the potential for bottlenecks numerous. Every layer of the home finance machine is fraught with risk. As the mortgage market is increasingly privatized and borrowers and investors are rendered more responsible for their own decisions risk will have to be re-priced. Before the dust has time to settle, the investment opportunities will be vast. To capitalize on these opportunities and manage new emerging risks will require gauging the trajectory of possible reforms, and intelligently predicting the effect of those dynamics on the various, interrelated parts of the next mortgage finance system. As investors, to disregard the magnitude and macro-level complexity of this task is simply to leave money on the table or worse: to risk devastating loss by not understanding the potential ripple effects of possible changes. Put simply, the magnitude of these reforms compels us to write this paper. We stand at the cusp of the largest privatization scheme in history. There are literally trillions of dollars at stake. Now, more than ever, it will be crucial to stay focused on the bigger picture. This does not mean, of course, that short-term gains are unimportant. To the contrary, it means that short-term prudence will require a long-term outlook. It is precisely that kind of synthesis that the ensuing paper aims to adopt.

Talkot Capital | The End of White Picket Finance

A Brief History of Government in Housing: GSEs, Policy and Politics One cannot overstate the pervasive impact of the government in the mortgage finance market since the 1930s. The GSEs are arguably its most significant creations. Together with the FHA, they have helped to provide reliable and affordable capital to the housing finance market on a trillion-dollar scale through the highs and lows of economic cycles. This has promoted homeownership and supported household formation, affording Americans the mobility to easily move from Washington to Texas be it for a better job or to start a family. Before the GSEs, the mortgage market was private. As such, mortgages were affordable and available only to the wealthy. Loans were typically 5-10 year balloons carrying extremely volatile interest rates, which made refinancing difficult at the bottom of economic cycles. Together with the FHA, the GSEs revolutionized the delivery of mortgage credit. The GSEs created more borrowerfriendly mortgage products like the 30-year fully amortizing fixed rate, standardized the underwriting process, and kick-started a secondary market which developed robust capital markets to purchase and manage mortgage assets. The problem with the GSEs was their hybrid status. As public-private companies, they enjoyed special privileges specifically, preferential tax treatment, lower capital requirements, and lower funding costs as a result of being implied government liabilities. These advantages amplified their public utility of efficiently delivering mortgage credit as well as their private utility of delivering profits to shareholders and compensation to management. In the beginning, the GSEs business models were simple: purchase loans originated from banks and lenders that conformed to their underwriting standards. Package those loans into securities backed by the underlying mortgage cash flows with an insurance-like guarantee to investors of timely interest and ultimate principal payments. For investors, the guarantee of principal by a quasigovernment entity implied that GSE-issued MBS carried no credit risk. This allowed average borrowers not just the wealthy access to the power of the United States AAA sovereign credit rating. The GSE business models evolved to include a retained portfolio function that levered the implied government guarantee. The retained mortgages were held on balance sheet and financed by issuing corporate-level debt at Treasury-like interest rates. In doing so, the GSEs were not just assuming the credit risk of their mortgage guarantee business but also prepayment and interest rate risk. Their investment portfolios peaked at $1.5 trillion. The GSEs could simply out-compete the private sector as both originators and lenders with a government insured profit-motive. In the end, these advantages left the GSEs under-capitalized heading into 2008. As defaults rose, they couldn t honor their guarantee of some $5 trillion in mortgage credits. The systemic risk they posed to the system forced the government to take them into conservatorship. At present, the bailout of the GSEs is expected to cost taxpayers more than $400 billion. 4

Peter J. Wallison s estimate from 2010

Talkot Capital | The End of White Picket Finance

Total Residential Mortgage Debt Outstanding as of Q1 of 2011

GSE or Ginnie M ae M BS

$5.87 Trillion

$1.21 Trillion $2.87 Trillion

Private Sector Issued MBS Other $0.49 Trillion

Unsecuritized Whole Loans

Source: Federal Reserve, Inside MBS

Today, the GSEs continue to guarantee over half of the $11 trillion of residential mortgage credit outstanding. 5 And combined with the FHA, government agencies have originated and guaranteed nearly 100% of mortgages since the 2008 crisis. This incredible market share is a function of a still broken private market; however, it is not entirely surprising in light of history. Before the bubble years of 2003-2007, government agencies generally securitized more than 80% of residential mortgages issued per year since the MBS market has existed.
Residential MBS Issuance Market Share since 1970
Agency Market Share 100% 90% 80% Market Share 70% 60% 50% 40% 30% 20% 10% 0% Private Label or Non-Agency Market Share

82

86

88

80

84

92

96

98

02

06

08 20

19

19

19

19

19

19

19

19

19

19

20

20

20

20

Sources: SIFMA, Federal Reserve

The White Paper states that the Treasury will provide the necessary capital to ensure that the GSEs continue to honor all of its general obligations and guarantees.

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20

10

90

94

00

04

Simply put, the GSEs are and have been the market. So while the need to at least reduce the role of these agencies appears obvious, without them the housing market will require vastly different mortgage credit delivery mechanisms. Reform of any scale, however, will be tempered by political and social interests that have always complicated general housing policy. As such, understanding the next iteration of the housing finance market what is likely to replace the GSEs historic role requires a deeper understanding of the politics of housing policy. This political process has always revolved around an understanding of some fundamental housing problem . In the 19th and early 20th centuries, it was a quality problem. In the 1930s, the problem was tied to a deflating economy. 1949, however, marked an important shift. That year Congress conceived of its mission in housing to help provide a decent home in a suitable living environment for every American family . 6 Quality and affordability particularly for low- and moderate-income areas have since been the two primary issues framing housing politics. In 1977, the passing of the Community Reinvestment Act (CRA) aimed to mitigate discriminatory lending practices or redlining by commercial banks and S&Ls that tended to under-serve low- and moderate-income neighborhoods. In the 1990s, amendments to the CRA directed more lending into these communities. Those amendments have since been criticized as contributing to the deterioration of underwriting standards.7 Today, the housing problem has again shifted in the aftermath of the financial crisis, creating two distinct camps loosely defined by political affiliations. To simplify matters, this paper will call each camp the Left and the Right. The Left continues to emphasize issues of affordability and to a lesser extent housing quality. Included in the Left s view is concern for new affordability problems for
6

