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81–438 PDF 2013

S. HRG. 113–35 

RETURNING PRIVATE CAPITAL TO MORTGAGE 

MARKETS: A FUNDAMENTAL FOR HOUSING 

FINANCE REFORM 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES, INSURANCE, AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED THIRTEENTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING THE IMPORTANCE OF BRINGING PRIVATE CAPITAL BACK 

TO MORTGAGE MARKETS, CONSIDERING WHAT MECHANISMS WOULD 

ACHIEVE THIS GOAL, LIMIT TAXPAYER RISK, AND FACILITATE A STABLE AND LIQUID MORTGAGE MARKET 

MAY 14, 2013 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.fdsys.gov/ 
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

TIM JOHNSON, South Dakota, Chairman 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

KAY HAGAN, North Carolina 

JOE MANCHIN III, West Virginia 

ELIZABETH WARREN, Massachusetts 

HEIDI HEITKAMP, North Dakota 

MIKE CRAPO, Idaho 

RICHARD C. SHELBY, Alabama 

BOB CORKER, Tennessee 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

JERRY MORAN, Kansas 

TOM COBURN, Oklahoma 

DEAN HELLER, Nevada 

CHARLES YI, Staff Director 

GREGG RICHARD, Republican Staff Director 

DAWN RATLIFF, Chief Clerk 

KELLY WISMER, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT

JON TESTER, Montana, Chairman 

MIKE JOHANNS, Nebraska, Ranking Republican Member 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

ROBERT MENENDEZ, New Jersey 

MARK R. WARNER, Virginia 

KAY HAGAN, North Carolina 

ELIZABETH WARREN, Massachusetts 

HEIDI HEITKAMP, North Dakota 

BOB CORKER, Tennessee 

RICHARD C. SHELBY, Alabama 

DAVID VITTER, Louisiana 

PATRICK J. TOOMEY, Pennsylvania 

MARK KIRK, Illinois 

TOM COBURN, Oklahoma 

KARA STEIN, Subcommittee Staff Director 

BRIAN WERSTLER, Republican Subcommittee Staff Director 

ALISON O’DONNELL, Senior Economic Advisor 

(II)
C O N T E N T S 

TUESDAY, MAY 14, 2013 

Page 

Opening statement of Chairman Tester ................................................................ 1 

Opening statements, comments, or prepared statements of: 

Senator Johan ................................................................................................... 2 

WITNESSES 

Mark A. Willis, Ph.D., Resident Research Fellow, Furman Center for Real 

Estate and Urban Policy, New York University ................................................ 3 

Prepared statement .......................................................................................... 34 

Andrew Davidson, President, Andrew Davidson & Co., Inc. ............................... 6 

Prepared statement .......................................................................................... 42 

Phillip L. Swagel, Ph.D., Professor, International Economic Policy, Maryland 

School of Public Policy, University of Maryland ................................................ 7 

Prepared statement .......................................................................................... 65 

Robert Van Order, Ph.D., Chair, Department of Finance and Professor of 

Finance and Economics, George Washington University School of Business . 9 

Prepared statement .......................................................................................... 70 

(III)

(1) 

RETURNING PRIVATE CAPITAL TO MORTGAGE MARKETS: A FUNDAMENTAL FOR 

HOUSING FINANCE REFORM 

TUESDAY, MAY 14, 2013 

U.S. SENATE, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT

Washington, DC. 

The Subcommittee met at 3:19 p.m. in room SD–538, Dirksen 

Senate Office Building, Senator Jon Tester, Chairman of the Subcommittee, presiding. 

OPENING STATEMENT OF SENATOR JON TESTER 

Senator TESTER. I would like to call this hearing to order of the 

Securities, Insurance, and Investment Subcommittee titled Returning Private Capital to Mortgage Markets: A Fundamental for Housing Finance Reform. 

I want to welcome our witnesses, and I look forward to hearing 

from them this afternoon about some of the benefits and challenges 

associated with bringing private capital back to the mortgage markets. And, more specifically, we will get at how different risk-sharing mechanisms will achieve this goal while limiting taxpayer risk 

and facilitating a stable and liquid mortgage market. This is a crucial issue within the context of Fannie and Freddie as they consider and engage in different risk-sharing mechanisms later this 

year and also as we consider what the future of housing finance reform might look like. 

We know that private capital will not automatically return to 

this market without an understanding of how the new system will 

function and what the rules of the road will be. Part of that is understanding more fully the mechanisms that are being considered 

to facilitate credit risk-sharing and seeing how investors respond to 

the enterprises’ trial run later this year. 

The FHFA has directed Fannie and Freddie to complete $30 billion in risk-sharing transactions and has directed them to consider 

expanded mortgage insurance, senior/subordinated securities and 

credit-linked securities. 

While these mechanisms provide opportunities for the enterprises to better manage credit risk, we must also understand how 

they will limit taxpayer risk, impact mortgage affordability and accessibility for consumers in all communities and all markets, facilitate market liquidity and stability, including in times of economic 

stress, interact with the TBA market and scale over time. 
2 

We need to understand what different mechanisms would mean 

for different market participants and players in the mortgage market, like small financial institutions, for example, and how these 

mechanisms should be structured and what levers exist to ensure 

that private capital actually returns to the mortgage markets and 

that it does not leave taxpayers on the hook if it disappears in 

times of stress. 

The good news is the housing market is showing signs of 

strength, property values are rising, and the enterprises are turning a profit, which once seemed unimaginable. The announcements 

of Fannie and Freddie last week are good signs, but they cannot 

lull us into complacency with the status quo. And I do not believe 

they should be used as an excuse to leave the enterprises in perpetual conservatorship. 

Now is the time for us to be working toward solutions that will 

bring private capital back into our mortgage markets and create a 

vibrant and competitive mortgage market that is built to last and 

able to withstand the next crisis. A marketplace that uses instruments like the 30-year mortgage will keep the dream of home ownership within reach of hardworking middle-class Americans. 

From my conversations with Members of this Committee, I think 

the opportunities to build consensus are there and the time to get 

serious is right now. I look forward to working with my colleagues, 

who will roll up their sleeves and get to work. 

We have some great witnesses with us here today, and I am looking forward to hearing from all of them as we drill down on this 

important topic. 

And, with that, I will turn it over to the Ranking Member, Senator Mike Johanns. 

STATEMENT OF SENATOR MIKE JOHANNS 

Senator JOHANNS. Mr. Chairman, let me start out and just say 

thank you for holding today’s hearing on this very critical, timely 

and important topic. 

And I would like to thank our witnesses for their insights and 

their expertise. I am going to have a very brief opening statement 

because I am most interested in hearing from you. 

I would say at the outset of the hearing, though, that I believe 

there is a bipartisan consensus that is emerging around the idea 

that the status quo with Fannie Mae and Freddie Mac is not an 

acceptable approach. A nationalized housing market with an implicit Government guarantee, I would argue, is not good government. 

I am hopeful that risk-sharing provisions such as those discussed 

today will begin to form the basis for private capital to come back 

into the housing market. The level of risk-sharing, the amount of 

private capital, the percentage of the Government guarantee—well, 

those are complex details and details we need to come to grips with 

before we can go forward. 

Perhaps today’s hearing can start to shed some light on the appropriate path forward. So I look forward to hearing from the witnesses, forging ahead on the important work of reforming a broken 

housing finance system. 

Thank you, Mr. Chairman. 
3 

Senator TESTER. Thank you, Senator Johanns. 

Does any other Member have an opening statement? 

OK. I want to welcome our witnesses here today—four folks who 

have spent quite a bit of time working on housing issues—and I 

want to thank them for their willingness to take time out of their 

busy schedule to be here this afternoon. 

First, we have Dr. Mark Willis, who is a Resident Research Fellow at the Furman Center, and he teaches housing and community 

development policy jointly at New York University’s Law and Wagner Schools. Before joining the Furman Center, Mark was a visiting scholar at the Ford Foundation and has also worked in community development at JPMorgan Chase and for the city of New 

York. 

Welcome, Dr. Willis. 

Next, we have Mr. Andrew Davidson. He is the President of Andrew Davidson and Company, a New York firm which he founded 

in 1992. His firm specializes in the application of analytical tools 

for mortgage securities and other asset-backed securities. Prior to 

founding Andrew Davidson and Company, Mr. Davidson worked at 

Merrill Lynch where he was a managing director, producing research reports and analytical tools to evaluate mortgage-backed securities. 

Welcome to you, Mr. Davidson. 

Then we have Dr. Phil Swagel. Dr. Phil Swagel is a Professor at 

the University of Maryland School of Public Policy, where he teaches international economics, and is an academic fellow at the Center 

for Financial Policy at the university’s Robert H. Smith School of 

Business. Previously, Dr. Swagel served as an Assistant Secretary 

for economic policy at the Treasury Department, acting as a member of the TARP Investment Committee, advising Secretary 

Paulson on all aspects of economic policy. 

Welcome to you, Dr. Swagel. 

And last, but certainly not least, Dr. Robert Van Order is the 

Chair of the Department of Finance and a visiting professor of real 

estate and finance at George Washington School of Business. Prior 

to his teaching career, Dr. Van Order served as a chief economist 

at Freddie Mac from 1987 until 2003, pioneering the development 

of Freddie’s models of mortgage default, prepayment and pricing. 

Prior to joining Freddie Mac, Dr. Van Order served as a director 

of the Housing Finance Analysis Division, for HUD. 

Welcome to you, Dr. Van Order. 

Each of you will have 5 minutes for your oral statement. Your 

complete written testimony will be made part of the record. 

And I think we will start with you, Dr. Willis. 

STATEMENT OF MARK A. WILLIS, PH.D., RESIDENT RESEARCH 

FELLOW, FURMAN CENTER FOR REAL ESTATE AND URBAN 

POLICY, NEW YORK UNIVERSITY 

Mr. WILLIS. Thank you very much, Chairman Tester, Ranking 

Member Johanns and Members of the Committee. I thank you for 

the opportunity to testify today on the role for private capital in reforming mortgage markets. 

My name, as you now know, is Mark Willis, a resident research 

fellow at the Furman Center for Real Estate and Urban Policy at 
4 

NYU. I am on the Mortgage Finance Working Group convened by 

the Center for American Progress and have done research for the 

Bipartisan Policy Working Group. 

My comments today reflect my own views and should not be attributed to any of the organizations to which I am affiliated. 

I want to make two major points in my testimony. 

First, restoring private capital’s historic role in the financing of 

home mortgages—that is the financing of large jumbo mortgages— 

should be a straightforward matter once regulatory uncertainties 

are resolved. 

Second, requiring the use of private credit risk-taking capital in 

front of a Government guarantee is also possible, but imposing 

such requirements should only be implemented after we have tested their impact on access to, and affordability of, mortgages that 

serve the vast bulk of the home buyer market. 

By test-driving different approaches, we will be better able to 

weigh the costs and benefits of having private capital take more of 

the risk and avoid unnecessarily disrupting the availability and affordability of new mortgages. 

I assume we are here because of a desire to decrease the risk of 

loss to taxpayers by having private capital absorb some amount of 

that loss. 

Some argue that the private sector is better able than the public 

sector to absorb and price the risk. However, we should note that 

the Government had to bail out purely private credit risk-takers 

whose mispricing helped fuel the subprime boom and bust. 

While it is a challenge for Government, or anyone, to set exactly 

the right fee for providing a wrap, Government requires less of a 

return than private risk takers do to provide that guarantee. 

It is also argued that sharing risk with private investors could 

add an extra set of eyes to assess credit standards and underwriting criteria and monitor whether the loans are being properly 

underwritten and serviced. 

Additionally, it is hoped that the active involvement of private 

sector actors will discourage, if not prevent, attempts by Government officials to fiddle with underwriting and other standards for 

political gains. 

While private capital is now, and always has been, the source of 

all the funding of home mortgages, it consists mainly of what are 

called rate investors. Credit investors, on the other hand, have generally only funded so-called jumbo loans—loans traditionally above 

$417,000. 

FHA can take a number of steps to move us down the road of 

housing finance reform in a measured and informed way. 

Now that the housing market seems to have stabilized, it is time 

to let the jumbo market again stand on its own without a Government guarantee. It accounts, after all, for some quarter of the dollar volume of per year and over 8 percent of all mortgages by unit 

count. 

The best way to trim back is to raise the g-fee on all loans over $417,000 until the private sector is able to capture as much of the 

market as it is willing to finance. By not formally pulling out until 

the private sector has moved in, the Government can avoid inadvertently leaving big gaps in the marketplace. 
5 

Once the securitization market for jumbo mortgages is functioning at scale, it will be possible to see how willing a private 

mortgage market is to offer mortgages that are comparable to what 

is available in the conforming market, including, for example, longterm, fixed-rate mortgages which are well priced and available 

without regard to geography or other factors that would limit access to those that now have it. 

If the loans are comparable, then the limit could be reduced 

again in stages. At each stage, the same test for comparability 

should be applied. 

On a second path, FHFA should also continue its current quest 

to determine the costs and constraints of bringing in private credit 

risk-taking capital ahead of Fannie and Freddie. Shared risk does 

offer the potential to reduce the burden that could ultimately fall 

on taxpayers. 

However, using such private capital has drawbacks as well— 

higher cost to borrowers and potentially tighter underwriting 

standards. Moreover, requiring private capital to take first loss will 

limit the Government’s ability in times of economic stress to ensure 

the continued availability of mortgage financing unless a way is 

found to dial back that requirement when, as we saw not so long 

ago, private capital quickly abandoned the mortgage market. 

Of all the options discussed to share risk, only those involving insurance seem compatible with the continued availability of well 

priced, longer-term, fixed-rate mortgage products with rate locks 

from 30 to 90 days. The two main types that are often most mentioned are mono-line companies and credit-linked notes, and these 

have differences based on regulatory requirements plus the functioning of the capital market versus an insurance market. 

In addition to testing the cost and viability of different options 

for sharing risk, it is important to be able to assess the tradeoff between the cost to the borrower and the degree of risk-sharing. 

Another focus for reform is to ensure that the lower cost of funds 

made possible by the Government wrap pass through to borrowers. 

As for the transition, once a determination is made as to the degree of risk-sharing that is optimal, the provision of the Government wrap can be moved to another entity such as the Government 

National Mortgage Association known as Ginnie Mae. The remaining functions in Fannie and Freddie could then continue in a new 

legal entity. 

New entrants should also be allowed, if not encouraged, to compete with the successors to Fannie and Freddie in securitizing 

mortgages that are eligible for the Government wrap. 

Let me conclude by saying that by running tests that provide 

market-based information we will able to proceed in a measured 

and informed way and so make sure that we do not unnecessarily 

and unintentionally impair access to, and affordability of, housing 

finance to the vast bulk of the housing market. 

Thank you. 

Senator TESTER. Thank you, Dr. Willis. We appreciate your testimony. 

Mr. Davidson, proceed. 
6 

STATEMENT OF ANDREW DAVIDSON, PRESIDENT, ANDREW 

DAVIDSON & CO., INC. 

Mr. DAVIDSON. Chairman Tester, Ranking Member Johanns and 

the Members of the Subcommittee, today we are discussing the financial structure of the mortgage market. In my written statement, I discuss rates investors and credit investors and how to 

bring them back into this market. However, it is important to keep 

in mind that mortgages are more than just a bundle of financial 

risks. 

Mortgages are a set of legal documents that create obligations for 

borrowers and lenders. 

Mortgages are a complex payment system that transfers capital 

from investors to borrowers and mortgage payments back from borrowers to investors. 

Mortgages are an instrument of Government economic and social 

policy as well as monetary policy. 

And mortgages are the hopes and dreams of millions of Americans seeking a better life. 

Because of the multiple dimensions of mortgages, housing finance reform is both difficult and essential. 

Today, there are trillions of dollars invested in GSE-guaranteed 

MBS. This investment largely flows through the TBA market, 

which is an essential component of our housing finance system. 

Unfortunately, that market now relies almost completely on the 

U.S. Government and taxpayers to bear the credit risk. 

There is a substantial amount of private capital currently bearing credit risk, just not in the GSE market. Due to the poor performance of the underlying loans in the private-label market, many 

securities that were purchased with the idea that they were lowrisk investments are now subject to credit risk. There is about $600 billion of investment in credit-sensitive 

bonds, much of it by firms that bought the bonds from the original 

investors. The existence of this large market has created tremendous analytical and investing expertise in mortgage credit risk. 

Thus, the issue is not so much how do we return capital to the 

mortgage market but how to structure the market so this capital 

and expertise is deployed for new GSE-guaranteed mortgages and 

not just for legacy private-label mortgages. 

Capital markets mechanisms, such as senior/subordinated bonds 

and credit-linked notes, can serve this purpose. If properly structured, these approaches will not impose an undue burden on borrowers. 

My firm analyzed the cost of private-market credit enhancement 

for the Bipartisan Policy Center’s Housing Commission. While we 

found a wide range of costs, depending on the risk characteristics 

of the loans, we also found that credit costs using private markets 

would be about the same as the current guarantee fees charged by 

Fannie Mae and Freddie Mac for similar quality loans as they are 

originating now. 

