Use CBs to Restart the PLS Market

In the United States there is a lot of discussion about how to reduce the taxpayers' exposure to housing finance. The conservatorships of Fannie Mae and Freddie Mac were a pointed reminder of the extent of the government's, and the taxpayers', role in housing finance. Additionally, after being taken into conservatorship, the GSEs were intentionally used to prevent a feared collapse of the housing market, further expanding their role.

As a result, the GSEs, together with FHA and GNMA, at one point provided more than 95% of the financing for new residential mortgage loans, and today they still finance roughly nine out of every ten new mortgage loans.  At the same time, the private label securities (PLS) market, which provided significant private funding for residential mortgage loans, essentially vanished.  The issuance of new PLS declined nearly 99% in the years following the crisis.

Today there is general agreement across the political spectrum that it would be desirable to restore some level of private funding for residential mortgage loans and reduce the role of the GSEs.  There are also plans to reform the GSEs and refine their mission in housing finance.  There is less agreement on the reform proposals.

On June 27, 2014, Treasury Secretary Jacob Lew requested comment on what steps could be take to restore a functioning PLS market.  Almost uniformly the commenters voiced the need to shrink the presence of Fannie and Freddie in the market in order to make room for a PLS market.  This reflected the view that under the existing authority of the GSEs, the private market would not be price competitive and would only be able to finance a small number of loans that did not qualify for financing through the GSEs under their very high loan limits.

However, the presence of the GSEs is not the only factor impeding the development of the PLS market.  The regulatory landscape for securitizing mortgage loans has been altered dramatically since the crisis.  Basel III imposes heavy, in some cases almost punitive, increased capital requirements on banks and most particularly for securitization exposures held by banks.  The risk weighting for securitization exposures can range up to 1250% and in some cases, such as non-cash gain on sale, the capital requirements will result in a deduction from Tier 1 equity capital.  Rulemaking by the Consumer Financial Protection Board exposes any holder of a mortgage loans to severe penalties for those loans not underwritten in accordance with the CFPB underwriting criteria, which are designed to protect the borrower.  SEC requirements for mortgage securitization require 270 data points of information to be disclosed for every mortgage loan in a securitization, both at the time of the offering and in periodic reporting for the life of the securitization.  Then there is risk retention, prohibited conflicts of interest, margin requirements for swaps, the Volcker Rule, conflicting requirements in foreign securities markets and a litany of other burdens on the PLS market.

So while shrinking the GSEs may be viewed as a necessary condition to restarting the PLS market, there is no consensus that shrinking the GSEs will by itself restore the PLS market.  And there has to be some hesitation in shrinking the GSEs, if there is no confidence that the PLS market, or some form of private funding, will be there.  So we have a chicken and  egg problem.  There is, of course, a bit of a safety valve in that banks can hold mortgage loans on balance sheet and fund them through deposits or senior debt.  But that is not viewed as other than a temporary solution.

This situation requires then that any shrinking of the GSEs be done slowly and limited to the extent that private funding alternatives develop.  Else you run the risk of severely limiting funding in the housing market.  But this approach raises the question of whether the private sector will bother making the necessary investments to issue PLS if the market is going to be so small for quite some time.

It would seem that covered bonds could provide a solution to this problem.  Covered bonds provide private sector funding for mortgage loans held on balance sheet at very efficient rates compared to senior debt.  And covered bonds provide term funding and a much improved asset-liability mismatch compared to deposit funding. Thus the use of covered bonds could expand the utility of the safety valve, allowing the GSEs to shrink quicker.

Do covered bonds displace the PLS market?  The answer is no, but it is a qualified no. Enabling domestic banks to issue covered bonds may induce some greater retention of mortgage loans as a result of the financing efficiency of covered bonds over senior debt.  Securitization transfers the risk of mortgage loans to investors, getting the loans off-balance sheet, and investors are repaid solely from cash flows on the mortgage loans.  Covered bonds, on the other hand, provide funding for loans that are hold on-balance sheet; the bonds are senior obligations of the issuing bank.  Thus the two financing techniques are not directly competitive.  And enabling domestic banks to issue covered bonds would allow the GSEs to shrink faster and enhance the likelihood of restoring a PLS market.

The covered bond market has been developing nicely in the United States through sales of covered bonds issued by foreign banks to U.S. investors.  There are now about $150 billion of U.S. dollar denominated covered bonds outstanding. There is also well-developed draft legislation that has attracted strong bi-partisan support in Congress.  It is legislation that could be enacted quickly if the administration were to push for it.

An idea worth considering.