Congressional affirmation set forth in section 1441 of title 42. Mortgage underwriting standards began to decline meaningfully in the early 2000s, but the increase in originating non-traditional mortgages began in 1995 primarily due to the Clinton administration s amendments to the Community Reinvestment Act (CRA). The CRA aimed to mitigate geographic or other types of discriminating lending practices in low- and moderate-income areas. But this discrimination was largely a function of underwriting costs. Underwriting costs are more or less the same for $50k and $500k loans. Hence, lower priced homes like those in low- and moderateincome areas are disproportionately more costly to underwrite. In aim to mitigate this apparent lending problem, the CRA required FDIC insured institutions to meet the credit needs of these areas. As such regulators pressured banks to make more loans, especially mortgage loans, to low income borrowers and neighborhoods, but it was more often the case that CRA banks en masse actually directed too much lending to these areas. Interest rates on CRA loans were counter-intuitively low, reflecting not the actual credit risk of the loan but the mandate of this capital allocation guideline. Two banking reforms exacerbated the problem. In 1994 there was the Riegle-Neal Interstate Banking and Branching Efficiency Act (RN Act) which allowed banks to merge across state lines under federal law; and then in 1999 the Gramm-Leach-Bliley Act (GLB Act) was passed, which repealed the part of the Glass-Steagall Act that had prohibited banks from offering a full range of financial services from commercial, insurance, and investment banking. Together these reforms would cause a renaissance in banking as banks could now enlarge their footprints and merge or expand into other types of financial institutions. But through it all CRA compliance was paramount. After passing the RN Act, federal bank regulators withheld merger approvals involving those banks which did not comply with the CRA. And in similar fashion, the GLB Act was passed such that any financial institution seeking re-designation would also have to follow and comply with the CRA. Bill Clinton explained it very clearly, "as we expand the powers of banks, we will expand the reach of the [Community Reinvestment] Act." Unsurprisingly, both events caused banks to devote more resources to their CRA programs and thus, more lending into low- and moderate-income areas. Home borrower risk as such quickly began to be mispriced, but many banks admittedly knew this and feared holding owning these credits themselves. Two features to the home finance system allowed them to export these known risks off-balance sheet. First were the GSEs who purchased newly originated loans which met their underwriting standards, which widened in the mid 2000s; and second was the securitization market, which allowed banks to pool loans together and sell them to the secondary private label mortgage market.
7

Talkot Capital | The End of White Picket Finance

the millions of current homeowners who have negative equity or are facing foreclosure. The Right, on the other hand, has attacked the latent costs of housing subsidies. They seek to mitigate, if not eradicate, these liabilities to taxpayers. In particular are the GSEs, FHA, and other implicit liabilities that compel, or may compel, taxpayers to incur significant losses and fund possible bailouts. The Left s arguments for promoting high quality, affordable housing for homeowners are numerous. Housing is more than just simple shelter. The home is the primary setting for the American family, a key to stable household formation benefiting the broader economy and a primary source of most Americans wealth. The location of a home largely determines access to education, employment, and other amenities. Property ownership also engenders a certain sense of American equity , given that homeowners want to protect the value of their home. As stakeholders, they are more likely to be active citizens and voters. And more generally, highquality, affordable housing relieves a significant social and economic burden on low- and middleincome families allowing them to prosper not to mention the tax revenues generated at every level of the homeownership process. Today, physically deficient housing makes up only a small percentage of the US housing stock, making affordability a cornerstone issue of the housing policy debate. Only 6% of households live in physically deficient or overcrowded conditions, while in 2007 30% of all homeowners and more than 45% of all renters were commonly classified as suffering an affordability problem .8 The Right s arguments, on the other hand, attack the latent costs of subsidizing housing and mortgage credit. Government housing programs, policies, and GSE obligations are taxpayer backed liabilities with the potential to incur significant credit losses. Additionally, there is the risk of a taxpayer bailout of the financial sector, which remains highly levered to real estate. Furthermore, these collective obligations and financial risks must be considered against the backdrop of the fiscal position at the US Treasury, which impacts sovereign borrowing rates and the value of the dollar amongst numerous other political, social, and economic effects. Recently, this second set of concerns has come to the fore, given the fresh memory of trillions in government interventions and stimuli, sparking debates about the soundness of the Treasury s fiscal position. These issues have recently been compounded by an S&P downgrade warning on America s sovereign credit rating. In short, both sides agree that the debate revolves around the issue of affordability. The Right worries over government balance sheets and the Left, household balance sheets. But these concerns are fundamentally intertwined governments are ultimately taxpayer liabilities and households are ultimate drivers of tax revenues. These two concerns are actually one and the same, pointing to the more important variable the state of the American economy. As Tim Geithner said after the release of the Treasury s White Paper, "One reason why we've been so careful not to lock in a path for phasing out the government's role is there's no certainty in this context and we have to be careful again not to do damage to the recovery.

A housing affordability problem is defined by the US Census Bureau as a homeowner or renter who spends more than 30% of their pre-tax income on housing.

Talkot Capital | The End of White Picket Finance

As a substantial driver of GDP (17 to 18% in 2009) and tax revenues, the housing industry is critical to both the economy and the budget.9 But what supports the housing market and home prices is leverage. One must remember the golden rule of asset markets: an asset s price is driven by the amount of leverage available to it. And for the last decade, housing values have been priced with GSE and FHA available financing and, worse, government financing is now the only financing currently available to prospective home buyers. To suddenly withdraw or change the availability of home financing will force the housing market to re-price itself. The new pricing model will instead be dictated by the availability and terms of new, private market leverage sources, which may not be accessible at every point of the business cycle. Depending on the severity of such reform, such changes could be the death knell for home prices, pressuring as much as four years of present foreclosure and shadow foreclosure inventory. 10 Diminishing equity in the nation s housing stock means destroying household wealth and risking asset values on bank balance sheets; and higher mortgage capital costs means restricting the mobility of American households to seek out better opportunities in different American markets. In short, policy makers must balance the Left s desire to ration mortgage credit and the Right s desire for fiscal consolidation, while keeping the American recovery afloat. That proper mix will largely determine the future value of the American home. Imagining the Future of Housing Finance A GSE-less world will require a private market that can originate and portfolio the bulk of American mortgage credit risk. A new system, therefore, will have to (1) efficiently connect borrowers and lenders through private capital markets in similar volume and (2) be the balance sheets to hold these mortgage credits. As we ve discussed, the GSEs have been significant in filling both these roles. They acted as issuers of mortgage backed securities (MBS) and investors in those same securities. At present, the government continues to shed billions of MBS that will have to be absorbed by private capital. The GSEs investment portfolios have already shrunk substantially to just $600 billion at March 31st 2011 since peaking over $1.5 trillion in 2007. They have been shrinking in accord with the government mandate to decrease their portfolios 10% a year. The Federal Reserve s portfolio has shrunk from $1.25 trillion to $925 billion and continues to shrink as MBS prepayments are re-invested into treasuries. Going forward as such, private balance sheets will eventually become the primary if not the sole repository for legacy and new production residential mortgage securities. But which balance sheets will hold them? There are two options: commercial bank balance sheets (FDIC insured financial institutions) and non-bank balance sheets (e.g. money managers, sovereign wealth funds, mortgage REITs).