The choice between senior/subordinated bonds and credit-linked 

notes, as well as other approaches, are primarily regulatory as opposed to economic. All securitizations are a particular pathway 

through a thicket of regulations that affect disclosure, tax treatment, regulatory capital and other operational requirements. Find-
7 

ing the right path has slowed the process of Fannie Mae and 

Freddie Mac utilizing these structures. 

Capital markets solutions will generally be most effective if they 

allow the broadest range of investors for both the guaranteed securities and the credit-sensitive securities. Protection from double 

taxation, exemption from securities registration, allowing reinvestment from both an SEC and tax perspectives, and simplifying risk 

retention rules are all necessary. CFTC oversight and CFPB QM 

requirements also need to be addressed. Clear and consistent rules 

would increase liquidity and lower the cost to borrowers. 

While the use of these instruments will lower the risk to taxpayers from Government guarantees of MBS, the stability of the 

mortgage finance system, and many other goals associated with 

Government involvement in the mortgage market depend more on 

the industrial organization of the mortgage market than the form 

of credit enhancement. Thus, the success of any system of housing 

finance will also depend critically on the path to get from the current structure of the housing finance system to the desired outcome. 

While there is much to commend the idea of shutting Fannie and 

Freddie down and starting again, I believe the best path forward 

will be to transform the GSEs from what they are to what we 

would like them to be. In this way, there are three possible paths: 

One, we capitalize the GSEs to shareholder-owned companies. 

We tried this, and it did not work. 

Two, nationalizing the companies and have them operate as Government-owned corporations—I do not think this will work either. 

Or, three, transform Fannie Mae and Freddie Mac into issuerowned cooperatives. Freddie was originally owned by mortgage 

lenders, and I believe we should return to that type of structure. 

Cooperatives offer several advantages. They can establish standards and provide access to all originators. They can be effective at 

monitoring loan quality. They can provide a mechanism for risk retention and true sale treatment. Cooperatives, using capital markets credit instruments, can provide a stable source of financing 

through periods of stress. And, most importantly, the TBA market 

can be maintained throughout the transition from conservatorship 

to cooperative ownership so that mortgages can continue to fulfill 

their many roles. 

Thank you for your interest in my comments. I look forward to 

your questions. 

Senator TESTER. Well, thank you, Mr. Davidson. We appreciate 

your comments. 

Dr. Swagel. 

STATEMENT OF PHILLIP L. SWAGEL, PH.D., PROFESSOR IN 

INTERNATIONAL ECONOMIC POLICY, MARYLAND SCHOOL 

OF PUBLIC POLICY, UNIVERSITY OF MARYLAND 

Mr. SWAGEL. Thank you. Thank you, Chairman Tester, Ranking 

Member Johanns and Members of the Committee. Thank you for 

the opportunity to testify on the vital topic of returning private 

capital to mortgage markets. 

The Government now stands behind more than 90 percent of new 

mortgages, distorting the economy and putting taxpayers at risk. 
8 

Bringing in private capital is the essential first step in housing finance reform. 

This can take several forms. One would be the capital of new 

firms that compete in conforming securitization. A second form 

would be private-label securitization and balance sheet lending; 

that is, mortgage origination with no Government guarantee. And 

the third would be risk-sharing under which firms would sell nonguaranteed tranches of guaranteed MBS or use other forms of risksharing. 

This can proceed without legislative action, and indeed, under 

the FHFA strategic plan it is moving forward. Ultimately, however, 

investors will require legislative action for this to take off in scale. 

After all, private-market participants will naturally hesitate to invest in 30-year mortgages unless they understand the rules in the 

future. 

The policy levers to bring in private capital include four possible 

levers. One is raising the price of the Government guarantee. Two 

is reducing the quantity of insurance offered by the Government or 

otherwise narrowing the scope of the mortgages eligible for the 

Government guarantee. Number three would be opening the housing finance system to new competition that, in turn, brings in private capital. And four would be requiring the firms that securitize 

Government-insured MBS to arrange for the first loss private capital to take losses before the Government guarantee. My written 

testimony provides details on several forms of this first loss capital. 

Reducing or eliminating the Government role in housing finance 

involves moving forward with all four policy levers. 

As reform moves forward, at first, all conforming mortgages will 

still be guaranteed by the Government but behind first loss private 

capital at the MBS level. 

As the price for the Government insurance increases and as more 

private capital is required in front of mortgages to receive a Government guarantee, eventually, not all conforming mortgages will 

receive the Government guarantee. Some conforming mortgages 

will choose to be originated without a guarantee, and the share of 

the Government in housing finance will go below 100 percent, or 

the nearly 100 percent it is today. 

Eventually, as the pricing of the guarantee fee becomes high 

enough and as so much private capital is required, eventually, no 

MBS securitizers will purchase the Government guarantee. Eventually, that would be a fully private market. 

So, in other words, to reach an outcome of a fully private market, 

at first the housing financing system must transition through the 

intermediate steps in which the Government guarantee recedes. 

There is a sense in which it is useful to formalize the Government 

guarantee so that it can recede. 

Interest rates for mortgages will rise as reform proceeds, reflecting the compensation demanded by private investors for taking on 

housing credit risk. In a sense, this reflects the fact that the previous system was undercapitalized. Whether it is possible for reform to arrive a fully private system depends on the social and political reaction to these higher mortgage interest rates. 

I worry that a housing finance system that is notionally private 

will inadvertently recreate the implicit guarantee in the previous 
9 

system. In my view, it would be better for the inevitable Government involvement in housing finance to be made explicit. 

Taxpayers should be compensated for taking on housing risk. 

Rather than leaving it implicit, they should be paid for providing 

a guarantee, and there should be considerable private capital 

ahead of the secondary Government guarantee. 

Housing finance reform that brings back private capital should 

proceed immediately even without resolving the question over the 

eventual role of the Government. 

The policy levers required to move forward with reform are the 

same for all of the options under consideration, including a system 

that is fully private, or at least notionally fully private. 

Bringing in private capital is the essential first step in reform. 

Thank you very much. 

Senator TESTER. Thank you, Dr. Swagel. 

Dr. Van Order. 

STATEMENT OF ROBERT VAN ORDER, PH.D., CHAIR, DEPARTMENT OF FINANCE AND PROFESSOR OF FINANCE AND ECONOMICS, GEORGE WASHINGTON UNIVERSITY 

Mr. VAN ORDER. Thank you, Senator Tester and Committee 

Members. I am very pleased to be here. 

This, obviously, is an important topic. I would like to start out 

also by saying it is actually a very difficult topic, intellectually as 

well as policy-wise. There are lots of different structures that have 

been tried in the United States for mortgages, and around the 

world. In some ways they are very similar, and in some ways they 

are very different, and they all have flaws. 

The topic, it seems to me, at hand is particularly about long-term 

fixed-rate mortgages. Adjustable-rate mortgages can, and have 

been, done around the world very easily by banks and funded with 

deposits. 

The question mostly for us, I think, is funding them through capital markets and how you do it. 

There seems to be a consensus emerging of the Government as 

a kind of backup, as putting it as the last guarantor and trying to 

get as much capital in front as you can. And I think that is right 

and appropriate. 

It is very much analogous to the role of deposit insurance and 

the way they have historically funded things like adjustable-rate 

mortgages and other things, where the Government backs up a 

Government insurance company in a bank that has capital in front 

of it. These are very common structures. 

One of the things I want to do—I have three points. 

The first one I want to talk about is what actually private capital 

is because it is actually quite ambiguous. Right now, something 

like 90 percent of the mortgages in the country are done through 

companies that are more or less owned by the Government. But, 

if you went back a few years, Fannie and Freddie actually, you 

could argue, had private capital; that is, they had private shareholders. 

If you went back a longer time ago, you saw the savings and 

loans that actually clearly had private capital. They all got into 

trouble. 
10 

And it seems to me while private capital is an important way of 

thinking of it, what is really important is where the risk is and 

how the risk gets controlled. Both of those are important. 

And I think this structure of having the Government at the end 

is an interesting one. It is also not a very new one, and I think that 

is one of the things I first want to remind you of. 

When I first got to Freddie Mac, I was curious about guarantees 

and things because, you know, it was what my employer had. And 

we took a look historically and asked the question, what fraction 

of mortgages have benefited from guarantees from the Government, either directly from FHA, from deposit insurance or from 

GSEs? 

The answer was it had always been about 90 percent. The only 

difference had been the structure of it. And that is about what it 

is now. 

The only time it was actually less than that was from about 2003 

until 2006, with the private-label market. 

This is not an unusual state of affairs. It is a common one. And 

the question is, what is the structure to manage it? 

Second, I have included in my testimony an appendix which is 

a little bit of data on credit risk and what actually has happened 

over the last few years. And I think it is important to understand, 

when we get into regulating things and talking about changes, 

what was and was not the problem. 

What was not the problem, particularly, was low downpayment 

loans or low-income loans. They do have high default rates. They 

are sometimes a problem. But, in terms of the lift, what was it that 

really went south? 

It was not particularly those. They did do badly, but the increase 

in their costs and decline in the credit quality was roughly the 

same as for lots of other products. 

In a period like we had a few years ago, when property values 

fall by anywhere from 25 to 50 percent, even loans with big 

downpayments suddenly have negative equity, and even borrowers 

that have good credit history and have high incomes default more. 

What did seem to matter was two things: 

One was the year in which the loan was originated. That is an 

easy one. If the loan was originated in 2003, that was golden, not 

because the world was necessarily better—it was a little bit—but 

because property values went up like crazy for the next few years, 

and that covers a lot of mistakes. Loans originated in 2006, with 

the same observable characteristics, were way worse. 

The second thing that mattered was the channel. There are some 

data—neat data—that I, as an academic, can get and lots of data 

now are proprietary, but some free data from FHFA on defaults by 

GSE loans and by private-label loans. The private-label channel 

was worse. Not only was it worse in the sense that on average it 

had higher defaults, but the lift, the increase in defaults, from 2003 

to 2006 was worse. 

The point here partly is in looking at this a lot of what happened 

is stuff that is difficult to observe from the outside. There were 

some changes in the downpayment structure, some changes in the 

credit score of borrowers, but those were not nearly enough to explain what happened to defaults. It was a bunch of different things. 
11 

And what I want to do finally is to talk about setting up incentive structures and push for contingent capital, particularly from 

the standpoint of management having a stake in the downside. So 

one of the things I want to leave you with is a proposal for various 

types of management incentive programs which look like holding 

bonds in a company, so that while they get the upside if they hold 

shares in the company, they also are forced to participate in the 

downside because their bonds will be converted into capital. 

Thank you. 

Senator TESTER. Thank you, Dr. Van Order. We appreciate it 

very much. 

Thank you all for your testimony. 

I think we will do 5-minute rounds and 5-minute questions, and 

we will do as many rounds as you want. 

I am going to start, and I will not direct it to anybody. I assume 

you all want to put your two bits in. 

I want to start by drilling down a little bit to better understand 

how credit risk-sharing mechanisms might impact mortgage affordability—something that you have all addressed. The very basic 

question, which is, how exactly would these mechanisms be priced 

in the cost of a mortgage or mortgage rate? 

You can start, Dr. Willis. 

Mr. WILLIS. So the cost to the borrower includes—let’s say there 

is a Government wrap and there is private capital ahead of it. So 

it would include the sum of the cost of the Government wrap. 

Let us look at the example of Ginnie Mae, which charges a fee 

for its wrap. And I think in the proposed idea here of a Government wrap for a conforming market on MBS going forward, there 

should be a charge based on that risk, and then the private sector 

requires a return on their taking the risk. 

There is a huge difference between what Government needs to 

charge and what the private sector needs to charge. The private 

sector requires a large reward for taking risk. 

The Government, on the other hand, in economics jargon, is not 

risk-adverse. It can and, under the Federal Credit Reform Act, does 

charge for its risk at a much lower price. It looks to get the full 

money back. It looks to get its return on an expected basis based 

on the Government borrowing rate, but that yields a much lower 

cost here. 

And there is a debate about whether the Government should be 

charging the same as the private sector, but as long as it does not 

and is being properly compensated under the Federal Credit Reform Act, any change in the mix between what is the risk the Government wrap is taking versus the risk to the private sector affects 

the cost. The more you increase the share that is private sector, the 

more you are increasing the cost, the more expensive the cost of insurance. 

Senator TESTER. Mr. Davidson. 

Mr. DAVIDSON. Yes, there are two different components we need 

to think about the cost. 

One is the cost of credit enhancements; let’s say there is a 3 percent capitalization requirement. Or, let’s say a 4 percent subordination that is going to be from the credit buyers. The other 96 percent 

is basically being covered by the rates investors. And so the most 
12 

important thing is protecting that 96 percent, in terms of the cost 

to the borrowers, and that is really why this Government guarantee becomes important. 

And not in good times, but in bad times, the spread between, 

let’s say, treasuries and mortgage rates can go up a lot if there is 

no confidence in investing in those loans. 

On the other hand, if we just look at the cost of the credit side— 

you know, let’s say in good times—and, let’s say, 3 to 4 percent is 

what needs to go into this credit enhancement piece. And then the 

borrower—the investors require, let’s say, 10 percent to 15 percent 

excess returns. That just translates into a 30 basis points to 60 

basis points cost of credit. 

The GSEs are currently charging about 50 basis points. 

So to that 30 basis points at the low end you have to add operational costs and the costs for a wrap. That is at the 50 basis 

points. 

And so it might raise guarantee fees 30 basis points more. Or, 

if we want to broaden from where we are now, it might be a little 

bit more. 

But we are not talking about changing mortgage rates by 50 or 

100 basis points. We are talking within the range of where we are 

now. 

Senator TESTER. Good. 

Dr. Swagel. 

Mr. SWAGEL. Chair, I will just add two things. 

I agree on the range of pricing. I mean, the Fed is going to be 

raising interest rates by a lot more, and that is going to be a lot 

more noticeable. 

Senator TESTER. That is true. 

Mr. SWAGEL. And it is important to have this layering of risk— 

the loan level capital, the real downpayments, private mortgage insurance with real capital and then the MBS level capital. 

So, two small notes in addition. The guarantee fee pricing could 

actually go down in the future? I think it is going to go up. It 

should go up now. The Government is not being compensated. But 

when there is enough private capital, a good deal of private capital, 

then the insurance the Government is providing is less costly; it is 

less risky. 

So this can go in both directions. 

You know, on the other hand, I do not think the Government is 

all that great an investor, and I think it is important to make sure 

that Government is properly compensated for taking on this risk. 

And one benefit of the way that the risk is calculated now is the 

Congressional Budget Office, I think, does us all a favor by calculating the risk on the same basis as the private sector and really 

protects the taxpayers from selling the insurance or counting a 

profit for selling underpriced insurance. 

Senator TESTER. Dr. Van Order. 

Mr. VAN ORDER. Yes, I agree on the accounting dimension. 

It seems to me that there is a lesson to be learned from the private-label market in terms of structuring. The risk-sharing in the 

private-label market and the risk-sharing in corporate structures in 

general is not so much sharing as prioritizing. 
13 

And I think the idea is to set up structures that look like that, 

where you know exactly who takes the first loss, exactly who takes 

the second loss, the third, the fourth, and you put the Government 

at the end, saying, yes, there really is a guarantee. This makes it 

much easier to do things like a TBA market, but to share the risk 

by slicing it in different directions and really understanding the 

priorities. 

One of the things with the structuring was there really were different clienteles that took the different pieces of the deals. It blew 

up. There were some problems with it. But the underlying idea 

that there were different clienteles who would take different strips 

of the risk and having the Government at the back is what we have 

been doing for the last 50 years in one way or the other. 

Senator TESTER. OK, Senator Johanns. 

Senator JOHANNS. Thank you, Mr. Chairman. 

Let me focus on some specific items that are of interest to me. 

I want to start out with the GSEs. 

You know, we turn the clock back a few years, and that was a 

mess, to say the least. Do you have a sense or, maybe beyond a 

sense, do you have proof that you could offer to me that the GSEs 

are slowly working their way out of the mess, becoming profitable; 

there is a light at the end of the tunnel? 

Anyone one of you. 

Mr. WILLIS. The piece that I would suggest to think about here 

is the g-fee, which is now more than twice of what it was historically. The main losses in Fannie and Freddie were in the Alt-A 

piece. They are not making Alt-A loans now. 

Senator JOHANNS. Right. 

Mr. WILLIS. So it appears that they have more—the fee that they 

are charging relative to the risk they are taking seems to be very 

favorable. 

So, if you look at those ratios I talk about, it seems pretty clear 

why they are making money on the additions to the portfolio—the 

mortgages they are adding today. 

Mr. DAVIDSON. I do not think we can really talk about the profitability of the GSEs without having a capital model in place and 

some measure of what risks they are taking on and whether or not 

they are properly insuring through enough capital for those risks 

in a bad environment. 

But even beyond that, my sense is at least the new book of business is well capitalized, or is earning enough return that would 

cover a reasonable amount of capital for a downside risk. But it is 

hard to go beyond that. 

Senator JOHANNS. It is hard to go beyond that. 

Mr. SWAGEL. Yes. 

Senator JOHANNS. And it is hard to have a crystal ball and say, 

well, the real estate market is going to continue to improve, and 

I mean if, if, if. 

But what I am getting to here is it seems to me that there is 

healing going on. There is healing in the market. There is healing 

in the book of business they are doing. They have changed the way 

they have done business. 

So this kind of leads to my next question. If, in fact, that is the 

case, is there a point then where we can say to the GSEs, if you 
14 

want to go out there and do business in the new world, fine, but 

pull back on the Government guarantee? Is that a doable model? 

All of you have talked about Government guarantee and this and 

that, but I am really getting down to brass tacks here. Is it a doable model to move them off the Government guarantee program— 

because I think that gets you in trouble—and have a system that 

is capitalized through the private sector? 

Mr. VAN ORDER. Yes, I would say I think it is doable, but there 

is always the question. 

Fannie and Freddie never had an explicit guarantee. They always wrote on their paper that this not guaranteed by the Government, which almost certainly meant that it was because no one else 

had to put that on their securities. 

Senator JOHANNS. And 100 and some failed—— 

Mr. VAN ORDER. So how do you do this; you see, I am going to 

get you off the guarantee, but this time we mean it? 

It seems to me the way to do it is in the context of this structure 

of having the Government at the end of the queue, explicitly there, 

and then having capital rules in terms of minimum capital requirements. 

But I also like stress tests. And I am going to come back to my 

retention capital. I like the idea of having a part of their capital, 

a part of their debt, be something that when times get tough can 

be automatically converted into equity, to give incentives to management and to have angry bond holders who have seen suddenly 

seen their bonds converted into worthless—not worthless, but 

shares. 

So I think you can do it. I think you do not want to pretend to 

not have the guarantee. I think you want to have it there, keep it 

at the end and as small as you can, and work your way back. 

Mr. SWAGEL. Yes. 

Senator JOHANNS. Go ahead. 

Mr. SWAGEL. I was going to say very quickly I think it can recede, that exactly what you said can happen. It is just going to take 

place slowly. 

The market is dominated by the Government. We are not going 

to get to zero, or something close to zero, quickly. But bringing in 

private capital is the first step. 

And I think eventually then the guarantee needs to be formalized. Rather than guaranteeing Fannie or Freddie as firms, transfer the guarantee to the MBS themselves and then let that guarantee shrink. 

Senator JOHANNS. You know, I am running out of time here, but 

here is the thought that goes through my mind. It seems to me 

that the GSEs are out there. You are right; there is not really an 

explicit guarantee. But guess what? Taxpayers stepped in and 

bailed out the system. Without that, we do not know where we 

were at. 

The challenge I think we face in going forward is politicians, of 

course, have a tendency to want to improve upon every system, and 

so they come in and say let’s do some more of this or more of that. 

And all of a sudden there are some quirky things going on, and all 

of a sudden there are some mortgages that probably are not very 

good. Then we get down to a point where we were a few years ago. 
15 

My philosophy is if we as politicians want to boost home ownership, do a program to boost home ownership. Put money into. Appropriate money for it. Buy down the interest rate. Do whatever to 

try to boost home ownership. 

And let’s just be honest. That is what we are doing. 

I think what we ended up with, to me, seemed like kind of a hybrid thing. Well, we did not really guarantee. But guess what? We 

did guarantee because we had to step in. 

So that is what is going through my mind, and maybe there will 

be some follow-up questions to try to see if that makes any sense 

or not. 

Thank you, Mr. Chairman. 

Senator TESTER. You bet. 

Senator Reed. 

Senator REED. Thank you, Mr. Chairman. 

And, gentlemen, thank you for your testimony. 

Dr. Swagel, I thought in reading your testimony you make the 

point that even for those who want a privatized system a first step 

is some type of Government guarantee to begin the process. 

In fact, I think you made an excellent point that the option the 

Treasury laid out can be viewed not just as options but as actually 

three necessary steps to get to a final end point, which is a 

privatized system with a standby residual Government role. 

Could you elaborate on that? Is that the concept you have? 

Mr. SWAGEL. Absolutely. It feels like a long time ago—February 

of 2011—when the Treasury put forth their paper, and they put 

forth the three options with the receding Government guarantee. 

And what was striking to me was that they were presented as 

three separate options, but to get to the first one you have to go 

through the third and second. It really is as the guarantee recedes, 

and that can recede by having the Government guarantee fewer 

mortgages or by, as we have all said, having the amount of capital 

in front of the guarantee go up. 

But they are all in the same line of the guarantee receding. You 

have to go through those stages. 

Senator REED. Right. Now one of the things I think you all generally pointed out is that if you have MBS, for example, you want 

the first loss to be borne by a private insurer and that insurer has 

to be well capitalized. 

So it raises several issues. One is, what do you mean by well capitalized, and two, who is going to make sure they are well capitalized? 

So do you have any—— 

Mr. SWAGEL. Yes. I mean, I was at the Treasury during the crisis, and obviously, AIG used to be AAA. 

So, the private capital—there are lots of different ways of doing 

it. We want to make sure it is real capital. We want to know who 

exactly takes the losses—— 

Senator REED. Right. 

Mr. SWAGEL.——and to make sure the loss-bearing capacity is 

there. 

So, in a sense, I think that is a nice part about the kind of socalled A–B structure, that the people who own the B pieces—they 

are taking the losses and everyone understands that. 
16 

Senator REED. A final point too is that in your testimony you 

point out that—in fact, I think—am I over time? 

Senator TESTER. You are fine. 

Senator REED. Well, fine. Excuse me. 

You point out that waiting to do this and not moving forward on 

GSE reform is a choice in and of itself. And I presume that you 

think that is the wrong choice. Or, can you comment upon that? 

Mr. SWAGEL. I do. So I worry that, in some sense, waiting until 

there is the perfect solution means that we do not do anything, and 

doing nothing means the GSEs stay in Government hands. You 

know, the Government share is 90 percent. 

And while there are many excellent people at the two firms, inevitably, they are going to leave as the status of the firms is uncertain. 

So I do worry about making that choice. 

Senator REED. Gentlemen, can I open it up—because I have 

raised these questions. I wonder if Dr. Willis or Mr. Davidson—— 

Mr. WILLIS. What I would like to add to these three options, in 

that it provides a path, is that—what I would add to that is that 

at each stage you ought to test and see whether the change in additional costs or changes in affordability and access are something 

that is a concern here. 

So you go bring private capital back into the jumbo market. Then 

you can see whether you want to lower that limit any further because, as we know right now, credit is very tight, so a little unfair. 

The jumbo market likes 60 percent loan-to-value. Banks prefer adjustable mortgages to put in their portfolios. 

So, yes, that is the sequence, but I do not think it is inevitable 

you want to march all the way down that path. 

Senator REED. Right. 

Mr. WILLIS. And, when we get to the end, we do know that banks 

cannot hold of these mortgages. So we are going to have to watch 

as we go down here, what the impact is—extending further down 

the road to reply purely on the private sector. 

And then the question is, where we have a conforming market, 

how and to what degree do we want to have private capital ahead? 

Senator REED. I think there is another aspect too here—that the 

markets go up and down. And there are times when the private 

market, just because of the returns and the economic climate, will 

cover all the needs. But there are those times where we deliberately want to support the market, and we have to have that option. 

So a complete system where there is no way for the Government 

to come back in—and one of the things Senator Johanns suggested 

is that maybe it is through a different mechanism—a housing trust 

fund or—but I think even in terms of this guarantee and this privatization there has to be at least a way to come back and move 

the market. 

Mr. WILLIS. Well, to have a mortgage market if you are relying 

on private capital to take first loss and it abandons the market as 

it did—— 

Senator REED. Right. 

Mr. WILLIS.——you will not have any, no matter what subsidy 

you provide. 
17 

So you do need to at least have FHA available and be ready to 

scale up. And some people may think you need more than FHA to 

be there, like we had the conforming market this last time around. 

Senator REED. One of the ironies is that as the private capital 

fled in 2008 and 2009, the only game in town was Fannie and 

Freddie, but at least we were able to keep a housing market until 

we started seeing other factors contribute to the re-emergence. 

Mr. WILLIS. I would just add even in the case in Fannie and 

Freddie—they could not do over 80 percent loan-to-value because 

the private money in the mortgage insurance industry also basically left the market. 

Senator REED. Thank you very much, Mr. Chairman. 

Senator TESTER. Thank you, Senator Reed. 

Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman. You are doing a 

great job. 

I enjoy your hearings. Thank you. Thanks for having this one. 

And I appreciate all the witnesses being here. 

To the last point—I was going to go in a different order, but Dr. 

Willis, you made one of my points, and that is when we had the 

crisis, because the mono-lines are all sort of part of the system, 

when the crisis—when you have a systemic crisis like that, basically they are gone. Is that correct? 

Mr. WILLIS. They do not appear to have had enough capital. That 

is correct. 

Senator CORKER. So, if you were going to have a system where 

you had private sector risk in front, you could do it numbers of 

ways. One would be a credit-linked note; I think you all referred 

to that. You could have A piece or B piece. But, if you really relied 

on the system to have private capital up front solely through insurance—I think there should be insurance on loans above 80 percent. 

I agree with that. 

But if you look at that, that is really not capital when you need 

the capital. Would that be correct? 

In other words, if you have private sector—let’s say you had a 

90–10 ratio and 10 percent was private sector, if you are relying 

on insurance, the insurance would not be there at the very time 

you were hoping for it to be there. Is that not generally a true 

statement? 

Mr. WILLIS. Again, that was the case—the idea, not to disagree, 

but the idea was you pick up a lot of the capital. That is right. 

Senator CORKER. History will show that I do not think private 

mortgage insurance will be a very good first-loss position because 

it would not be there when you need it. 

Let me ask you a question, all of you. Is there any reason we 

would not go ahead and be dropping loan limits? 

I mean, you could be sort of getting to where Johanns was heading a minute ago by taking us from where we are today at 725 

down to where we were pre-crisis. I mean, the average home in 

America today is much less than, or less than, where it was back 

when this began. So is there any reason we would not begin doing 

that today? 

Mr. WILLIS. There are two ways to do it. 
18 

Absolutely, from my point of view, I agree we should go down at 

least to $417,000 and then maybe test whether to go lower. 

Many proposals are to lower the loan limits in stages. And my 

fear is that you are not opening the whole market at once. So private investors may not feel justified to—— 

Senator CORKER. So, adjust that down over a period of time. 

Mr. WILLIS. My preferred way would be to increase the g-fee 

above $417,000 until the private sector comes in so that you always 

have the existing system that can provide mortgages to the point 

where the private sector comes in. If you just withdraw down, you 

might leave gaps in the market that you do not need to. 

So it is an issue of how you do it, not whether you should. 

Senator CORKER. Does anybody disagree with we ought to figure 

out some way of lowering the limits? If you do, say yes. 

Mr. SWAGEL. No, absolutely, I agree. We give a tax break to $1.1 

million in mortgages. So you can imagine scaling down, or refocusing, those benefits on people who really need them to buy a 

house. 

Senator CORKER. I assume everybody else generally agrees. 

Mr. VAN ORDER. Yes, the $417,000, which is sort of the underlying limit right now, is based on when property values were at 

their peak. 

The way it is done now, you cannot lower it without legislation. 

You have to wait until property values come up. But it is certainly 

the case that even at $417,000, in most parts of the country, that 

is a pretty big house. 

Senator CORKER. Right. Let me keep on moving through and 

thank you for being the way you are. 

The GSE’s balance sheets today are pretty large, and I know 

they have had to buy back some loans that have had some difficulties. Do you know of any reason we would not be moving quickly 

in this market, with rates where they are, to unload that portfolio 

or at least take advantage of market conditions? 

Mr. DAVIDSON. My view, generally, is that we should not be mixing securitization and portfolios. So anything we can do to separate 

those activities—if you could just get Treasury and the Fed to do 

their purchases from the GSEs—— 

Senator CORKER. Fannie and Freddie, yes. 

Mr. DAVIDSON.——that would be great. It would definitely be 

much better for those organizations. 

Senator CORKER. So does anybody disagree that we ought to be 

taking advantage of market conditions and taking this balance 

sheet down in a methodical thoughtful way? 

Mr. VAN ORDER. Well, yes, with an emphasis on methodical and 

thoughtful. 

The portfolio was not the problem for Fannie and Freddie. It was 

credit losses on the regular business. 

You can let it fade away. Whether you hold it or sell it into the 

market, at this point, it does not affect anything real. 

Senator CORKER. Well, it helps you, though, move to a system 

more quickly, I think, where you have an explicit Government 

guarantee, if that is where we are going to end up, and it causes 

that process to move along in a much better way. 
19 

Mr. VAN ORDER. The loans that they have in their portfolio are 

basically two sorts. 

Most of the time, until recently, they bought back their own 

mortgage-backed securities. So you are not really changing the 

credit guarantee by whether you hold them or whether you sell 

them. 

The other were the private-label securities, which are amiss, and 

they are winding down. They turned out not to be as bad as people 

thought. 

So the private label—you could sell them, but they are a big 

messy. The other stuff are already guaranteed anyhow. 

Senator CORKER. Go ahead, Phillip. 

Mr. SWAGEL. I just wanted to add that I strongly agree with 

what Andrew said about not mixing them, and in some sense the 

portfolios were not the problem for Fannie and Freddie; they were 

the problem for everyone else. 

Senator CORKER. Right. 

Mr. SWAGEL. I mean, the systemic risk in the system came from 

the funding required to fund the portfolios. 

So I agree with what Andrew said. 

Senator CORKER. Very good. Is there a way—if we were to set up 

an A and B piece, some ratio like I laid out earlier, certainly not 

at 4 and 96 but at some number, would that provide—is there 

mechanism that would provide the B-piece’s owners, the sub-piece, 

a way of actually doing underwriting in a way that is better than 

just taking all comers? 

Mr. DAVIDSON. One of the issues is that the GSE portfolios are 

gigantic, and so the traditional way you would underwrite a subpiece would be to go through the loans and do loan-level analysis. 

I think if the GSEs are going to start selling off their credit risk, 

people are going to have to take that risk a little bit more on a generic basis and not on a loan-by-loan basis and focus more on the 

processes that the GSEs have rather than the loan-level data. 

I mean, we love to look at loan-level data at our firm. We have 

millions and millions of loans. But, when you have a structure that 

has 100,000 or 200,000 or 300,000 loans in it, that really makes it 

a lot more difficult to do loan-level due diligence. 

Senator CORKER. If you were scaling up, though, a new entity— 

let’s say you had designed a way to basically move away from 

Fannie and Freddie in a methodical way and you created an entity 

that had an explicit guarantee and you were building up the process there, where you had the A and B pieces or a credit-linked 

note, either one that worked best, or maybe some other mechanism. 

Would there be a way, if you were building up and not looking 

at the portfolio that is in place, but building up to actually look at 

the B-piece’s owners or the credit-linked note pieces, to be able to 

look at the actual loans that were being put forth and give greater 

underwriting ability to those people who are actually buying the B 

piece? Is there a way to do that? 

You still think it is too much scale? 

Mr. DAVIDSON. I do not think you will really have an efficient 

system that is built on that, but there is no reason why you should 

not have access to loans if you need it. 
20 

I think it would just be very difficult to say we have a system 

with 25 million loans or 50 million loans and that the investors are 

going to be focusing on 5 or 10 million of those loans in that level 

of detail. 

Senator CORKER. Sorry, Mr. Chairman, for being over. You are 

doing a great job leading. I am not doing a good job following. 

[Laughter.] 

Senator TESTER. Thank you, Senator Corker. Your apology goes 

to Senator Warner. 

Senator WARNER. Yes, that is right. I am expecting to get my 

extra 3 minutes added on as well, but to then say I am going to 

build off my friend, Senator Corker’s, comments. 

Let’s, again, keep looking at this A piece/B piece structure with 

the assumption being that we are putting them—you know, the 

current model, kind of out of its misery. 

Wouldn’t that B piece—I think you may have mentioned, Mr. Davidson, if it had been at 4 percent—let’s assume for hypothetical’s 

sake that we are at double that. Should we have any concern that 

some have expressed, that if you double that, you have got banks 

over here with a 4 percent tier-1 capital requirement, that you may 

be—basically, too many of these banks will simply hold these loans 

on their books since the price of that private capital up-front will 

mean it is more economical to keep these within the banking industry itself. 

Mr. DAVIDSON. The senior/sub A–B structures have an advantage 

versus insurance in that if you require too much capital—so let’s 

say that I am right and we need 4 percent, but to be careful we 

make it 8 percent, which might not be the worst idea. We now have 

an extra 4 percent of capital, or 4 percent of credit enhancement, 

that is not going to take very much risk. 

If you can convince investors that it is not a very risky instrument, they will price that not too much differently than a senior 

bond. So the cost of having extra credit enhancement is much less 

than having too much equity. 