According to the National Association of Home Builders (NAHB) historically, residential investment has averaged roughly 5 percent of GDP while housing services have averaged between 12 and 13 percent, for a combined 17 to 18 percent of GDP. 10 Data from LPS Mortgage Monitor Report from December 2010

Talkot Capital | The End of White Picket Finance

Before moving on, it is worth noting how features unique to mortgages have shaped the development of the mortgage market. Mortgages, themselves, are tricky assets to own. They have typical bond-like characteristics like interest-rate risk, but carry two additional risks: prepayment and, to a lesser extent, credit risk. The lender has effectively sold the borrower an option to: (1) prepay his mortgage principal in part or in full at any time; and (2) delay or default (including walking away ), leaving the lender with only recourse to take possession of the collateral property or home. Prepayments historically have been a function of interest rates. When interest rates decline, borrowers have an incentive to refinance into a new mortgage with a lower interest rate. When interest rates rise, borrowers have a decreasing incentive to prepay as their interest rate moves below the market rate. This is a bad option to own as an investor. As interest rates decline, investors receive early principal payments which now can be re-invested at lower rates. Conversely, as interest rates rise, lower prepayments means investors are now stuck with an asset extending in maturity earning a below market return. This is the primary reason why 15- and 30-year fixed rate mortgage products are particularly difficult to own for investors. This maturity problem (also known as negative convexity) is amplified for the leveraged spread investor who assumes additional risks in floating rate funding costs and possible margin calls.

Talkot Capital | The End of White Picket Finance

Credit risk is less tied to interest rates and more a function of employment and the general economy. Declining employment and income negatively impact the borrower s ability to service the debt. The recent crisis also demonstrates that borrowers will often strategically default or walk away from a property when the market value of the home falls below the outstanding mortgage balance. Today, bank balance sheets are inefficient destinations for mortgage credits. For starters, bank credit at US-chartered commercial banks totals just over $8 trillion while total multifamily and residential mortgage debt stands at roughly $12 trillion.11

The banking system simply isn t big enough to finance the nation s housing stock. Secondly, new capital requirement rules imposed by Dodd-Frank and Basel III will make holding mortgage credits on bank balance sheets increasingly more expensive. Bank officials last year agreed to raise the minimum common equity requirement for lenders to 4.5 percent from 2 percent of assets weighted for risk, with an added buffer of 2.5 percent for a total of 7 percent of assets weighted for risk. The requirements will be even more stringent for mortgages, such that non-bank private capital will be able to own mortgages with lower capital reserves than banks.12 This mirrors the post-bailout view that banks, as now explicit government liabilities, will increasingly be regulated like utility
11 12

Federal Reserve (2011) and Mortgage Bankers Association (2011). As JPM CEO Jamie Dimon said, Why would we own mortgages if you can own them at 7 percent capital and I have to own them at 10 percent?

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companies to serve a public finance function. Thirdly, holding long duration assets like a 30-year fixed rate mortgage exposes the banking system to significant interest rate volatility risk. This was actually a rationale for the GSEs to foster a secondary mortgage market. Lastly, transferring the bulk of mortgage risk to the banking system does not mitigate systemic risk: taxpayers are still on the hook. One must not forget that the banking system, as debt crises repeatedly expose, is just another implied government liability. Non-bank balance sheets, on the other hand, offer a means to disperse risk while efficiently connecting private capital sources and end borrowers. Unlike banks, they do not benefit from the government backstop of the FDIC and hence, suffer fewer regulations. This allows them to take more risk, but these are risks that are willingly assumed to earn a return. Non-bank balance sheets are composed of private capital pools that are raised to manage such risks. This doesn t mean banks won t have a role in the future of mortgage finance. It simply means that we should expect nonbanks to be a more primary acquirer of mortgage assets in the near future because of these dynamics. Beyond the balance sheet issue, there remains the issue of origination or how the private sector will efficiently connect borrowers and lenders through capital markets. The clear answer is securitization. Securitization created the first mortgage backed securities in the 1970s and has since been instrumental in scaling the growth of the mortgage finance market. Mortgage backed securities are debts issued against a pool of mortgage cash flows. By bundling tens to hundreds of similar mortgages, idiosyncratic risk decreases. Other key innovations for secondary market investors were tranching the prioritization of debt classes or tranches within a securitization and the guarantee of timely payment of principal and interest by GSE issued MBS or agency MBS. Together these innovations make securitization beneficial to all market participants. For the financial system, securitization freed up capital allowing banks to underwrite more mortgages without having to hold them on balance sheet and observe capital requirements and charges. For borrowers, securitization provides a lower cost of credit to households and businesses by connecting them to previously inaccessible capital sources. For investors, it affords them attractive investments in a liquid market with built-in features which allow them more prepayment certainty and the ability to vary their credit risk exposure. Securitization swiftly transformed the residential mortgage credit sector. Outstanding mortgage debt grew from a mere 25% of US GDP in the 1970s to over 80% in 2007.13

13

Source: World Bank, Federal Reserve

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Residential Mortgage Debt and GDP

$16,000
Residential Mortgage Debt Outstanding

$14,000 $12,000 Billions ($) $10,000 $8,000 $6,000 $4,000 $2,000

Ginnie Mae issues first MBS

Nominal GDP

Fannie Mae issues first MBS

Mortgage bubble begins

$0 1951 1956 1960 1965 1969 1974 1978 1983 1987 1992 1996 2001 2005 2010 Source: Federal Reserve

Since the inception of agency securitization, the private or non-agency securitization market has been limited to serving the jumbo and home equity markets until 2003. In the bubble, the private market was able to securitize non-conforming and lower quality mortgages, to the point that it gained a majority share of the MBS issuance market in 2006. Before the bubble, the private market was typically 10-15% of the market. As it stands today, the non-agency securitization market has yet to thaw from the 2007 credit freeze. The dysfunction is surprisingly not an investor demand problem, but a function of non-cooperation with rating agencies and primacy of FHA and GSE lending. The conforming loan limit is currently at an all-time high of $729,750 and FHA has reduced its required down-payment to a slim 3.5%. The rating agencies are under fire for mis-rating securities specifically AAA mortgage backed securities and have since basically shut their doors to reviewing non-agency mortgage securitizations.14 Their collective reluctance on new RMBS credit risk, however, speaks to the larger problem. Non-agency structured products, like private label mortgage securitizations, are in the midst of being regulated for having propagated risky or exotic structured products to unsophisticated investors. Many claim that they were the source of the world financial crisis and should be banned for being needlessly complex. But it seems silly to ban electricity just because the grid failed. Nor is it the answer to make everyone an electrician.15 Securitization may not be easily understood by the borrowers who benefit from lower interest rates, but it unquestionably is an efficient conduit in connecting the right borrowers with the right lenders.
14

Just two private label securitizations have been completed in the last three years. Both were heavily critiqued by rating agencies. 15 Gary Gorton s metaphor from Slapped by the Invisible Hand: The Panic of 2007 (Oxford University Press: 2010)

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That being said, it is undeniable that non-agency securitization as it existed in the 2000s created a misalignment of incentives in the securitization chain. Originators would often securitize anything as long as they could get the rating agencies AAA stamp of approval. This gave birth to the pernicious alchemy that was re-securitizing dubious and subordinated collateral into seemingly pristine products that were then sold to the marketplace. In the originate-and-distribute business model, writes the SEC, lenders did not bear the credit risk of borrower default, which led to a deterioration in credit quality of the underlying assets. Instead, that risk was passed on to investors. With no regulatory oversight of the rating agencies due diligence, the only check against the system was the discretion of private investors. Unfortunately, as the world learned, investors and lenders largely trusted these ratings and historical credit performance of RMBS credits. In 2005, Moody s historical model estimated that Aaa RMBS or HELOC (home equity loan) losses to be just 2.3%.16 In 2009, Moody s released a report that now projects 2005-2007 nonsubprime HELOCs to suffer cumulative losses of 25-55%.17 In other words, we can t just rely on the rating agencies. We need a better grid a new architecture capable of handling and managing how securitization connects lenders and borrowers. In summary, to supplant the GSEs dual role in originating and investing in mortgage securities, the private sector will need time and money. It will take time to construct new origination architectures that meet the efficiency and scale of the GSEs; and capital equity capital - to finance the ownership of the legacy securities that are being run off government balance sheets and the new mortgages our future system will produce. Each of these tasks by itself will be a taxing, multi-year process. For both to happen in sequence, or possibly simultaneously, would be a truly extraordinary event in the history of financial markets. RMBS 2.0: QRM Addressing these recent weaknesses in the non-agency securitization market, the Dodd-Frank Wall Street Reform and Consumer Protection Act has aimed to prevent the originate-and-distribute business model. Regulators will require private securitizers to retain a risk portion of each securitization sold to the market. Regulating the non-agency securitization market, however, does not pair well with the grander vision of unwinding government programs. We have to remember that the private market before the bubble was always little brother to the government. The only time it was a force in mortgage securitization was during the bubble years of 2003-2006 when it mainly issued toxic, unstable securities which nearly brought down the system. Before the bubble, the private market performed a select role for jumbo and home equity loans. Today there is no private securitization market to speak of. In short, policy-makers may be, in effect, regulating a market that does not exist. Moreover, these regulations, which will raise mortgage costs, could not come at a worse time for deleveraging households. Under Dodd-Frank, securitizers will be required to retain 5% of the credit risk for each securitization they create unless that securitization is wholly composed of qualified residential mortgages (QRM). The FHA and GSEs would be exempt from risk retention rules. A QRM has yet to be permanently defined. On March 29, 2011 regulators proposed a tentative definition of a
16 17

Moody s Investor Service 2005 Moody s Investor Service 2008

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QRM as a mortgage with a maximum loan-to-value of 80% with standardized debt-to-income ratios (28% / 36% or less) and product requirements. So far market participants and commentators have called this first definition too narrow. Only about 20% of GSE acquired mortgages since 1997 meet the proposed QRM definition. Moreover, based on 2009 data, it would take 15 years for an average family to save the $43,000 or 20% down payment on a median priced home. Not such an easy thing for households to do when roughly a quarter of current borrowers owe more than their homes are worth.18 For now, the impact of the QRM rule is confined to non-conforming mortgages primarily those which fail to meet the GSE and FHA underwriting standards or those which exceed the conforming loan limit. But this is likely to change. The Treasury s White Paper advocates tighter underwriting standards, higher down payments and lower conforming loan limits at the GSEs and FHA. Analysts predict that the current FHA required down payment a slim 3.5% will be raised to 5-10%. At the GSEs, analysts expect the minimum down payment will be 10% with mortgage insurance. If securitizers are to have more skin-in-the-game then, the logic goes, so should borrowers. Additionally, the conforming loan limit is set to fall to $625,500 October 1, 2011 with further reductions expected. A February 2011 George Washington University report, for example, advocates a reduction to the 2006 level when the FHA loan ceiling topped out at $362,790. Thus, tighter credit standards at the agencies and lower conforming loan limits will expose more borrowers to mortgage costs impacted by the QRM rule.
Fannie Mae's Conforming Loan Limit History
$700 $600 $500
Thousands Fannie Mae Single Family Fannie Mae High Cost Single Family S&P Case-Shiller 20-City Home Price Index

$400 $300 $200 $100 $0

82

86

88

92

96

98

02

06

08 20

80

84

19

19

19

19

19

19

19

19

19

19

20

20

20

20

Source: Case-Shille r, Fannie Mae

As more borrowers fail to meet the underwriting criteria for the agencies and QRM, the question becomes: what will be the cost of risk retention? JP Morgan estimates that the cost of risk retention could increase non-QRM loans funded through securitization by as much as three-percentage points over the current conforming interest rate. The National Association of Home Builders (NAHB) estimates that every percentage point increase in interest rate makes a median price home unaffordable to approximately 4 million households, which is roughly 7.5% of mortgage borrowers.