So, for example, if we told one bank, you have to have 4 percent 

equity, and another bank, you have to have 8 percent equity, the 

8 percent equity—— 

Senator WARNER. Obviously—— 

Mr. DAVIDSON. Right, they would be out of business. 

But in the capital markets, too much credit enhancement costs 

less. It is still costly but not—— 

Senator WARNER. Would the panel concur with Mr. Davidson’s 

comments or disagree? 

Mr. SWAGEL. Absolutely, and I would go even further—that if it 

does encourage more balance sheet lending, as long as banks have 

lots of capital and good regulation, well, that would be fine. 

Senator WARNER. Any others want to weigh in on that? 

[Pause.] 

Senator WARNER. I guess the other question too is that with 

what we are hoping coming out of FHFA in terms of a greater 

standardization of the securitization portal, with the repurchasing 

agreements, with servicing agreement standardization, should 

there be a particular—as we try to get the FHA to kind of get the 

utility functions better done, should there be any priority in any of 
21 

those items that you feel if you were in charge of FHFA right now, 

with getting one of these right, right away? 

Mr. WILLIS. I think they have already shown some priority in 

terms of reps and warranties and with regard to servicing guidelines here. And I think those are really important as well as pooling and servicing agreements. You remember PSAs were a huge 

mess because every PLS, for example, seemed to have a different 

one. 

So I think if part of what you are asking is are they putting in 

place standardization that should help the market, it seems to me 

pretty clearly that they are doing the right piece here. 

Others may want to comment on the common securitization platform. It is always better, I guess, to improve that once than improve it in both of the different divisions. 

Senator WARNER. And if they were getting it right, wouldn’t that, 

Mr. Davidson, get to the point in terms of the whatever that private capital, first risk dollar is? 

If there is this standardization that we all hope they are getting 

toward and we all are encouraging them getting toward, that 

should actually improve your ability to do that underwriting. 

Mr. DAVIDSON. That is correct. So the more you are operating 

under standards that are public, the less you need the need for sort 

of the loan-level due diligence in underwriting, provided that you 

have some process in place to make sure that Fannie and Freddie 

are actually doing what they said they are doing. And so that 

would help liquidity. 

Senator WARNER. Do you want to add? 

Mr. SWAGEL. I was just going to add in addition to what FHFA 

is doing I think a really hard thing is getting, in a sense, what people broadly refer to as legal and regulatory certainty—that if we 

want a restart of private-label securitization there has to be some 

confidence about the regulatory environment. 

And it is a tough one because if a bank or lender does something 

wrong, we should go after them. But they have to understand the 

rules. 

And since we want origination to take place within QM and outside of QM, I think right now there is a lot of uncertainty that is 

probably preventing some of that from happening. 

Senator WARNER. I want to get my last question in before my 

time is expired, unlike certain Senators. 

Let’s assume for a moment that we were unwinding GSEs as we 

know them now and we were creating these new issuers with this 

private capital. One of the concerns as we try to think through 

this—and we want to make sure we maintain this robust market— 

is, how do we make sure that there is an ability for those small 

community-based banks or credit unions or others to access this 

market if they do not have access to the Fannie or Freddie window? 

Could we create a co-op? Is there some mutual? Is there another 

way that we can make sure in one view of this new world where 

they are going to still get equal treatment and fair treatment? 

And I would love to hear from each of you. 
22 

Mr. VAN ORDER. I think that is actually tough, and I think a part 

of the problem is there is this real conflict we have in a lot of players who all can put bad things to you. 

I mean, we had a similar problem a long time ago in the savings 

and loan industry when there was a comparable collapse and it 

was a lot of little institutions that took risks. And they kind of all 

took the risks at the same time, and they added up. 

And one of the things I think you need to worry about as you 

replace Fannie and Freddie is, are you replacing them with something that has better incentives to control risks, or are you replacing it with something like the S&L industry a long time ago? 

Senator WARNER. I would love to hear everybody else, and then 

I will give it to Senator Warren. 

Mr. SWAGEL. I will go very quickly. 

Yes, it is a really important issue in the sense that it goes to the 

market structure of the industry, and I think what we want in the 

future is competition. We want lots of firms undertaking the role 

that Fannie and Freddie are doing now and doing securitization 

with a guarantee. 

And we see the negative effects of not enough competition in the 

spread between mortgage-backed security yields and mortgage interest rates. There is not enough competition in origination, and so 

interest rates for home buyers are higher. So home buyers are 

harmed by not enough competition in this industry. 

And so we want the competition of the small banks. I think a 

mutual is a good way to do it. 

I would say if there is competition and other firms competing 

with Fannie and Freddie, some of those should serve the smaller 

banks. The smaller banks should not have to go through the big 

banks to do it. 

Mr. DAVIDSON. My concern with any of the multiple issuer/multiple guarantor models is either a race to the bottom or difficulty 

in regulating them. And that is why I favor transforming Freddie 

and Fannie into issuer-owned cooperatives with requirements of access to small issuers. 

It has worked for the home loan banks. They give advances to 

all their members, regardless of size, as long as they can put up 

the appropriate amount to capital. 

Mr. WILLIS. You just made part of the comment I was going to. 

I think it is a really important issue, and as I said, we should 

do this one step at a time and see what is happening. And if small 

originators are being eliminated, we need to think carefully about 

the system we have created. 

I would just add to the Federal home loan banks—they have a 

voting system that allows the small banks to have a larger share 

of the vote than they would have based on their capital, and that 

might fit with the cooperative model that Andy is mentioning. 

Senator TESTER. Congratulations, Senator Warner. You outdid 

Corker. 

Senator Warren. 

Senator WARREN. Thank you very much, Mr. Chairman. Thank 

you, Ranking Member. I am glad you’re having this hearing. 

And thank you all for being here. 
23 

I just want to shift the question just a little bit. You have been 

talking some about the transition and mixing within that where we 

are trying to ultimately end up. 

The question I want to ask is, what is the center of the bull’seye? 

However we get there by transition, what exactly are we aiming 

for? 

And I read your testimony. I listened to all of you. And I just 

want to see if I have this right across the board—that you all favor 

layering the risk between the private market and what the Government has to do, publicly; that you all favor making explicit the 

guarantee that is there, that Fannie and Freddie—or whoever 

would call whatever names we give them—are making and then 

make people pay for that guarantee that they are getting; and that 

the two variables, the sort of hard nuts to solve in this, are how 

you ever get the pricing right when the Government is doing the 

pricing and how you get the layering details right; that is, who 

steps in at what point. 

And the reason for that is that it bifurcates into two points in 

time. One is the worry about the lending incentives; that is, that 

the private market is out there with the right set of incentives. The 

Government is, obviously, rather different on that. And the second 

is whether or not you have got adequate loss bearing capacity if 

there is collapse. 

Is that a fair description—because if it is, we need to know 

that—that that is really the center of what all four of you at least 

are anchoring in on. And to the extent it is not, I just want to hear 

from you. 

So that is why I put it out there. 

And, Dr. Van Order, maybe you would be the right place to start. 

Mr. VAN ORDER. Well, I particularly am interested in the incentives because any time you have structures like this, which are 

good, there is always the potential for moral hazard. 

We used to call this unbundling. The traditional bank or savings 

and loan took all the risk. The securitization process unbundled it. 

That is neat. It goes back to our founding father, Adam Smith, and 

the division of labor. 

The problem with it is as you do that, as you get along the food 

chain, you have got the moral hazard problems. People can abuse 

one another. 

I think these are the right structures, but I have not seen anything in them that really makes sure that that thing does not happen. 

And it happened like crazy a few years ago. It happened in the 

private-label market; it happened in all sorts of situations, where 

people did not feel they had a stake in what they were selling to 

other people or they would not get caught. 

So I like capital, but I really think you need to worry about the 

incentives at the level of management and the companies to really 

perceive themselves as being on the risk all the way down, not just 

for a little bit of it. 

Senator WARREN. I understand your point, but I just want to 

make sure that I am locked in on this, Dr. Van Order, and that 

is while you would put the emphasis on the incentive question and 
24 

others might put it in other places, the basic structure as I described it is where you would end up? I just want to be sure on 

that. 

Mr. VAN ORDER. Mm-hmm. 

Senator WARREN. OK. Good. Let the record reflect you are nodding yes. 

Mr. VAN ORDER. OK. 

Senator WARREN. OK. Good. 

Dr. Swagel. 

Mr. DAVIDSON. Sorry. 

Senator WARREN. I was just going to come up the line here. 

Mr. SWAGEL. I agree. I agree, absolutely. 

The emphasis I would add, since we are going to agree on that 

emphasis, is on the shrinking of the guarantee. So make it explicit 

because I think it will be there. 

If you do not make it explicit, it is implicit, but then shrink it. 

Protect the taxpayers. Provide better incentives. And then I 

think that also helps address the price—— 

Senator WARREN. But, Dr. Swagel, let me just push back. 

Mr. SWAGEL. Please. 

Senator WARREN. How do you shrink it if at the end of the day 

we talk about a Fannie and Freddie that had no explicit guarantee 

and yet when it all falls apart, when the market falls apart, the 

answer is the United States taxpayer is called to come in and backstop? 

Mr. SWAGEL. Yes. 

Senator WARREN. So I do not even understand what it means to 

say that part of the target is to shrink it. 

Mr. SWAGEL. So I would use the tools that I mentioned—have 

more first-loss private capital—— 

Senator WARREN. No, no, no. I am not asking you about tools to 

shrink it. I am asking you, how the end can be to shrink it in a 

world where you have got the guarantee and if the world falls 

apart the U.S. taxpayer will be called on to come in? Every single 

player in the marketplace after 2008 now knows that. 

And so I do not see how it is anything different from we price 

for it and we try to figure out how to layer in a way to deal with 

the incentives. 

I just do not understand how you can talk about shrinking it. 

Mr. SWAGEL. Well, it might be a semantic difference. In my 

mind, shrinking the guarantee is when the Government covers less 

than every conforming mortgage and when there is first-loss private capital before the guarantee. 

Senator WARREN. Well, this is layering question. That was the 

second half we were doing. So maybe we are in the same place 

then. 

Mr. SWAGEL. Yes. So it is really just a matter of how much 

layering and then what is the market share of the Government. 

Senator WARREN. All right. Fair enough. Fair enough. 

Mr. Davidson. 

Mr. DAVIDSON. So I guess my main adjustment to that thought 

is that I think there are different segments of the mortgage market 

that are going to have different structures. 
25 

So, for example, there is the FHA portion where the Government 

is providing the credit piece and the wrap on the MBS. Then in 

this other layer we have been talking about what is currently the 

GSE market. That is the area where we have the multiple layering 

of private capital and Government guarantee. 

Senator WARREN. But let me ask, Mr. Davidson, is there really— 

do you have any doubt that the Government implicitly backstops 

the entire market? 

Mr. DAVIDSON. So, you know, the Government did not backstop 

the AAA private-label bonds, which are now trading at 50. So it did 

not backstop the entire market. 

What the Government did was step in and say we will make sure 

there are new mortgages that we will stand behind. But it did not 

stand behind the private-label MBS. It did not stand behind the 

CDO market. 

Senator WARREN. Well, one could argue, respectfully, that when 

you step into a market that has collapsed and offer funding into 

it, you have backstopped that market. 

Yes, we imposed some losses. And this is what I was talking 

about. That is what the layering does. It imposes losses, but it does 

not change the fact that the Government is the one that still backstops the entire market. 

Mr. DAVIDSON. I guess what I am saying is I want to segment 

backstopping loans that already existed and backstopping new 

loans. Clearly, every new loan is now guaranteed fully by the U.S. 

Government, but there are loans that were originated that are not 

being backstopped by the United States in the legacy book. 

Senator WARREN. Oh, fair enough. Fair enough. 

Dr. Willis. 

Mr. WILLIS. I agree that we should keep a guarantee on the 

MBS. 

I also agree that the Government has got to come in if there is 

a systemic failure, and so we might as well charge now and buildup 

a reserve against that contingency to protect the taxpayers. 

I think there is a role for private risk ahead of that Government 

wrap. I think we should test for that to see what effect it has. 

Whatever your view of MI going forward (I recognize that Senator Corker is not in favor of the MI), I do not think anybody wants 

to defend the way it was. 

But there are a lot of changes perhaps in the rescission rules, 

capital, all sorts of things, with regard to insurance. And you could 

talk about them even taking a deeper loss than above 80–20. They 

actually take 35 percent. There also were issues with reps and warranties. 

Senator WARREN. Fair enough. 

Mr. WILLIS. So that is a way to do risk. 

So there are a number of ways to do that. 

As for getting the pricing right, everybody wants to point out the 

Government did not do it well. Quite honestly, FHA—that loss is 

relatively small here, particularly compared to what the private 

sector lost here. Ginnie Mae is still doing very fine here. 

I do not suggest that the Government not charge fully based on 

the Fair Credit Reporting Act accounting for the risk, but I will 

point out that if worse comes to worst and they make a mistake, 
26 

we have ways of—you know, the Government is not going to go out 

of business, and it can survive. 

And people disagree about this. It then can raise the rates and 

pay itself back in a sense by penalizing future borrowers, but that 

may not be a fair way to do it. 

Senator WARREN. Thank you, Mr. Willis. 

I appreciate the difference in focus for each of you, but I take it 

we at least understand the structure that all four of you are putting forward. 

Thank you. I did my best to go over. 

Senator TESTER. You did well. 

Senator WARREN. I am trying to follow the lead of my seniors. 

Senator TESTER. Yes, it is a poor example that they set, though, 

Senator Warren. 

[Laughter.] 

Senator TESTER. No, it is just fine. 

And we will have another round. We have got plenty of time. I 

mean, this is a very important issue. 

And thank you, guys, for your straightforward testimony. I very 

much appreciate that. 

As you know, the FHFA has directed the enterprises to engage 

in about $30 billion of risk-sharing transactions this year and directed them to consider things like expanded mortgage insurance, 

senior/subordinated securities, credit-linked securities—things you 

guys have talked about. And I am sure that this is going to be an 

effort to pave the way for further risk-sharing in the future. 

Are there specific things that we, as policymakers, should be 

looking at as these transactions unfold and market participants respond? 

Mr. WILLIS. What I am concerned about in the direction they are 

going now in is in order to do the $30 billion they seem to think 

that they have to raise g-fees even higher—g-fees that are now 

twice as high as they were before, credit quality on new mortgages 

probably better than it has ever been. And that is solely in order 

to make sure that they can run this experiment without losing 

money. 

And I think they are foreclosing policy options for you all by 

doing that. 

They should run these experiments, see in fact what they cost, 

and then you can have an open discussion about what the tradeoffs 

are here in terms of bringing private capital, in terms of what kind 

of products, as I have said, what kind of underwriting, et cetera. 

Right now, they are marching ahead, as I read it, to increase the 

g-fee just so they can run this experiment. And, as I said, I think 

that forecloses or makes it harder for you to choose some of the options that you may want to choose once we see the end of this experiment. 

Mr. DAVIDSON. I would say in the experiment, you know, one of 

the biggest problems why we did not have a deal a year ago is the 

regulatory impediments to doing the kinds of transactions that 

make economic sense. So I would hope that you would sit down 

with FHFA, Fannie Mae and Freddie Mac and ask them what 

hoops were they trying to jump through that prevented them from 

doing the transaction that they thought would be most economic. 
27 

Senator TESTER. OK. Excellent. 

Mr. WILLIS. I think we should recognize that Freddie actually 

has done both of these, right? 

They do K Series, which is a senior/subordinated on the multifamily, and they did what is called moderns—others here can comment more about them—which were using credit-linked notes. So 

they have tried this in the past. 

Senator TESTER. OK. 

Mr. SWAGEL. Right. I agree with what Andrew said. 

You know, the $30 billion seems like a small amount to me, but 

I understand that they want to test it out. 

You know, I think g-fees can go up and down. As I said, they will 

go down as the amount of private capital comes back. 

But I think the key is for taxpayers to be protected. We should 

not be underpricing this insurance. We should all understand rates 

will go up. 

In a sense, at the beginning, when the market is illiquid and 

there is only a little bit of this risk-sharing, there will be a premium. Investors will demand a premium. So rates will be too high, 

but hopefully, this market will develop, and that will smooth that 

over time. 

Senator TESTER. So you anticipate the rates will be—when the 

offerings are made, they will be higher than they probably will be 

later on. 

Mr. SWAGEL. Eventually, just because it will be such a small security class, that there will be a liquidity premium. 

Senator TESTER. Gotcha. 

Mr. VAN ORDER. Yes, I think this is fine. 

My only question with experiments like this is to learn something you need to see them through a few cycles. One of the things 

that happened a few years ago with subprime loans was people 

began pricing them by just looking at one cycle. So this is something that will require a lot of patience. 

I do not care that much about the pricing, but if you are going 

to do this, you have got to watch it for a while because I think 

things will look good for a while. And we want to be careful if they 

look good, projecting it too far. 

Senator TESTER. Gotcha. 

Look, the structures that are under consideration are not new, 

but the effort, I think, with Fannie and Freddie is largely experimental, where they are going. 

What specific issues would you be considering with respect to 

scalability of these mechanisms, both as enterprises increase risksharing transactions and as we consider the transition out of conservatorship? 

Go ahead, Mr. Davidson. 

Mr. DAVIDSON. So the credit-linked note structures are extremely 

scalable if you can get investors because they do not alter any of 

the operations of Fannie Mae and Freddie Mac. Unfortunately, 

they are not the most investable right now, and they create some 

issues for REITs because they are not REMIC transactions. 

The senior/subordinated transactions, which are the cleanest and 

what has been done on the multi-family side, are great trans-
28 

actions for your less liquid products, but they are not going to be 

as scalable. 

So it is sort of a tradeoff. You have a clean structure that is not 

scalable and a scalable structure that is not, you know, clean from 

a regulatory standpoint. 

Mr. WILLIS. I did not come here to defend the insurance side of 

this, but I will point out the insurance is probably quite scalable 

here particularly because there is a reinsurance market out there 

as well. So all of these are just relative. 

I agree with everything else that was said here but just wanted 

to add that. 

Senator TESTER. OK, Senator Corker. 

Senator CORKER. Thank you again for your testimony, and I 

want to follow up on Senator Warren’s comments about the shrinking. 

I do think there was a semantics issue, and I just want to point 

out that let’s just say you had a 90–10 model, just for talking purposes. You would have automatically shrunk the public side by 10 

percent, immediately on the front end. 

And I will say that if Fannie and Freddie in this last go-round 

had just had a 5 percent capital buffer there would have been zero 

taxpayer losses. 

So it is not a small thing to talk about a 90–10, and that is an 

immediate shrinking. So I do think you all are talking past each 

other just a little bit on that issue. 

On the mortgage piece that you just brought up, Dr. Willis, it is 

true that insurance is very scalable. But you do not really have 

much when you are done, right? 

I mean it is not the same as hard cash, which is what you would 

have with a credit-linked note or with A or B piece. It is hard cash. 

It is there. It is gone. And if something happens—— 

Mr. WILLIS. Well, again, I am not an expert in insurance. 

There is a concept called risk-to-capital. 

Senator CORKER. You have a highly leveraged product in front of 

you. Is that—— 

Mr. WILLIS. Right, right. But if you leveraged it at—let’s say you 

think you want 10 percent. You could leverage it at 10 to 1. 

I mean, you could require that level of capital for them to have, 

and you would have the same protection there. 

Senator CORKER. You would have 1 percent of the 10. You only 

have 1. 

See, with the credit-linked note or with the A and B piece, you 

have 100 percent cash. 

Mr. WILLIS. For that portion that—— 

Senator CORKER. For that portion. 

Mr. WILLIS. Absolutely right. 

Senator CORKER. So if you had a 10 to 1 leverage, you would 

have 1 percent cash in front. 

Mr. WILLIS. Right. 

Senator CORKER. I guess we have had numbers of discussions. So 

it is a very different model. 

And I am all for private insurance on the portion above 80 percent. I just think as an equity piece that is not really what you are 

getting. Does that make sense? 
29 

Mr. WILLIS. I have to defer to you on the insurance, in the leverage, but all I am pointing out is you could require them to hold 

more capital. You could require them to hold more reserves equivalent to whatever you wanted elsewhere. 

The insurance model is a different model. It builds up capital 

over time. There are other—there are differences that you are referring to. 

But, as a matter of practice, you could make them hold; say it 

is only acceptable capital in front of the Government guarantee if 

you hold the certain ratio here. 

Senator CORKER. It would still be a leverage ratio. 

Mr. WILLIS. OK. 

Senator CORKER. I think everybody agrees to that. 

Dr. Van Order, the incentive piece—I am interested in what you 

are saying there. 

I mean, if you—let’s just say you had an A and a B piece, the 

not scalable but superb model. And I assume that with the B piece, 

whoever held that would want to be able to determine who the 

servicer is because they would have all the risk. Is that correct? 

Mr. VAN ORDER. Yes. 

Senator CORKER. So talk to me a little bit about the kind of 

things that would be disincentives, or take them in the wrong direction, because it seems to me they would have every incentive to 

make sure that what they were doing was not going to fail. Tell 

me how that could go awry. 

Mr. VAN ORDER. Everybody in the deal has limited liability. And 

the question is, at what point do you run out of yours? 

But, yes, if you have got someone that is on the hook from beginning to end and they are in a position to handle the information 

properly from the servicer, then, yes, it should work pretty well. It 

should mimic. 

What we would like to do is take the—we need the guarantee at 

the end. What we would like to do is take it off the table in terms 

of behavior. Right. So set up something so that they behave as if 

they did not have the guarantee and still have the guarantee. 

Let me give you an example. You were talking about raising capital ratios to 5 percent. The problem with raising capital ratios to 

5 percent is you might change the behavior of the people because 

at 5 percent a lot of safe assets are not profitable anymore and you 

might move them into riskier assets. 

And that is—— 

Senator CORKER. But on the B piece, they would not be doing 

that. That is not what they would be doing. 

Mr. VAN ORDER. That is a different question. You are right. 

Senator CORKER. That is just your equity. 

So, I guess, tell me how we might go awry. 

Mr. VAN ORDER. Well, because when you have an equity position, 

you have a limited liability. 

So what you would want to do if you are in an equity position 

is you might want to set up something where 90 percent of the 

time everything was fine and 10 percent of the time it went wrong 

and it went wrong in a huge way because your liability is limited. 

Maybe I have got it turned around. 

Senator CORKER. Let me go—thank you very much. 
30 

Let me go to another point. 

So we have a superb non-scalable model which is the A and B 

piece, or we have a credit-linked note which is scalable but not 

quite as superb. How do we figure out a way to solve the problem? 

Mr. DAVIDSON. My view is it has really only to do with the current regulatory structure. Right. 

So it really has nothing to do with the economics because the economics of senior/sub and the economics of credit-linked note are 

virtually identical. 

You have some amount of cash that is sitting on the sidelines. 

It is earning some return. And, if there are losses, it gets taken 

away from the investor, which is opposite of the insurance model 

where you keep your cash and then when something goes wrong 

you hand over your cash. 

Senator CORKER. If you have any. 

Mr. DAVIDSON. If you have any left. 

So, really, if these experiments work and Congress wants to pursue this, it is not going to be that hard for you to change some of 

the rules so that senior/sub or credit-linked notes work both extremely well. 

Senator CORKER. So the impediment is not due to the structure; 

it is due to us. 

Mr. DAVIDSON. Yes. 

Senator CORKER. And if we were to craft a piece of legislation 

where we wanted an A and B piece or credit-linked note, we could 

do so in a manner that both were very scalable and superb. Is that 

correct? 

Mr. DAVIDSON. That is correct. 

Mr. WILLIS. I will just add; you also have to deal with the compatibility with the TBA market, right, which today it is not, as I 

think you pointed out in your testimony. 

Mr. DAVIDSON. That was my scalable point—was interfering with 

the TBA market. 

Senator CORKER. This has been an outstanding hearing, and I 

thank all of you. 

Mr. SWAGEL. Right. It just seems like that you would have—the 

A and B really would be quite different. Right? 

The A would be liquid. The TBA market would be concentrated 

there. And then the B would just be very different. And different 

types of investors would have different interests. 

Mr. WILLIS. But you would not be able to use the TBA market 

now to provide—easily provide—a rate lock, a forward committed 

rate, because you would not be able to do that with a B piece without legislative change. 

Mr. SWAGEL. Right. 

Senator TESTER. Thank you, Senator Corker. 

We have got a vote at 5. 

You each have 7 minutes because my close is very short. Go 

ahead. 

Senator WARNER. Well, mine is going to be even quicker than 

that—one quick question. 

Assuming we follow up on what Senator Corker is saying, we 

have got this A and B piece. I actually do think there is a way to 

structure—I do not have quite the concerns Dr. Van Order does 
31 

about that if we have got that 10 percent risk capital up front, and 

I think we can take care of most extraordinary risk. 

What I worry about, though, is trying to make sure on the 

servicer piece. I try to understand the servicer piece more and more 

and the 25 to 50 basis points that they get paid. Usually, they get 

paid additional for back fees and other things through the operations. That is really a nice revenue stream there. 

How do we make sure that if we have got this private capital up 

front, or even a Government backstop later, that if the servicer is 

not aligned the right way—back to your point, Dr. Van Order, in 

terms of incentives—we can get that servicer out of that role and 

get somebody that is better aligned, in, when they have got such 

a flush revenue stream there that may or may not be rewarding 

actual performance? 

Mr. VAN ORDER. Actually, the Ginnie Mae market is a neat example of this because they have, for years and years, required very 

high servicing fees, and yet the originators and sellers would rather not receive them because they would rather sell the securities 

at higher prices. 

What Ginnie Mae uses them for is the servicers are responsible 

for making the timely payment. Ginnie Mae is a backup to that, 

but the servicers are responsible for making it. 

And it is profitable. The right to service—to pool the mortgages— 

trades at a positive price, and the reason is it is valuable. 

And what Ginnie Mae has done—and Fannie and Freddie did a 

little bit, but Ginnie Mae did in a really neat way—was if you did 

not do this they could take all of your servicing, just take it away 

from you, and sell it to someone else. 

So, actually, that was an example of—this was like a performance bond which they could take away from you, and I think that 

is a neat way of setting it up. 

Senator WARNER. I would love for you to get me some more information about that. 

Does anybody else want to have a quick comment? 

Senator WARREN. Good. Thank you. 

Senator TESTER. Senator Warren. 

Senator WARREN. Thank you. 

And I am going to have to be quick too because I have to go preside. 

So let me ask the one question, something we have not talked 

about, and that is we were talking about pricing—how the Government prices for risk and how the private-market prices for risk. 

And I think it was you, Mr. Davidson, who talked about with 

millions of mortgages in Fannie’s or Freddie’s—or whatever its successor is. The question is how do you price out of that to try to sell 

off some of that and how difficult that is when we are dealing with 

so many mortgages. 

So the question I want to focus on for just a second is about data 

tagging, whether or not you have any familiarity with the idea behind this. The notion that we now have better capacity than ever 

in the past to tag even something like a mortgage with lots of information—information about the characteristics of the borrower, information about the characteristics of the originator—and to keep 

that information with that mortgage we can now do, or at least we 
32 

can theoretically do we could do, as it is sliced and diced and put 

into different pools and keep its performance information always 

pegging in so that, over time, you have this incredibly robust data 

base about performance. 

Now you do not have cycles yet until it plays out over longer and 

longer periods, but you do have incredibly detailed information 

about how it is working. 

Does that potential change just in the technology of what we can 

do or what we can do, I hope, in the near future that we were not 

able to do up through the present—does that give us a better capacity either for the Government to price risk or for the private 

market to be pricing the risk as it buys from the Government and, 

therefore, solve some of our pricing problem? 

Any thoughts around that? Anybody? 

Mr. Swagel? 

Mr. SWAGEL. Sure. I think, yes, that is exactly right. So I very 

strongly agree. 

In some sense, the previous model was you do not need to know 

any of this because Fannie and Freddie are there. 

Senator WARREN. Yes. 

Mr. SWAGEL. So this is just—it is sunlight. 

Senator WARREN. This is like inverting that approach. 

Mr. DAVIDSON. So, I mean, Fannie and Freddie just released a 

tremendous amount of delinquency data that the market never had 

before. 

Senator WARREN. Yes. 

Mr. DAVIDSON. Which is, you know, crucial to price these instruments. 

But I guess I would caution that more data does not make it 

more correct data. And so—— 

Senator WARREN. What does that mean? 

Mr. DAVIDSON. We still have the issue that someone is originating a loan. They are writing down what their income is on that 

document, and maybe it is verified in some fashion. And there is 

an appraisal. If the income and the appraisal are false because 

there was fraud, then all of the rest of the analysis you do after 

that is not valuable. 

Some of that is—— 

Senator WARREN. Fair enough, but let me just break in there, 

Mr. Davidson, just because I am going to run out of time. 

It is also the case that you can start picking up the originators 

that are not the ones who are following the rules because now you 

can isolate by originator for whose loans are going sour fast. 

Mr. DAVIDSON. Yes. So I think a good representation and warranties and good data about that will improve this whole process. 

Senator WARREN. Good. 

Mr. WILLIS. It is another hearing, but do not forget second liens 

in your database. 

Senator WARREN. Good point. Good point, Dr. Willis. 

Mr. VAN ORDER. And a neat thing that is going on in developing 

these mega databases is linking it up with the borrower and the 

information from credit repositories. I think one of the neat things 

going forward will be the early warning systems in mid-stream so 
33 

you see this guy’s credit score has deteriorated. How predictive is 

that? 

And splicing these together is not easy, and there are serious 

issues, but I think that is pretty neat. 

Senator WARREN. So I hear a glimmer of optimism. Good. Thank 

you very much. 

Thank you so much. My apologies and excuse me. 

Senator TESTER. Perfect. Thank you, Senator Warren. 

I just want to thank the witnesses again. I especially want to 

thank the fact that if you guys had something to say you were not 

bashful about saying it, and I very much appreciate that. That is 

what hearings should be about—is getting good information so that 

we can make good decisions. 

And I think this hearing has underscored the importance of getting private capital back into the marketplace, where we are protecting taxpayers and how we transition Fannie and Freddie out of 

conservatorship. 

I certainly look forward to working with the folks here today and 

a whole lot of others that I know are very concerned about the 

housing finance system and concerned about us really doing the 

right thing and building a housing finance system that is going to 

last well into the future. 

Just some housekeeping, this record will remain open for 7 days, 

and any additional comments and any questions can be submitted 

for the record at that point in time. 

With that, once again thanking the witnesses, and this hearing 

is adjourned. 

[Whereupon, at 4:50 p.m., the hearing was adjourned.] 

[Prepared statements supplied for the record follow:] 
34 

1For example, rate investors in Fannie Mae and Freddie Mac debt and mortgage-backed securities have included sovereign funds which see the U.S. Government as providing a guarantee 

against credit loss. 2 Banks do hold some mortgages in portfolio but 1) are limited in their appetite for long duration instruments such as 30-year fixed-rate mortgages, 2) look to diversify their assets to guard 

against sharp losses in any one sector of the economy, and 3) have only limited portfolio capacity 

in any case. While bank assets have grown in recent years, they still barely exceed the total 

value of mortgages outstanding and bank deposits fall well short of this total (See Federal Reserve Flow of Funds reports). 

PREPARED STATEMENT OF MARK A. WILLIS 

RESIDENT RESEARCH FELLOW

FURMAN CENTER FOR REAL ESTATE AND URBAN POLICY

NEW YORK UNIVERSITY

MAY 14, 2013 

Chairman Tester, Ranking Member Johanns, and Members of the Committee, I 

thank you for the opportunity to testify today on the role for private capital in reforming mortgage markets. I am Mark A. Willis, a Resident Research Fellow at the 

Furman Center for Real Estate and Urban Policy at New York University and an 

adjunct professor at the Wagner School of Public Service, also at NYU. Previous to 

that, I was the Executive Vice President for community development at JPMorgan 

Chase, having started many years earlier at one of its predecessor institutions, 

Chase Manhattan Bank, as president and founder of its Community Development 

Corporation. Before that, I served as an economist at the Federal Reserve Bank of 

New York and worked in New York City government. 

Since 2008, I have focused much of my research work on housing finance reform 

and have written articles, consulted for a number of organizations, lectured, and 

participated on numerous panels on this topic. I am also a member of the Mortgage 

Finance Working Group convened by the Center for American Progress and have 

conducted research for the Housing Commission of the Bipartisan Policy Center. 

The views contained in this testimony are mine and should not be attributed to any 

of the organizations to which I am affiliated. 

I want to make two major points in my testimony today: First, restoring private 

capital’s historic role in the financing of home mortgages—financing jumbo mortgages—is a straightforward matter once regulatory uncertainties are resolved. Second, requiring the use of private, credit-risk-taking capital for the much larger remainder of the housing finance market is also possible, but such requirements 

should only be implemented after we have tested their impact on access to and affordability of mortgages for the vast majority of the home buyer market. By testdriving different approaches, we will be better able to weigh the costs and benefits 

of having private capital take more of the risk and avoid unnecessarily disrupting 

the availability of new mortgages. 

Background 

Before discussing the details of increasing and deepening the role private capital 

plays in mortgage markets, it is useful to clarify the different roles it has played 

in housing finance in the past. Private capital is today, and always has been, the 

source of all the funding of home mortgages. What we are discussing now is to what 

extent this private capital is insured or guaranteed by the Government. 