18

Sources: FHFA and Corelogic. Corelogic estimates that 23% of borrowers are underwater representing $750 billion in negative equity. A March JPM report estimates that 27% of borrowers are underwater.

Talkot Capital | The End of White Picket Finance

20

10

90

94

00

04

14

So while QRM is likely to be successful in facilitating a sustainable private securitization market, an increasing number of households will struggle to afford the costs imposed by these regulations. Examine the finances of the average American household with a mortgage. Our average family has annual income of $63,000, which leaves them with about $46,500, assuming an all-in tax rate of 30% (and deducting mortgage interest, of course).19 We assume that they have a 5% 30-year conforming $180k loan against their median priced home, which equates to roughly a $960 monthly mortgage payment. After all other necessary expenses, they are left with just under $500 for emergencies, education, cell phones, internet, cable, home repairs, entertainment and perhaps even savings. There might not be a lot of room for error, but if jobs are kept, our average family can squeak by. Now consider what happens when we substitute their conforming mortgage with two possible types of non-conforming, non-QRM mortgages. If their mortgage rate rises to 7.5%, their monthly payment jumps almost $250. Alternatively, a 15-year mortgage at 5% raises their mortgage payment over $450 dollars.
Income Statement for the Average American Household with a Credit Card
Per Year Assumed Mortgage Type Income Tax Liability* Net Income Car (payment/insurance/maintenance) Transportation Fuels Insurance & Pension Credit Card Debt Mortgage Property Taxes + HOA Food Utilities What's left? 30-year 5% Conforming $62,857 $16,400 $46,457 $6,000 $3,235 $5,000 $2,213 $11,520 $3,000 $6,000 $3,500 $5,989 Per Month 30-year 5% Conforming $5,238 $1,367 $3,871 $500 $270 $417 $184 $960 $250 $500 $292 $499 Per Month 30-year 7.5% $5,238 $1,367 $3,871 $500 $270 $417 $184 $1,259 $250 $500 $292 $200 Per Month 15-year 5% $5,238 $1,367 $3,871 $500 $270 $417 $184 $1,423 $250 $500 $292 $36

*30% all-in rate (federal + state + municipal); mortgage interest deducted

Source: BLS 2009, EIA 2011

The math for our average American family suddenly doesn t work.

19

Bureau of Labor Statistics, 2009

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This kind of potential payment shock to households could not come at a worse time. By all indications, households and consumers are deleveraging from the excesses of the credit boom, paying down or minimizing debt to rebuild their balance sheets. Starting in 2000, households accelerated their debt consumption, loading up their balance sheets and doubling the total consumer debt outstanding in just seven years. Unsurprisingly, the bulk of it was a growing mountain of residential mortgage debt that now has been slowly contracting each month since peaking in Q4 2007. While this has been driven primarily by defaults, household mortgage debt remains above its pre-bubble trend. Additionally, real estate values have fallen significantly faster than mortgage debt since the crisis. If anything, this is an indication that deleveraging will be a slow, painful process that will take years, as household incomes are diverted to minimize debts.

De-leveraging US Household Mortgage Debt Could Last Until 2020

$12 $10 $8 Trillions $6 $4 $2 $0 Oct-81 Oct-11 Oct-21
8 2 0 0

$30
Trend since 2007

Household Mortgage Debt Real Estate Market Value

$25 $20 $15 $10

Trend from 1983 to 1997

$5 $0

Oct-85

Oct-89

Oct-91

Oct-01

Oct-15

Source: Nomura, based on Federal Reserve Data

A still elevated homeownership rate also suggests that more deleveraging is to come.
Homeownership Rate in the US since 1984
70.0 69.0 Percentage (%) 68.0 67.0 66.0 65.0 64.0 63.0 62.0 61.0
6 8 4 2 6 8 2 9 8 9 8 9 8 9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 1 1 1 1 1 1 1 1 2 2 2 2 0 0 6 0 4 0 4

Source: Federal Reserve

Talkot Capital | The End of White Picket Finance

Oct-19

Oct-83

Oct-87

Oct-95

Oct-99

Oct-05

Oct-09

Oct-13

Oct-17

Oct-93

Oct-97

Oct-03

Oct-07

16

American households deleveraging en masse has never happened before. There have been recessions where specific groups and regions have suffered the pains of repairing underwater balance sheets, but we ve never had a balance sheet recession as an entire nation. There are many reasons, ranging from the evolution of consumer finance markets to pure demographics to explain this, but the most obvious is the 30 year rally in interest rates starting in the early 80s. Neo-classical economics has inscribed into monetary policy the theory that lower interest rates will increase current planned expenditures, boosting production, consumption, and asset prices via new borrowing and refinancing old debts. And history has proven the theory true. Periods of overindebtedness were always followed with periods of lower rates allowing corporations and borrowers to alleviate balance sheet and income statement stress. This occurred in sequence with a series of several important financial innovations, like securitization, which made capital markets more efficient affording debtors even lower rates. In 2008, the Federal Reserve cut the Fed Funds rate to 0.25% and announced that it would purchase $1.25 trillion in MBS (QE1) aiming to do just this again, but the refinance boom never materialized. Consumer credit in aggregate continues to contract as consumers de-leverage to salvage their balance sheets. This makes the QRM debate all the stickier. On the one hand, households are deleveraging because they have too much mortgage debt. They desperately need higher home prices to allow them to monetize these assets and repair their balance sheets. On the other hand, withdrawing government housing finance subsidies and effectively tightening the private label mortgage market will raise the cost of mortgage credit. By the golden rule of capital markets - the price of an asset is driven by the amount of financing available to that asset this can mean only one thing. If the price to finance a home rises, then, holding everything else equal, home prices must fall. Compounding these problems is the existing supply of houses that continues to weigh on real estate markets, making those mortgages more burdensome. In May 2011, Lender Processing Services issued a report estimating that almost 4.1 million homes were in or nearing foreclosure or roughly 8.5% of all active mortgage loans. 20 This is in addition to the 3.87 million previously owned homes currently for sale. 21 And things aren t getting better. Foreclosure starts increased in May 2011 and delinquency rates have remained stubbornly close to 8%.22 Demand cannot keep pace. Foreclosure sales were just 78,000 in May 2011. Household formation from 2000-2010 averaged 888,500 per year. 23 At those rates, it would take 8.9 years to digest both the shadow foreclosure inventory and existing homes for sale. Foreclosure inventory is expected to peak anywhere from late 2011 to 18 months from the time of writing. Yet if the homeownership rate returns to the pre-bubble level of 64%, that s another 3 million homes that need to get taken out of the market. Adversely changing the leverage available to finance these assets would only exacerbate defaults (especially strategic defaults) and extend the work-out period as the cost of mortgage capital increases. In summary, the imminent regulations to the securitization market may prove beneficial in preventing the production of 2006-like toxic securities, but it may also prevent the production of any mortgage securities. A narrow QRM rule could severely limit the ability of non-agency lenders to compete with the GSEs and FHA, thereby undermining the Treasury s explicit goal in the White
20 21

LPS May Mortgage Monitor National Association of Realtors May 2011 22 LPS May Mortgage Monitor 23 Data from Mortgage Banker s Association. Note that between 2005-2008, the US lost 1.2 million in households while population increased 3.4 million.

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Paper to reduce the government s footprint in the housing finance market. The costs imposed by QRM could also make mortgage credit significantly less affordable, precipitating another leg down for home prices. Rationing mortgage credit and supporting home prices is not possible. There is no win-win magic bullet. Either somebody loses or we all lose together. A New World of Mortgages: Privatization and a Mother of Capital Calls At present, just over $1.5 trillion of agency MBS is owned across the balance sheets of Freddie, Fannie, and the Federal Reserve.24 Again, the GSEs are mandated to decrease their portfolios by 10% per year and the Federal Reserve is reinvesting MBS prepayments into treasury securities. As these portfolios run-off and shrink, private market balance sheets will have to portfolio these assets. Assuming prepayments don t fall significantly, it s estimated that the private market will have to portfolio anywhere from $200 to $300 billion in 2011 alone. To finance these assets at 10:1 leverage, private markets would have to raise $18 to $28 billion in equity capital in 2011 and possibly as much as $175 billion over the life of the government runoff. This transition of agency MBS from government to private balance sheets is a de facto privatization of mortgage assets and will effectively act as a slow and steady capital call. This is the price of having had these assets under-collateralized on government balance sheets for so long. Lower private market leverage ratios will necessarily tie up more equity capital reserves keeping mortgage spreads wide and pressuring rates higher. And all of this is before we overlay the Treasury s desire to shift more of the share of mortgage originations to the private sector. Shifting the composition of mortgage origination, in turn, shifts the composition of collateral types in the MBS market. More non-agency securities means higher financing costs, which encumbers even more equity capital. And lastly, more mortgage collateral backed by credit risk increases the secondary or shadow banking system s vulnerability to repo runs. For the GSEs and the Federal Reserve, owning agency MBS portfolios was and continues to be easy. The GSEs only need to hold $2.5 dollars in equity capital against $100 in assets. The Federal Reserve s monopoly on the printing press gives it theoretically infinite leverage. The private sector, on the other hand, is much more constrained in its access to leverage. Many portfolios of agency MBS are financed through the repurchase agreement or repo market where securities are sold for cash and pledged to be repurchased at some future contracted date and price. In essence, a repo is a loan collateralized by a security. The difference between the value of the security and the loan is the capital requirement or haircut . Haircuts are a key constraint for leverage bigger haircuts mean holding more equity capital. A 5% haircut means that to purchase a $100 of securities, the purchaser must post $5 of equity capital to finance the other $95 of purchases. That translates into a 19:1 debt to equity ratio, but lenders typically keep these ratios in check. Agency MBS typically fetch 3-5% haircuts. Non-Agency MBS, on the other hand, typically fetch slightly higher haircuts of 5-25% depending on credit quality. Thus, by private market standards, agency MBS held on government balance sheets has been inadequately reserved. As such, the transition of assets from government to the private balance sheets will necessarily require new equity capital.

24

At the time of writing the agency MBS holdings for the Federal Reserve was $927 billion. At 3/31/2011 Freddie Mac s investment portfolio was $263.6 billion and Fannie Mae s investment portfolio $349 billion.

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Thankfully there is a well-developed capital market to acquire and manage agency MBS. The question then becomes - how significant will this capital call be and what private sector balance sheets are the logical receptacles for these assets? As previously mentioned, private markets in 2011 alone will need to reserve $18 to $28 billion in new equity capital to accommodate government runoff of $200 to $300 billion in agency MBS collateral. Examining the market of estimated current ownership of agency MBS reveals that that there is probably more supply than demand despite little net issuance. The demand dynamics of the agency MBS market are increasingly being driven by regulation and the after-effects of the financial crisis. Commercial banks, as discussed, are in the throes of reregulation and more stringent capital requirements. This has forced them to hold more capital reserves relative to their non-bank private sector competitors. As credit demand recovers, banks will also seek to underwrite new loans to replace their holdings of securities like MBS. Foreign investors have slowed their appetite as sovereign wealth funds remain fearful of GSE reform and the dollar. Money managers and insurance companies will remain opportunistic buyers, but have been underweight mortgages fearing higher interest rates. This leaves roughly 8% of the market as active buyers primarily REITs and hedge funds. Consider that mortgage REITs, which are the public equity market s favored vehicles to manage dedicated portfolios of agency MBS, have a collective market capitalization of just $27 billion.25

Supply/Demand Dynamics Ownership of $5 Trillion Agency MBS

Federal Reserve 17% GSE Investment Portfolios 11% Foreign Investors 13% Local/State Governments 2% Money Managers/Index Funds/Insurance Companies 27%

REITs/Other 4%

Hedge Funds/Brokers 4%

Commercial Banks 21%

Sellers

Stable / Opportunistic Buyer

Buyers

To appreciate the magnitude of the new capital required to finance this government run-off, consider that there are roughly $500 billion in equity reserves in the system at present.

25

Talkot estimate calculated by summing up the equity capital financing agency MBS amongst all mortgage REITs.