It is also useful to understand that there are two types of investors bringing private capital. First, there are those investors who are interested in taking only interest rate risk and prepayment risk (these are called ‘‘rate’’ investors). These investors 

purchase mortgage-backed securities (MBS) where there is essentially no credit risk, 

e.g., when the Government insures against the risk of borrower default. Then, there 

are those who take that credit risk, either alone or in addition to interest rate and 

prepayment risk (these are called ‘‘credit’’ investors). It is generally understood that 

the pool of capital available from these rate investors far exceeds that for the credit 

investors.1

In recent decades, much of the funding for mortgages has come through the secondary market, as opposed to through financial institutions that make loans and 

hold them on their own books.2 Many investors purchased MBS issued by Fannie 

Mae and Freddie Mac, which are backed by mortgages below what has been called 

the conforming loan limit (pre-crisis was set at $417,000), believing that there was 

an implicit Government guarantee of these securities. Direct investors in Fannie 

and Freddie also appear to have felt shielded from credit risk, despite the technical 

fact that these two agencies had been privatized decades ago, and it turns out that, 

at least for the debt investors, they were right—the Government has fully stood be-
35 

3 Banks also buy MBSs to hold in portfolio. These securities may or may not involve credit 

risk depending on whether the MBS is covered by a Government guarantee. 4 If subprime and/or Alt-A re-emerges as an asset class, then it seems likely that a secondary 

market to fund it will also be able to re-emerge once a healthy jumbo PLS market has been 

reestablished. 5These percentages are based on an average of the annual HMDA data for home purchase 

loans by owner-occupants for the years 2004 through 2011. 6The U.S. Treasury has inserted $187.5 billion in capital into Fannie and Freddie in the form of senior preferred stock and has received back $121 billion in dividends. As of August 2012 

all of the earnings of Fannie and Freddie are being swept back into the Federal budget. Based 

on the amount and rate of recent payments and sweeps from Fannie and Freddie the Government appears well on its way to recovering the full amount of the capital it invested. 7 It is worth noting that the premiums charged by both FHA and GNMA (the Government 

National Mortgage Association guarantees MBS backed by FHA-insured mortgages) have been 

sufficient up to now to cover any losses out of the reserves they have built up over time. It is 

also likely that, given the rules governing FHA, a transfer of less than a $1 billion may be triggered during the next fiscal year even though FHA has enough money to cover foreseeable losses 

for the next 7–10 years and can expect higher net earnings going forward since it has raised 

premiums while the credit quality of new loans has risen significantly. 

hind those securities. Even the equity investors in the Agencies appear not to have 

paid enough attention to the riskiness of the mortgages they backed or owned. In 

the end though, these investors did bear the cost of the financial failure of these 

two firms. Accordingly, most of the investors in this part of the mortgage market 

have in the past only had to concern themselves with interest rate and prepayment 

risk since the Government has guaranteed timely payment of principal and interest 

on all securities. 

Only larger loans (the so-called jumbo loans) and loans that were subprime or labeled Alt-A—the financing and regulating of these latter types of loans I take as 

beyond the scope of this hearing—have traditionally been financed with private, 

credit-risk taking capital mainly by banks 3 and by investors in private-label mortgage-backed securities (PLS).4 Before the crisis, loans larger than $417,000 were not 

eligible for purchase by Fannie Mae and Freddie Mac (‘‘Fannie’’ and ‘‘Freddie’’-collectively the ‘‘Agencies’’). Thus, investors in these securities and banks had to cover 

default risks. 

Following the 2007 onset of the nationwide decline in housing prices and the great 

recession, the Government expanded the range of loans that were eligible for purchase by Fannie and Freddie by raising the size limits for eligible loans. The Economic Stimulus Act of 2008 temporarily raised the loan limit in some parts of the 

country with high housing prices as high as $729,750 for them as well as for the 

Federal Housing Administration’s (FHA) insurance program. While the limit for the 

Agencies has now fallen back somewhat to $625,000, that limit still encompasses 

over 97 percent of the mortgages and almost 90 percent of the dollar volume originated annually for the purchase of homes.5 So it is not surprising that some 90 percent of the mortgages for the finance of home purchases rely on the Government 

guarantee, which means that the taxpayers remain entirely on the hook if defaults 

should exceed the financial capacity of Fannie and Freddie to absorb any resulting 

losses.6

Calls for using private, credit-risk-taking capital to decrease the risk of loss to 

taxpayers are made on several grounds: First, there is the simple desire to have private capital absorb some amount of the loss. Second, some argue that the private 

sector is better able than the public sector to price the risk,7 although the latter 

is something of a specious argument given that the Government had to bail out 

purely private credit risk takers whose mispricing helped fuel the subprime boom 

and bust. While it is a challenge for Government (or anyone) to set exactly the right 

fee for providing a ‘‘wrap,’’ Government does have one advantage: it can cover losses 

out of tax revenues and even recoup those losses by raising the premium it charges 

going forward for providing the guarantee (as it has done through the addition of 

loan level price adjustments and increases in the so-call g-fees charged by Fannie 

and Freddie and as FDIC has done with regard to deposit insurance). A third potential benefit of having private investors take credit risk alongside the Government 

could be an extra set of eyes to assess credit standards/underwriting criteria and 

monitor whether loans are being properly underwritten and serviced. Additionally, 

it is hoped that the active involvement of private sector actors will discourage, if 

not prevent, attempts by Government officials to fiddle with underwriting and other 

standards for political gains. 

In the end, it is important that America have a housing finance system that can 

provide mortgage products that are well-priced and accessible and safe for all borrowers who can sustain home ownership, while at the same time minimizing systemic risk to the economy as a whole. 
36 

8These percentages are based on an average of the annual HMDA data for home purchase 

loans by owner-occupants for the years 2004 through 2011. 9Project Restart has been a project of the American Securitization Forum. 

10Most observers agree that broad access to a long-term (15 or 30 years), fixed-rate mortgage, 

which have been at the core of the U.S. housing market, is critical for a healthy housing market. 

Many are concerned that the availability of this type of product might be put in jeopardy without the Government guarantee. 11See, for example, Roberto G. Quercia, Lei Ding, and Carolina Reid, ‘‘Mortgage Underwriting 

and Access to Credit’’, University of North Carolina, Center for Community Capital, October 6, 

2011, which reports that some 40 percent of mortgages made between 2004 and 2008 were made 

with a downpayment of less than 20 percent. http://www.ccc.unc.edu/documents/Mtge.Under. 

Access.Credit.CFPB.10.6.11.No.2.pdf. 12These percentages are based on an average of the annual HMDA data for home purchase 

loans by owner-occupants for the years 2004 through 2011. 

Taking Steps that Make Sense 

The FHFA can take a number of steps to move us down the road of housing finance reform in a measured and informed way: 

Turn the jumbo mortgage market back to the private sector 

Now that the housing market seems to have stabilized, it is time to let the jumbo 

market stand on its own without a Government guarantee. It accounts, after all, for 

some quarter of the dollar volume of mortgages per year and over 8 percent of all 

mortgages by unit count.8 While it may in the end make sense to trim back further 

the share of the market eligible for the Government wrap (see discussion below), 

opening up the market above $417,000 should provide a very significant opportunity 

to attract private, credit-risk-taking capital. 

The best way to trim back is to raise the g-fee on all loans over $417,000 until 

the private sector is able to capture as much of the market as it wants to. An alternative approach, which some have suggested, is to lower loan limits one step at a 

time to $417,000, but this could leave parts of the market underserved or even 

unserved, especially if the private sector is reluctant to gear up to serve this market 

until it is of sufficient scale to justify the costs of setting up and running the necessary market infrastructure and to offer investors sufficient liquidity. While Project 

Restart 9 and other efforts are underway to re-think the workings of a PLS market, 

some remaining regulatory uncertainties, especially with regard to risk retention 

under Dodd-Frank, probably need to be resolved if the private sector players (e.g., 

investors, originators, servicers, etc.) are going to be sufficiently motivated to take 

the lead to reach agreement among themselves on the rules of the road necessary 

to be able to come back at scale. Otherwise, it may take a g-fee increase that is significantly above what pricing should be needed in the long run for the private sector 

to compete for the jumbo business. 

Then evaluate whether to lower the loan limit below $417,000 

Once the jumbo private securitization market is functioning at scale, it will be 

possible to evaluate the impact of any further lowering of the limits for the private 

sector to begin to serve the vast bulk of the mortgage market which lies below 

$417,000. This part of the market (74 percent in dollar terms and 92 percent of the 

units) has historically benefited from a Government guarantee and not relied on 

credit investors. 

If there is no significant difference in what private, credit-risk-taking capital 

proves willing to finance in the jumbo market compared to the existing offerings in 

the conforming market, then further testing of the right level for the loan limit 

should be undertaken. But any expansion of the non-conforming market should only 

be done in stages. At each stage, the goal should be to ensure that the additional 

market segment will continue to offer a comparable range of mortgages including, 

for example, long-term, fixed-rate mortgages, which are well-priced and available 

without regard to geography or other factors that would limit access to those that 

now have it.10 Similarly, if the jumbo market requires higher downpayments and/ 

or higher FICO scores, then extending it into the heart of the mortgage market 

would risk excluding many potential home buyers, particularly first-time and lowerwealth home buyers.11

An additional option is to consider varying the loan limits based on variations 

across metropolitan areas in median home prices. For example, a loan limit of 

$417,000 preserves a Government guarantee for only 14 percent of the mortgage 

market in San Francisco (27 percent of the units) while the comparable percentages 

for Dallas and New York are 83 percent and 47 percent (95 percent and 68 percent) 

respectively.12
37 

13Of course, every sector of the economy would like to have access to money at lower cost 

based on U.S. Treasuries plus a charge for risk that does reflects the Government’s borrowing 

costs and not those of risk-averse investors. Favoring the housing sector is consistent with the 

belief that housing provides important social benefits. For a discussion of the FCRA versus fair 

value, see John Griffith, ‘‘An Unfair Value for Taxpayers,’’ Center for American Progress, February 9, 2012. http://www.americanprogress.org/issues/budget/report/2012/02/09/11094/anunfair-value-for-taxpayers/. 14 As Mark Zandi wrote, ‘‘the FHA shows how Government action during the Great Recession 

forestalled a much worse economic fate. If FHA lending had not expanded after private mortgage lending collapsed, the housing market would have cratered, taking the economy with it.’’ 

See Mark Zandi, ‘‘FHA role may be bloated, but we’d be much worse off without it’’ The Washington Post, December 15, 2011, available athttp://articles.washingtonpost.com/2011-12-15/ 

news/35285815l1lmortgage-loans-private-mortgage-mortgage-securities. 15 If there is to be such a ‘‘dial’’, it will be necessary to determine who would make the decision, according to what criteria (e.g., would there be automatic triggers or would the decision 

be delegated to a Government entity like Treasury, the Fed, or HUD), and what changes in procedures would need to be instituted to replace the functions that private capital was expected 

to perform. A similar issue exists with regard to any lifting of the loan limits for the FHA, but 

in this case FHA is already structured to work without relying on private capital. 16FHA was able to filled part of the gap opened up by the withdrawal of private capital by 

allowing its share of the home purchase to rise from less than 5 percent in 2006 to more than 

30 percent in 2009. See U.S. Department of Housing and Urban Development, ‘‘Annual Report 

to Congress Regarding the Financial Status of the FHA Mutual Mortgage Insurance Fund Fiscal 

Continued 

Weigh pros and cons of requiring private, credit-risk-taking capital ahead of a Government guarantee on ‘‘conforming’’ MBS 

Since these tests are likely to reveal the value of having a conforming market supported by a Government guarantee on MBSs backed by qualified mortgages, FHFA 

should continue its current quest to determine the costs and constraints of bringing 

in private, credit-risk-taking capital ahead of Fannie and Freddie in that conforming 

market. Sharing risk does offer the potential to reduce the burden that could ultimately fall on taxpayers. 

However, using such private capital has drawbacks as well. Private sector investors need to be rewarded for taking risk, and they may require tighter underwriting 

standards (called credit overlays) than the Government is willing to insure. It is 

simply naive to expect private investors to adjust their expectations of an acceptable 

return in order to make home ownership more accessible and affordable or to put 

capital at risk during market downturns. Their presence may also make it harder 

for smaller originators to have access to the Government wrap. Finally, it is important to consider any systemic risk posed by involving private capital across the 

board. Even if the investors in the MBS are protected by the Government wrap, it 

is important to ensure that large losses by private capital in this position do not 

result in the need to once again bail out the private sector. 

Shifting risk onto the private sector is also likely to raise the cost of mortgages. 

Government is able to provide its guarantee at lower cost because, unlike private 

investors, it is does not have to be rewarded with a high rate of return for taking 

risk. Government has the ability to recover from losses by tapping other sources of 

revenue and so will not be put out of business if, by some unexpected set of circumstances, losses exceed the existing reserves built up by charging for the guarantee. Private capital, on the other hand, needs a high return to take on such risk 

and so its use will push up the rate that borrowers will have to pay. While some 

economists argue that the Government should charge the same as the private sector 

to take on risk (so-called ‘‘fair value’’ pricing), the accounting spelled out in the Federal Credit Reform Act is designed to ensure that the Government is appropriately 

compensated for the risk it takes, based on the Government’s borrowing rate.13

Moreover, reliance on private capital to take first loss will limit Government’s 

ability in times of economic stress to ensure the continued availability of mortgage 

financing through the conforming market, which can moderate the impact on housing prices and consequently on household wealth in the event of an economic downturn.14 As we saw most recently with the housing bust and great recession, private 

capital can move quickly to withdraw from the mortgage market. New PLS originations disappeared and private mortgage insurance became close to unavailable. 

When that happened, Fannie and Freddie (along with FHA) stepped in to provide 

that essential countercyclical liquidity. Therefore, a requirement for private capital 

to be ahead of a Government guarantee will make the availability of mortgages 

backed by the Government guarantee (other than FHA) highly pro-cyclical unless 

a way can be found to dial back that requirement quickly.15 Alternatively, the Government can decide to rely just on FHA to ensure continuation of a housing market 

that functions well enough for both buyers as well as sellers.16
38 

Year 2012’’ (2012), available at http://portal.hud.gov/hudportal/documents/huddoc?id= 

F12MMIFundRepCong111612.pdf. 17The term ‘‘pass-through’’ refers to the fact that the payments made on the mortgages that 

back the security are simply passed through to the holders of the MBS in proportion to their 

investment. 18 A TBA market also exists for GNMA securities but it serves only mortgages that qualify 

under the FHA, VA, or RHS programs. 19For example, see James Vickery and Joshua Wright, ‘‘TBA Trading and Liquidity in the 

Agency MBS Market,’’ New York: Federal Reserve Bank of New York, 2013, available at http:// 

www.newyorkfed.org/research/epr/2013/exesumlvick.html. 20 No judgment is being made here as to the relative merits of a senior subordinate structure 

for the PLS market where there is no Government guarantee and no TBA market. 21This structure is even now being used by Freddie Mac for some of its multifamily MBS in 

its K-series, but it should be noted that multifamily MBS does not trade in a TBA market. 22The Government National Mortgage Association (GNMA) guarantees securities with mortgages backed by FHA or other mortgages backed by a Government agency. 23 In general, insurance companies are subject to state regulation with no Federal oversight 

bodies comparable to those that exist for banks. 

Another aspect of the current housing market that needs to be preserved is the 

To-Be-Announced (TBA) market, where Fannie and Freddie ‘‘pass-through’’ MBS 17

are traded today.18 Most observers agree that the loss of this very deep and liquid 

market, which benefits from its appeal to rate investors, would likely raise the cost 

of mortgages and jeopardize the continued availability of well-priced, longer term, 

fixed-rate mortgage products with rate locks from 30 to 90 days.19 Unless we are 

prepared to do without such a market, we should consider bringing in private, credit-risk-taking capital only if it is compatible with a well-functioning TBA market. 

For risk-sharing with a Government wrap, focus on insurance options because they 

are compatible with a TBA market 

Unfortunately, one of the private, credit-risk-sharing vehicles commonly discussed 

is incompatible with the TBA (To-Be-Announced) market and particularly with its 

ability to allow for rate locks. This option looks to structure an MBS into at least 

two tranches, one senior and one subordinate, also called A and B pieces.20 The senior (‘‘A’’) piece would retain the Government guarantee of timely payment of interest 

and principal while the ‘‘B’’ piece would be sold off to private investors who would 

stand to lose all of their investment before the GSE would take any losses.21 Mortgage payments are first distributed to the investors in the ‘‘A’’ piece, who are thereby shielded from losses that are less than or equal to the payments owed on the 

‘‘B’’ piece. In other words, shortfalls in payment from borrowers are absorbed first 

by ‘‘B’’ investors, and only if losses are in excess of what the ‘‘B’’ piece can absorb 

will the ‘‘A’’ piece suffer losses. As a result of being willing to take the first loss, 

investors in the ‘‘B’’ piece look to be paid more than those holding the ‘‘A’’ piece, 

yielding an interest-rate charge to borrowers which is a weighted average of the two 

interest rates plus other charges such as a servicing fee, etc. 

While the ‘‘A’’ piece with its Government wrap would be able to trade in TBA 

market, the ‘‘B’’ piece would not. Trading the ‘‘B’’ piece in the TBA market would 

violate SEC rules that prohibit the selling of securities where the underlying mortgages have not been identified in advance. The MBSs that Fannie and Freddie guarantee are specifically exempted from this requirement as are those guaranteed by 

GNMA.22 This means that it will not be possible to use the TBA market to price 

the ‘‘B’’ piece in advance, making it a lot harder and presumably more expensive 

for loan originators to offer borrowers a rate lock. Also, the ability to raise capital 

using this structure is highly dependent on credit rating agencies, which will have 

to assess the risk inherent in the ‘‘A’’ piece if it is to trade without a Government 

wrap and yet whose role in the crisis was significant and has yet to undergo reform. 