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Holders
($ in billions)

Agency MBS Market in 2011 Assets Owned $925 $600 $1,400 $1,150 $700 $250 $250 $125 $5,400

Debt to Equity Ratio 40 0 10 0 13 7 0 1.4

Equity Reserves $0 $15 $1,400 $105 $700 $18 $31 $125 $2,268

Federal Reserve GSE Investment Portfolio Money Managers Commercial Banks Foreign Investors Hedge Funds/Brokers REITs / Other Local/State Governments Total

Source: Credit Suisse, Federal Reserve. Debt to Equity Ratios are primarily Talkot estimates

Given the factors we ve considered, let s imagine what this market looks like in 2015, provided it doesn t grow. On the supply side, GSE portfolios will continue to shrink 10% per year. The Federal Reserve s holdings will shrink at some prepayment rate, which we assume to be 15%. On the demand side, we will assume that REITs and hedge funds have a disproportionate appetite for the new supply relative to the traditional rate buyers for reasons we ve already scrutinized. Consider that Mortgage REITs have already raised $8.1 billion in 2011 until the time of writing.26
Agency MBS Market in 2015 Assets Owned $480 $400 $1,425 $1,200 $700 $400 $620 $125 $5,350

Holders
($ in billions)

Debt to Equity Ratio 40 0 10 0 13 7 0 1.3

Equity Reserves $0 $10 $1,425 $109 $700 $29 $78 $125 $2,350

Federal Reserve GSE Investment Portfolio Money Managers Commercial Banks Foreign Investors Hedge Funds/Brokers REITs / Other Local/State Governments Total

Source: Credit Suisse, Federal Reserve. Debt to Equity Ratios are primarily Talkot estimates

Given these parameters, it would require an additional $80 billion in equity capital to finance the 2015 MBS market. Of course, this $80 billion would be spread over several years, but this is almost 20% of the current capital base for MBS which has taken decades to form. Raising $80 billion in equity would be like creating another Visa, Goldman Sachs, or Facebook. If we extend this calculation to a case where the government completely exited their holdings of agency MBS, then the total capital call could be as high as $175 billion.

26

Bloomberg June 2011

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These already high estimates, however, do not account for the impact of the Treasury s desire to shift mortgage origination volumes away from the GSEs and the FHA. In pre-bubble times agencies had been the issuers of roughly 80% of annual MBS issuance (the 80/20 world). Now, the Treasury s White Paper envisions the private sector becoming the primary issuer of MBS. To be conservative, let s imagine that the private sector only meets the agencies half-way, where each is responsible for half of annual MBS issuance (50/50 world). So assuming a $1 trillion in annual issuance (mortgage origination volumes have averaged more than $1.25 trillion the last three years) that means $500 billion will be originated from the agencies and $500 billion from our new robust market of non-agencies or securitized QRMs. In the 80/20 world, it would require $85 billion in equity to finance this $1 trillion. 27 In the 50/50 world, it would take closer to $100 billion an additional $15 billion capital call. And this doesn t consider that over 2/3 of MBS investors are rate-sensitive buyers which is to say that they cannot take credit risk and possibly could be restricted from buying QRM-like products. Many of these traditional rate-sensitive investors have provisions in their operating documents that prevent them from investing in credit-sensitive securities. $15 billion is roughly equal to the equity raised since 1997 by the largest publicly traded portfolio of agency MBS Annaly Capital Management but there is an arguably more trenchant problem in granting the Treasury the 50/50 world. $15 billion in equity is sizable but still digestible. The more salient problem is how a 50/50 world will necessarily change the composition of collateral types in the repo market. One of the key features of agency MBS is that they bear interest rate but not credit risk because of the government guarantee. The credit component of their risk profile carries the default risk of their sovereign backer, which for America translates to almost zero. This special feature makes agency MBS fundamentally what economists like Gary Gorton would call information-insensitive. 28 In other words, when transacting these securities in a purchase, sale or repurchase agreement, neither side has an asymmetrical information-advantage relative to the other transacting party. As such, agency MBS are afforded extremely attractive financing rates because repo lenders can know the value of the collateral without further inspection. Conversely, securities like non-agency MBS, equities, and securities that bear pronounced default risk are necessarily more informationsensitive . For such securities, it is possible for one party to have non-public or even secret information about the value of the debt. Speculators who have knowledge of this information can take advantage of those who do not. These dynamics were key in the formation of the securitized products and key in how those products blew up financing markets. Daily repo volumes are massive, but a precise measure of this opaque market can only be estimated. The Fed estimates that tri-party repo peaked at $2.8 trillion in 2008, but even the Fed admits this is just a fraction of the greater repo market.29 The BIS estimated that in 2008 the US repo market exceeded $10 trillion (including double counting of repos and reverse repos).30 Gorton estimates it to be close to $12 trillion.31 That would make it slightly larger than the US banking system, which undeservedly garners more attention and concern. The
27

Assuming 12:1 leverage for agencies and 7:1 for non-agencies. Gorton 2010. 29 Copeland, Martin, and Walker, The Tri-Party Repo Market before the 2010 Reforms. Federal Reserve Bank of New York Staff Reports, November 2010. 30 King and Hordahl, Developments in repo markets during the financial turmoil. BIS Quarterly Review, December 2008. 31 Gorton 2010.
28

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repo market is primarily composed of lenders who have cash accounts so large that the traditional banking system cannot accommodate them. Money market funds and current account surplus countries like Qatar or China are good examples. In 2006, we briefly glimpsed a 50-50 world. For the first time ever, private label securitization eclipsed the agencies in issuance, producing vast quantities of non-agency collateral. This was primarily a function of the repo market s voracious demand for high quality collateral securities carrying AAA ratings which manifested as incredibly attractive financing rates. The now defunct Thornburg Mortgage held just 4.51% capital against a portfolio of AAA non-agencies.32
The Spike of Private Label Securitization
$2.00
MBS Issuance in Trillions ($)

$1.75 $1.50 $1.25 $1.00 $0.75 $0.50 $0.25 $82 86 88 80 84 92 96 98 02 06 08 20 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 10 90 94 00 04

GSEs Private Label

Source: SIFMA, Inside M BS, and the Federal Reserve

A dearly underappreciated fact is how the repo market s demand for high-quality collateral spurred the creation of highly-rated structured products. AAA ratings were the designation of informationinsensitive debt in 2006 AAA MBS had a historical default rate of 0.00%.33 But there was a significant turning point in the market when repo depositors discovered that some of the high quality securities collateralizing their deposits - specifically private label RMBS - carried significant credit and default risk. Almost overnight, information-insensitive securities became information-sensitive securities and the repo markets seized up. In not unusual fashion, this fomented what could be called a bank run and has been now appropriately dubbed a "repo" run. Like hasty depositors lining up outside a bank demanding their money, repo lenders panicked and asked for more collateral, increased haircuts, or simply refused to roll or renew financing agreements with particular forms of collateral. As financing dried up, asset prices plunged forcing margin calls and liquidations, which in turn sent prices plummeting further, causing more margin calls and liquidations. That many repo agreements had to be rolled overnight exacerbated the panic. The leveraged non-agency investor was suddenly bankrupt. Ratings for non-agency MBS became meaningless, given the panic in the repo market. Agency MBS, on the other hand, did not crater quite the same way. The non-agency contagion did affect agency MBS prices and agency repo terms to the extent that several large hedge funds managing
32 33

Thornburg Mortgage s 2006 Annual Report. It should be noted that TMA also funded itself through CDOs. S&P and UBS calculations from 2006. They also detail that AAA CMBS, HELs, and ABS all had below 0.03% 5 year default rates.

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AAA agency MBS went bankrupt (e.g. Carlyle Capital Corporation was levered 31:1 before having to liquidate in March 200834). Nevertheless, agency MBS was remarkably resilient. This is partly because the Federal Reserve will lend against agency MBS at its discount window, which assures all lenders that no matter what, the Federal Reserve is a fundamental backstop to the repo market (and it was). Non-agency MBS lenders do not enjoy the security of a lender of last resort. The resiliency of agency MBS in the crisis, however, is primarily a function of a more salient feature, which provides the reason why the Fed accepts agency MBS as collateral. This, of course, is the government guarantee which makes agency MBS information-insensitive. This leads us to an important and much underappreciated point. As a market that is estimated to be larger than the US banking system, we can t ignore the repo market s effects and systemic importance in global finance. Yet, its health is more or less tied to the quality of the collateral that composes it. Just as when depositors in the early part of the 20th century worried about the value of bank assets, repo lenders worry about the health of the collateral assets backing their loans in a repo. So how do we prevent supposedly information-insensitive securities from becoming informationsensitive again? This is a problem with the Treasury s vision shifting the share of originations to private markets will in turn shift the composition of MBS collateral types in the repo market. This means more potentially information-sensitive securities in financing markets supplanting more information-insensitive securities like agencies which maintain their integrity through crises. Thus, depending on how we define QRM and the kinds of securities the new non-agency securitization markets produces, we could be increasing the systemic risks yet again in broader financing markets. For this reason, the creation of sustainable high quality collateral will go a long way in supporting the health of this part of the financial world and mitigating the potential for future repo runs. Thankfully, we are at a point in the cycle where these kinds of risks are probably not imminent. Yet regulators should be sensitive to these variables in crafting the next iteration of the mortgage finance market. Reform Moving Forward: Revolution or Evolution? Markets tend to function more or less in a Darwinian fashion. Amongst various types of economic endeavors, certain ones are better suited to particular environments. The well-adapted survive and proliferate. Mal-adapted ones do not. Government institutions, on the other hand, are established for one kind of environment and have no automatic mechanism to adjust themselves to new environments. The fate of a designed institution is inevitably left in the hands of policy-makers and legislators. They must be ready and able to react to fundamental changes in circumstance with mirrored shifts in the institutions they oversee. Anything less entails political and economic decay, which could yield the next crisis. As such, the aftermath of the credit crisis has necessitated reforms of institutions like the GSEs and the FHA. The real question, as we have discovered, is one of timing and scope. Do we pursue a policy of immediacy to reform our current dysfunctional

34

The details provided by Carlyle s press release explaining the company s imminent and complete default illuminate the anatomy of a repo run: During the last seven business days, the Company received margin calls in excess of $400 million. As the Company was unable to pay these margin calls, its lenders proceeded to foreclose on the RMBS collateral. In total, through March 12, the Company has defaulted on approximately $16.6 billion of its indebtedness. The remaining indebtedness is expected soon to go into default Overall, it has become apparent to the Company that the basis on which lenders are willing to provide financing against the Company s collateral has changed so substantially that a successful refinancing is not possible.

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institutional equilibrium and risk economic growth? Or do we instead maintain a broken system for as long as it takes consumers to heal and risk fiscal rectitude? The post-crisis world has forced the government s hand it has to act but how? Will reform be gradual or sudden? Will we get an evolution or a revolution? The gradualist approach to reform appears most likely. As we ve discussed, the government has become the primary insurer of the nation s housing stock and deleveraging households can t afford more debt or higher costs of housing. The other side of reality is that the American economy and US fiscal position simply cannot afford another housing dip. A logical conclusion is that the government must facilitate a period to work-through the roughly 5 or more million homes that need owners. In this case, privatization does not mean dramatic or sudden shifts that force borrowers into more expensive QRM and other non-agency mortgage products. Instead, it means extending the time frame in which government agencies continue to be the primary residential housing lender. The origination shift envisioned by the Treasury will have to be postponed probably at least 10 years. It could take 5 years to digest foreclosures and excessive mortgage debt and another 5 years to begin the wind-down of GSE and FHA origination share to pass the mortgage baton to private label securitization market. What seems certain, however, is that GSE and Federal Reserve balance sheets will run-off roughly 10-15% of their $1.5 trillion in MBS per year, necessitating nearly $80 billion in equity capital over the next 5 years. This is already happening and should keep MBS spreads wide, creating a prolonged period where investors can reinvest cash flows at attractive spreads. For rate-sensitive investors, this will be a boon. A revolutionary approach to home finance reform, on the other hand, could potentially bury the economy. A serious rationing of mortgage credit could double or triple foreclosure inventory, setting off another downward spiral of debt deflation. Such a scenario would reduce incomes, making debts more burdensome, threatening the US fiscal position and crushing households further. If even just half of underwater residential borrowers default, that could tack on roughly another 5 years supply of homes. And if those foreclosures cause home prices to fall another 10%, cause half of the remaining underwater borrowers to default and add close to another 5 years of foreclosure inventory. As it stands, households, banks, and the American economy will be hard pressed to digest 4 to 5 million foreclosures. An avalanche of 10 to 12 million foreclosures would make Japan s Lost Decade look desirable. As investors, our job is not to boil the situation down to one, single view. It is, instead, to understand many different views simultaneously, and in doing so, to predict how different actors will respond to the maneuvers of both sides of an intricate political discourse (or even stalemate). It is also our job to be ready to respond to the potentially serious economic impacts of various political outcomes if and when they become visible. This white paper has attempted to outline our particular view on the important issues framing reform. It is an idiosyncratic view, designed less to present an authoritative vision than to underscore the complexity and magnitude of mortgage finance reform. Uncertainty looms large. There will be incredible opportunities, but also staggering risks, on the road ahead. For investors, finesse will not just be rewarded. It will be required. Talkot Capital | The End of White Picket Finance 24