Instead, FHFA should focus on insurance type options for that extra layer of protection for taxpayers. Insurance can work with traditional, pass-through MBSs that, 

with a Government wrap, should be able to trade the same as Fannie and Freddie 

Mac MBS now do in a TBA market. 

There are two main types of insurance that are most often mentioned for this purpose. One type is provided through mono-line insurance companies that are in business solely to insure mortgage risk. A variant of this approach is the private mortgage insurance (PMI) business that was a response to the statutory requirement 

that Fannie and Freddie obtain third-party coverage on loans with a LTV ratio 

above 80 percent. On a number of accounts, the PMI model evidenced major shortcomings when hit by the latest housing bubble and bust. However, with changes in 

rescission rules, tighter capital-to-risk rules, and enhanced regulation and supervision at the state and Federal levels 23 it may be possible to come up with a design 
39 

24 Even with risk-sharing ahead of the Government wrap at the MBS level, requiring PMI 

might still make sense at the loan level for loans with LTV greater than 80 percent. Alternatively, a risk-sharing system could be built on a strengthened PMI model but with first-loss 

coverage much deeper than 30–35 percent. 25 CLNs have been used previously by Freddie Mac under a program called Freddie Moderns. 26 It is a separate matter if the investors themselves can absorb the losses without becoming 

insolvent or potentially creating systemic risk across a broader segment of the financial system. 

that would be acceptable to the customers of their product, e.g., Fannie and Freddie, 

and to the regulators and credit rating agencies.24

An alternative way to insure first loss would be to use credit-linked notes (CLNs)- 

a type of security which can be bought and sold in the public credit markets.25 With 

CLNs, private investors put their capital at risk by purchasing the notes. These 

CLN investors advance the full amount of the note, and these funds are held in 

trust (thus this is described as a ‘‘funded’’ insurance model).26 If a loss occurs, the 

funds go to cover the losses; if no loss occurs, the funds are returned to the CLN 

investor. In the meantime, the CLN investors receive regular payments which provide them with a return on their capital. Compared to the Senior-Sub or the traditional mortgage insurance model, this structure is more flexible as to what risks can 

be covered. Rather than covering an individual loan, or a single security, a draw 

on the CLN can be triggered by performance of a so-called ‘‘reference pool.’’ This reference pool can be as simple as the specific mortgages backing that MBS, or a 

broader group of mortgages, or a cross section of a GSE’s entire book of business, 

or other even broader economic indicators such as the unemployment rate or house 

price index. 

A key factor in the choice among these alternative forms of insurance comes down 

to the overall cost imposed on borrowers for a given amount of protection. While in 

theory, the cost of the private capital to cover a given amount of risk should be the 

same regardless of the institutional form, these two types of insurance are subject 

to very different regulatory regimes which can affect the relative costs of providing 

the coverage. Moreover, there are other differences that should also be taken into 

account such as impact on small originators, on the widespread availability of mortgages across geographies and all segments of our society, scalability, ability to modify and restructure loans, etc. 

Investors in CLNs, for example, may be more restrictive in the types of loans they 

are willing to insure and in dealing with smaller originators and originators that 

work in only a limited number of geographies. Investors in CLNs may prefer to 

work with originators that have been rated for the quality of their origination and 

servicing systems or have large, diversified pools of mortgages while insurance companies may find that working with as many originators as possible over time may 

help them diversify their risk, rather than seek to diversify one MBS at a time. At 

least in theory, though, a large enough ‘‘reference pool’’ could accomplish the same 

thing for CLNs. Insurance companies may also be more motivated and capable than 

the principals in the CLN to provide a second set of eyes to monitor the origination 

and servicing systems to minimize loss and be more flexible in allowing for loan 

modifications and refinancing. 

As for scalability, both approaches would seem to be able to scale up, assuming 

that there is sufficient private capital willing to invest in the stock of the insurance 

company or buy the CLNs. The insurance companies also have access to re-insurers 

which can add to their capacity to take on risk. For CLNs, a critical element for 

them to be able to compete effectively may be sufficient scale to provide liquidity 

for the trading of these securities. 

Test for the optimal allocation of risk-sharing versus cost to the borrower 

In addition to testing the cost and viability of different options, it is important 

to keep in mind that any incremental costs will have to be borne by borrowers. 

Since, as noted earlier, the Government does not need to charge as high a premium 

for taking on a given amount of risk as private capital requires, the higher the degree of risk-sharing, the higher the likely cost to borrowers. 

In order to sort out the tradeoff between the cost to the borrower and the degree 

of risk sharing, the Government needs to be explicit in how much to charge to buildup an appropriately sized reserve to protect itself and thus the taxpayer from having to call on tax dollars. The amount it needs to charge (and the size of the reserve 

it needs to buildup) depends on how much risk it is taking. The amount of risk, in 

turn, depends on how much it lays off on the private sector as well as the underwriting and servicing standards it sets. 

At one extreme, Government can require enough private capital to be able to absorb all expected loss with a high degree of certainty. In this case, the Government 

would only need to impose a very small charge to cover the de minimis probability 
40 

27See Toni Dechario, Patricia Mosser, Joseph Tracy, James Vickery, and Joshua Wright, ‘‘A 

Private Lender Cooperative Model for Residential Mortgage Finance’’ Staff Report No. 466 (Federal Reserve Bank of New York, 2010), available at http://www.newyorkfed.org/research/ 

stafflreports/sr466.pdf. A similar proposal has been put forth by Andy Davidson. 28The Housing Commission of the Bipartisan Policy Center has proposed that the role of 

‘‘public guarantor) be performed by GNMA or by a newly created Government entity. 

of the tail risk that it retains. Alternatively, the amount of first loss placed on the 

private capital can be limited or none at all, leaving the Government with more of 

the risk, which it can cover at lower cost than the private sector would likely be 

willing to do. 

In evaluating its risk, the Government will also need to take into account 

counterparty risk, that is, whether the insuring entity will be able to come up with 

the money it has promised. For CLNs, this issue may not arise if the notes are fully 

funded. However, once the full amount of the notes has been paid out, the Government must make up any difference. In contrast, insurance companies may be able 

to pay out more but they are regulated based on risk-to-capital which means that, 

at any point in time, there is a limit to the losses that they can cover. However, 

if desired, there is a way to structure an insurance contract similar to the protection 

provided by a CLN and that would be to set a cap on total payout, i.e., include a 

stop-loss provision. 

Insurance companies also could have more discretion to allow loans to be modified 

or refinanced if the buyers of the CLNs require highly prescriptive rules for the 

treatment of any mortgages that are in the ‘‘reference pool.’’ Similarly, insurance 

companies would seem to have more ability to rescind coverage in the case of defects 

in the origination process, but this is technically an issue of the language in the 

insurance contract requiring payment contrasted with the language in a CLN as to 

when it also must pay out. 

To determine the tradeoff between more risk-taking by the private sector and the 

cost of mortgages, it makes sense to test some different structures with varying 

amounts of risk being laid off on the private sector. The challenge in designing these 

tests will be to choose which levels of protection to test in order to get a good idea 

of the parameters of the tradeoff. To do this, it is essential for the Government to 

determine the appropriate premiums it needs to charge for different levels of residual risk. 

Ensure cost savings are passed on to borrowers 

Regardless of the final structure chosen, it is critical to ensure that the borrower 

benefits from the lower cost of funds made possible by the Government wrap. Many 

have argued that the duopoly of Fannie and Freddie allowed them to capture for 

their shareholders and senior management excess profits that limited the benefit of 

the implicit Government guarantee from flowing to borrowers. Going forward, this 

means that all the players—from the originators to the servicers to the securitizers 

to the private, credit-risk-sharers (if there are any)—provide their services based on 

a competitive price. If any of these markets lack sufficient competition, then it will 

be essential for Government to intercede in some way to prevent monopoly like profits at the expense of the borrower. One proposal that has been put forth to deal with 

this possibility is set up a cooperative to securitize the MBSs and retain first-lost 

risk with the originators putting up the capital and being themselves members.27

I leave it to others to identify other alternatives that would also help ensure the 

savings are passed on to borrowers. 

Transition 

Separate out the provision of the Government wrap from Fannie and Freddie for 

‘‘conforming’’ MBS and re-launch Fannie and Freddie without any Government 

guarantee, either implicit or explicit 

Once a determination is made as to the degree of risk-sharing that it considers 

optimal (that share could be zero), the provision of the Government wrap can be 

moved to another entity such as the Government National Mortgage Association 

(GNMA/Ginnie Mae).28 The remaining functions in Fannie and Freddie could then 

continue in a new legal entity or entities. New entrants should also be allowed, if 

not encouraged, to compete with the successors to Fannie and Freddie in 

securitizing mortgages. 

Coordinate any changes with attention to the role of FHA and the single 

securitization platform being developed by FHFA 

While this hearing does not directly concern what role the Federal Housing Administration (FHA) should play in a reformed housing finance system, it is worth 
41 

29 U.S. Department of Housing and Urban Development, ‘‘Annual Report to Congress Regarding the Financial Status of the FHA Mutual Mortgage Insurance Fund Fiscal Year 2012’’ (2012), 

available at http://portal.hud.gov/hudportal/documents/huddoc?id=F12MMIFundRepCong 

111612.pdf. 

noting why its continuation is important and, in particular, what changes should 

be made now to enhance its ability to protect both taxpayers and future borrowers 

from being exposed to unnecessary risk. FHA has three roles to play: First, FHA 

needs to ensure that all those who can sustain home ownership have access to reasonably priced long-term, fixed-rate mortgages. Second, FHA needs to prevent the 

collapse of local, regional, or national housing markets when the private sector pulls 

back from offering mortgages. Third, FHA needs to promote innovation by piloting 

new products and underwriting and servicing practices. 

All three roles are important, but the provision of countercyclical support to the 

new mortgage market is probably most relevant to this hearing. If it is concluded 

that private capital should be brought in ahead of the Government wrap and if 

there is no mechanism devised to dial it back in the face of a withdrawal of private 

capital has withdrawn, then it is essential to preserve FHA’s ability to scale up even 

more than it did during the most recent fall in housing prices and the great recession. Even with Fannie and Freddie still originating loans (although with limited 

support from the PMI industry to do loans with LTV’s in excess of 80 percent), FHA 

alone provided as much as 40 percent of mortgages for home purchase with over 

70 percent of these loans going to first time home buyers.29

It is worth noting that FHA also needs to pull back from the jumbo market. As 

part of the response to the fall in house prices and the financial crisis, the FHA 

was permitted to dramatically increase the size of loans that it could offer. With the 

stabilization of the housing market and the desire to crowd in private capital to the 

jumbo market, the loan limit for FHA should be lowered to $417,000 if not to the 

lower levels that prevailed earlier. 

Impact of a single securitization platform 

FHFA has announced plans to develop a single securitization platform to replace 

the back office functions of the Agencies. While its creation will not necessarily inhibit the ability to implement the steps outlined above, it might be just as easy, if 

not easier, to modify existing systems to accommodate the necessary changes. As 

originally announced, the plans for this platform were very ambitious, especially 

given the intention to design it with sufficient flexibility to accommodate the wide 

variety of originators and originating platforms beyond those of Fannie/Freddie. 

However, regardless of how flexible and all inclusive the final product, it needs to 

incorporate the possibility of providing first-loss protection either directly or through 

third-party entities. 

Conclusion 

In exploring how to bring more private capital into the housing finance system, 

there are a number of steps that FHFA should undertake. One path is to restore 

private capital’s historic role in the financing of the mortgages bigger than $417,000. 

This should be able to be done in a straightforward matter, once regulatory uncertainties are resolved, by raising the g-fee until the private sector takes over that 

part of the market. With actual information on the cost of and product mix of loans 

being offered in the jumbo market, we will be better able to evaluate the benefits 

of having a Government guarantee supporting MBSs in a conforming market. Many 

housing market experts worry about loss of a TBA market and of a well-price, fixedrate mortgage with 15 and 30 year maturities. By taking one step at a time, we 

will be able to see for ourselves if lowering loan limits further will limit access and 

affordability of mortgages. By doing it in stages, it will be possible to prevent unnecessarily harming the bulk of the housing market. 

Given the skepticism that a purely private mortgage market would work well for 

the vast bulk of the housing market (save for the portion served by FHA), FHFA 

should also continue to pursue its exploration of the cost and structure for requiring 

private capital to take first loss ahead of a Government guarantee. By test-driving 

different approaches, we will be better able to weigh the costs and benefits of having 

private capital take more of the risk and avoid unnecessarily disrupting the availability and affordability of new mortgages. 
42 

. ..... ANDREW 

AVIDSON 

&CD 

Slnlemcnl of Andr~1l' [}.Il;dson 

President. Andrew Davidson & Co .. In,;. 

before the 

Unil~d Stales Senate COlllmiUee 00 Banking, Housing and Urban Affairs 

Subc()!II'nince on Securities, insurance. and lill'cslmenl 

"Returning Private Capital to the Mortgage arkc\s: 

A Fundamental fOf Housing Fin:ll1<;e Refom .. · 

May 14, 2013 

'\,KI,"", D:nidliOn & (0., In •. 

",,-.. •• <1-1'0,<0'" 

65 Dlmk .. 51 ..... 1. Hflh Hoor 

,"'''-" .... 11. N\' loo n 

211.! H'11I~ 

I\ m .274.0St5 
43 

Page 2 

" Ir. ChMinnan and M~mbrr.l ufth Sub.,tmuniul'\': 

Thank you 10.. llil" lIppClrtlulit y ltl dist"USl; rd uming pr,,"alc .::tpltal 10 the 1l1<\f1!:"t<' 

mln:~ts. Pril'alu capilDI ll \'~~tme1ll1n thc mongage man:d can be bifur.:a1cd inlo Rate " 

ln1'eMingand ''Credie inl'esting. RlltS IIlI'<!stOrll bear interes.t rnlC ri.k aud pr'<! pa}m~nl nsk. bIn 

generullyseek to a,'oid CT~dil riSk. PriV:lte capital R.3tes irl WStOOl pNI'ide trillions of dil!lur.110 

tbe mortgage bao:ked se,;uritic~ mari.:"ct through il\".:shnenl~ in MRS guarnnlt:\:d by I'annie ,\Iac, 

Freddie " lac and Ginnie ~lac. nlis compl)llCllt of the market ll.~ ~rfonniX! ~~Mllcly\\"elt 

through the linancial cri~ ~. Prior 10 the 1."Ti~i~. thcl\! was a!.a a significant amount af R,lks 

in""Sling through tl){".lripk·A """lor of the pri\'al~·I~bel mongag.: mar!;.>!. This SI.'ctor ha._ 

Credit inl'eSlon> takeOll theri~k ol'nOl receil'ingfult and timely paymo:!ll ofprincipallilid 

illt e~~t, g.:nemlty due lo!h.:. inability or !lnwiilingness or tile borrower 10 make p~)1nCI11 5 and Ihe 

illu\kquacy ofMlI akrallO} CQI',:r Ihe d~b . I'r;(lt 10 Ihe cri~i~, private ~apil~J prol'i&d fund~ fill" 

Credit in\"C:~lin.g through R \'ari~lyofl'chidc5 illChlding inl'cstmcnt in Gowmmmt Spoll~ortd 

Ibe GSE'..I; and Il ~ol1lp3ni~ ,,"as wiped out. IItld 1110' GS& W~~ pl~~d in ~<l~rI·alor.;.h ip , Tho 

mortgage markt1110W prim.rily re li llS (m lhe US GOWl1Intcnt !>ewing the l.T~di t risk of newly 

originated mortgages vi. FilA guarllnt~e$ alld T~as ry's pr~f<'ll'<!d od .. in ve>;tnllml in Ihe 

GSu. 

While il iii gem.".lly ,,"clilinoll'n Ibalthere is signilicanl amolltll uf privale capilal in 

Ralcs inl'esting ill gllllranlL..::d MBS. it is less wdl known tbatlhere iii slill a significanl amount of 

Cr.:dit inI'Csling Ul the pri,·alc.tabel lllOrtgage Olarl..~1. ortb. approximately S2.2 tritti\lll dollars 

,\"",..... Ih"'ici,on':' Co .. Inc. 

.... W.od ·' .... Olh 

6~ lilt ...... i>t ... I. Hf111 n ... r ,'Or .. ' \'ork.:"\, IOOt2 hI21l.l7ul17S 

~·. 2,17U .. ~5 
44 

Pag~ 3 

ofpri'·al c·label ong:lg~~ al Ihe peak oflhe market, Ihere is still approximatel y $900 billion of 

to I:",dil risks and do 1101 med Ih~ hi hc.~ 1 CTooil IBlldard::; . As!;uming lin a"~r1Ige price of7j. 

ther.! is over St'iO() billion currentl y inl'csled pri" ale -label sccuriti~'S that bear ~TCdit risk ~luch or 

that invcstment W:IlI uMnti"ip:ued, a.~ i')I'cstmcnlJ! Ihat "'ere though! to be low risk !umed Out 10 

have iJ.!ell bo ugh! hy C~dit il1l'<'Stors se eking to invest opponunistically. Duc 10 the size of 

e"~LLre the market hali dewlopi:d Ihe anal}1ical .md inI'Cstrncnt illfraslrWltrre til mlUlagt lhis 

risk. 

bl e: MmJor rom.s ofln,'estmenl In the mortgagr market 

<r.~' ind,tMes 'lI !trl«'l~ "hid." ~"" "" eJ'<.j, dlrnilli hed II, IIr c ri~j } 

RATES CREDIT 

GSE(Fallllic, Oll\'emment C'J\raraulec f"u",r31e (iuaflllllcl 

Freddie) TI1AJMBS GSI "<1",t\ 

1m Cllu;tv 

Pril':rte·Label (nOli' \o":!lo~!il!lm(1!1 CQllntera!i'oo !o!dit 

agenc y) Qnur:vll<' .. nh,,"c~m nt 

'\."S'~";I>' Subordin~ ed 

Credit·liuked nOh:~ 

Today, there is a substrutlial amount of oontilluing and n~'w Rftlcs invcstment in tho GSE 

1110I1gag.: market, bllllilt!~ Credit inl'cslmcul. COll\'mlCly, there is subSL1nti:1I ntillu;n gal1d 

new Credit inwstment in the pri l'R -lab 1 martel. but li1l1 ~ Rates irwcstmen1. [nihil; ligh!. thc 

goa l of n:!1Iruing pril'U1c capital to the mort ug~ market can b~ thought of as two SCpllT:ltc 

problems. 

1. Relum privat~ cupi1alto Rat~s" in\'~slin g in !he private_label "mngag~ m3ri;cl 

,\n<I"'M tb,'\,".,,, & Cu., t,, ~. 

M .. "..~ .. ·cu.'''nl 

105 UkKMr Slrf'~ Ftm, Hoot 

NOM "<~,,,,\' l()Dll 

'r(lllUTUOi$ 

h. ZlUT4.0$.l$ 
45 

2. R~ um pri\"a1~ carital to "Credit" inw!'ting in the OSE moctgsge malket. 

Rotes inwsting in the printe-Iabcl markCl geller.llly refers to tl ~ Illosl senior or highest 

rated d:l8S.:s of private-label s~~",iti ~s . Whil" there W:IS approximately 52 lrilliotl of AAA bonds 

allhe peal.: oflhe pril'ute-I:tbe! market. fi..'PreS(nting abmu 20% of all mortgsges. il is import:ml 

10 recognize tllallhis may nOI hav~ been as significant as;1 8C<.'Il1S. ASIiMtanlial portion orlhe'S.! 

bort d~ wac held by f.lImic Mae. F~die Muc IlI1d Home Lo~n &loks and tlms werc 00111\11)' 

pri"a1C capital al' the h"ldings lI'ero.sllpporud by j~Surulce ofGSE lIebt. In Bdditi"n, a ~ignifi~a nl 

portion of the pri\"&te·I~1 se-nior bonds WCfe flooting rale notes Bnd i11cref()l"c did n01 support 

fixed-Tale tnOf1g.lges. 

O,,'enlhe lrem<.11dous regulalQ1)" lUlcertainly sUlTOunding pri\".1\e-Iabcll!t'~\lritizali'-'11 , it is 

lIolli~ly thai there will he significant growtb in this se.10r in tile near Illiure. nor is il likelylhat 

i1li~ se.::llu would prtJl'ide a s\lbl<l ~oun:e offin;mcing for the bulk ofille mortgage mnr~~ ul1d~ 

even the b<.'St of circum&tanc.:s. l'w;t history indicates thaI in timcs ofs(m;s Ihis marl~t 

~iglli icanlly IUld~rpcrfomlS Ihe gtlaranteed nHlrket fur Ral<'l> ;nI·esUllenlS. 

f'ri.-ale Capital rur the GSE martd 

for the rel1laindcroftll!S s\,ltcmcnl, I will 00l1ccntrnte ol1lhe scoond flow: fi..'"\uming 

private ~apjtJIIO CmJit invc:sting in Ihe OSE market and tilt instituliOllill structures necc!oSary 10 

sur-pon lhllS<' !1o\\"~. To begin Ihi~ dis~us,i011 il is Ilseful to understand Ih~ antQUI11 of capitallh31 

i~ fi..""<iuin .. d 10 bear the credit ri,1; oflhe GS£ llHIn.et. 111m: arc currently UOOUI SIO lrilliOI1 

dolbrs QfmonS"S~. "ut~I""di lS- Fannie M~" and Freddie I...lac ourrent!y b""rlh~ credit risk of 

.lmOSI 50% orlhose ().1n~ and issu.:-. abCHd SI ttiJ]jou " fne'" !)Iort gag~ cnm",it1l) nL" ~u"h yeUJ. 

One si111plc way of assessing the amOlUll of apiulll~l-d ed il; to look al hank capilal 

,\NJrt\> ll., kiJol' & C"., Int. 

". .. · ..... 11-''' ...... 65 .HIott!; .. $1 ... 1. Frflh l·l ooT 

1" .... \'QT1<, ,\Y \(1\1n 

T.; 11l.174.91t15 

.~2IUH.O'~S 
46 

f~'1uiJO!men!~ . If!hc~~ luaus weru held by illSllred dC'()Qsi10riel\, ri l·b~d eapi!:!l wlluld ~ about 

4'h. 111~ ~UIT~nl (lQI1folio ofl();U1S wuuld ~uire L-api!:!l or aooul $200 billion. OIl an :1l11lltal 

b;u;is. lhe OS!': guamulccs would be cn~raling aboul $40 billion of capilal JO!quir..'lIcm :lIlhc 4% 

level. lkc~usc Ih is mlluunl is less Ih"n Ih~ sCI'cnd humiJO!d billion dollars uf capilal1l13t 

clllTcnllybe'U'lllhc credil ri,;k urlhe kga;;y pril II~-la~1 mortgages, il is highly lik.::ly Ihal capital 

could be ;,l1rJL'tcd 10 this markel gjwlIlllc right mL'Clmni ms and the appropriate pricing. 

Prior III eon8en'at<)li;hir, GSEs slmrdlOldcl"1l bore Ihis cr~dit rig!.:. 1l00,cwr, the GSEs 

were only T(qulred to hold45 ba.>i~ points or 0.45°" minimum capilnl for lhdr offbalaucc 5hect 

credil posur'" Iflh~ (;S~ had hccn requin:d 10 hold 11ION CJpilal or filr.: ... d \0 take OIl 'S.~ 

risk, they would 1101 hal'<' d~plet~d their ~apilal. Yd tile nature oflhe GSEs was to I.'O/\\inu:llly 

h<!meoll'lk'nhip." II I\:lr osp~ct, il is dear thl insu01dcnl eapitalr.:!iUllc'd in a seWT<' bul'tkl1 for 

taxpay,-rs, Due 10 Ihis eXp"ricn~. tBxpaycrs are reluctant 10 sup!'on a s~'S ttll1lhal rcca]lit;l.lize~ 

Dt>1t'1'fl!ining t"~ Amou.!1 uf Capilal ? 

Whcn pri\ al~ ~dpil81 is U.'Icd 10 prol~ 1 the gllvcmmcnl from losseS'. the ris\; to Ih~ 

taxpa~\'f uecreases as tht fJuillilyofthe IO"l! ~ increasd and as th~ amonnl ofpril':lt<! ~apitnl 

incrc:l.<es. Bcuuse the risk to th~ govcnnncnl gnaranlor de~ ..... as~s as the amount ofpri\'ate 

capit~1 in~re~scs. it is imponantlo s.."1 appropriruc 1evds of cr.:dil enlJ..1n,tmcnt. A fnunc"",,rk 

for as ~~i ll g the mnOUI)\ of capital rcquirt:d is hl assess the amount of los8 al dilTcrcnll~wls of 

prob:lbilityor under dirr~r.:nl .$.~ scenarios. The ligurcbcl<)\\' illuSIr.lles IheS(.' relatiOl\ hi~ . 

Ih~ red line ows the losses on a pool ufmongago!s under incT....sing lr~ ,~ scenarius. l11e 

find ...... I).'·; ..... n & Co" In<. 

.. .,..,. ~d .... <~m 

,~rn.t< <r I .... (, F"-I~ ~lOl1r 

N~..- , 'ork, ..,,' toon 'r.t212,1?U075 

1' .. 112.274.0545 
47 

Pag.: 6 

gre~n area shows th~ prohability "fthose s~rtal"ios. TIle bluc lin ~ is the Slun of the probabilities 

for each scenario combined with the prob.~bilit )'o flhc scenarios wilh higher loss.:s than that 

scenario. This chan indicates that credit cnJUlllc<:mcnt of ",,0. would prol'idc proh!Clion fOf 

99.3" .. of 1I11 11C~ na ios . In the most adn-rse scenario shown in till' chart the government WQuid 

pay 3% of th~ loan amount Modest II'r.lp f~ 1I'0uid cover tll<)se ()S.~cs 01·C'T JOllg cycles as the 

probability of loss is very low. A wrap I~~ of3 basis p-<>ints per rear would be mor~ thM 

ndeql~11C 10 covcrlh~ los •. (30;' loss x 0.5% probahility " 0. 15% lik'limc lo~ s. and ().15 o life 

lime 1051 divided by 5-Y~llT life - 0.03°. or J basis pointli per year.) 

Risk orJ.mm t o!<ll and Rf<! uirro ~djt Enh u IICf mfll\ 

• .. ,. ~ 

- " 

I'· - r: .• 

.• .• 

Higher 

subordination 

reduces the 

risko! 

triggering 

government 

guarantee. \.. , .. ... ;!· ... .,".~ ",~·, Fi, 

---_ ....... , ---- _ ...-"--

AnQlher way to asSes, lhe amount of '-'fedit cnh:l.J1cenwnt !"I>ljuir<-d is 10 oo~ utthc 

hislOrical perfoonanc~ of the lo.1ns gu31":\11\Ced by Fallilie lI[ac and Freddie IIla~. [t is rlOle\\"onhy 

Ihallll1' OSE.<; oombincd dr.twon Ihe Tr~a5ury \VIIS under S200 billion. This amount represents 

less than 4% ofthcir combined guardlltec portfolio. In uddilioll. many orthe losses "-e"" from 

l<lwor no doo::llmclllatillll loans thai ~hou d ~ilher IN sewrdy coru;trnincd <»"prohibiled in 

guarnnteed ~IBS . 

And ....... O,,'j,bon & Co.,ln •. 

....... _<o'" 

!i5 tllo.rk .. S. .... 1, FIfth .,...,.. 

....w rorl;,:~\ OOn 

r.t 1t I.l'~..907~ 

~ .• , 112.l' .0!'4~ 
48 

Page 7 

Freddie " loc re....... ntl y released ddailed 10:111 level credit perfOllnanCil data on it$ fultydocumented, rully-mnorlizing. 3O-ycar, lixcd·r.tlc nmrtgugcs. '111~ ""rfonnan"c oftlu:sc loam; 

through the crisis should provide an indication of the amOlall of cn:dil enhancement required 10 

prote.::t a go\ errun~n1 guaranlor trom IQ!1Scs. ·lbis data was sllllunari7.cd in a r~pl)l1 by Laurie 

GoOOm3n of Amherst Securiti c;;.t 11le 2001 cohort of loans has the worst pcrfonnruwc and 

~peri~lIocd an 11.1% default rat~, when measured as 180 days delinquent. ( .. \ssuming a 30% 

S~\ eri , llial wonJd lJll.nslatc inlo a 3,3~" loss, at 4(l'!'O Sl.",~rit)', a 4.4~" loss.} In addilion. 

Ck>odlHan shows thai there is significant variation on default rates by fICO Ilnd LTV 

Ch:lr:lcleristiQl. 

Any guarantee progr.Ull will need to establish ~ rJnge ufacc.::ptat>lc loan charnCleristics 

1m- guarnn1~ro Sl'Cllriti~ and an llpproprialc kvel of credit enh:ulccmcnl based upon Ihe 

char,\c eri~ ti Cj; oflhe "all~ . Even ut\~ a rJl1g~ or 3l1owab!c loan characteristics i. dc'k'Tmined. 

origination and underwriling processes are scpar,\led front the in\'\."Slmem function. 

It is essenlial 10 have ronlraClual mechanisms 10 ensure thai the und"rwril~rs have 

pr~rly ~soo Ih~ qll~lity or th~ underwriling infonllution :IIld ~fe held re>;po.>rIsible for the 

aCC llrJCY of Ihe infQllllat;OI\ they provide. [n Ihal f<lSpeL1, l/u: cllrrenl r.!preselllatiOll Md warranty 

process is nawoo both in con"'"'pt and in execution. ~\ gcn.-m1. il would be b.:uer 10 mow from a 

process Ihal1cads to cll llrc.....,t~ nt ofrcpresclllllliotls and wllmml;cs upon default 10 ol1e Ihal 

foctlses 011 valid1tion !lIthe incq>tillnllfthc 10011. [n addition. a se t or~uall ics for delivering 

nawcd 101llis would be more ~fte.:ti\ c th ltll the ClIrrenl method of fepurch:tS~ feq"~~ts. 

' I..uno GooJm~n OIl at. AIlIherot M<Kli;ag.l .... ghl. "A 1'"", LooI; 01 Freddi", Newl.<!an t...,.el CrC<l,\ Pr,rorm~ 

Data. MovclJ 25, .wl3 

And",,,· !la,ill.on" Co., \Il<. 

,,",,',," .• d -(I>.<onl 

65 11I<<<Mc S. ... l •• ,1110 ~l,",r 

I'i .~ 1'Or"- NY won T. lll.nJ.!I07~ 

t· .. , Ul.n~.I)S.j!O 
49 

Page 8 

hlll)~ thc C<l~ '! 

Pril'ale .::tpim) .'OIt1~'S at 3 coot, 'Ill private illl'OlSIQr.; d..~n~nd returns o:QIllmI.'OS U"'JI~ with 

the level ofri:!k th.:y bi:ar, AndNw Davidsurl & Co, has perfonn,-d $ev~T31 ~nal)'S<lS ofth~ cost 

of pril'ate ':.1.pitul. including a study f<)T th<l Bipartisi:l!l Policy C"lller's HOllsing Commission.! In 

our r~port we slat<,d: 

~dit cost~ I'll!')' ~ignificantl y b~d on OOTnllwr c .... -dil s~"()r~ (FICO) and L1V rnt;QS. 

for~x:tmple, the ~T~dit oost for loons with PICO gr .. ~ter thaI! DO and LTV below 80% 

would ~ l;:-ss than 25 ba.~ s poinlS a yeM. while the t'rt!di\ C()!;t r<lr loans with f iCO below 

700 and LTV gr~al~r thall 9O~ o W(Jllld be nl01'<' than 10 tim~s high~r and ~~..,c d 250 ba~is 

points a ),"3r. Polic), decision. to widen 01'" nalTOW Ihe ~dit bo.~" could haw a gn>al 

impact 1)]1 the T<"quired An]1ual Credit C()!;I). 111': r~~u lt, h~re IL.<SUm~ modcst home pri~c 

appr~ciatiou in the bas.: .:as", consistent with IQng term inC<)lt1c b'Tt)l\lh, However, dUTiug 

p..'fiods offalling h0111~ prices or greater market wlcenaimy. the marl.:i:l price for credit 

guarantees would Ix: higher. 

Usiog similllT methods we fourKI that the ,1I111U:\\ credit cost associutcd wi1h 11ll.: 100l1S 

~Itm"ntly OrigiM\~d by th~ Fr~ddie Mue would be abOllt 30 10 35 ba~iii points lind that 

~ubord in ut n J.:wls of 6~" would protect the gO\'cnnucnl guarantQf from losses III ihe O.S~. 

p...m~bility ltvd In ~dditioo 10 the IInlluIII ~ri!dit cost ofJO to 35 Inl!ii~ points thac would he 

additional operational cqsts of perhaps 6 to 8 b1lSis points. The gownnuent gllnralHor ~ho{l ld 

also charga a ti!e fqr its IH~p. !I"tlta~ fee 1\"l!rC 5 to IU b.'I.<is poinl~. Ille owrall required guar:111tcc 

j~'e would be" I to D bDS;S pornlll. Such n ICl'd is high~r than tile gU;Jfante.: f~'I$ th al tltc GSEs 

charged hil;!orieally, b,u .:ousistcnt wilh their cumml I~ vel . 

While sc~~ing to bring in new c!tpit31 and nell' fonns of capil"llo redllc~ tha ri~k 10 

axpa~'~rl' frum future I[)ss~s on mOl1gag~. it is imp<:lr1Unlthal the new ~tl\l~ ture s do not interfere 

And .. ,,· 1I~,id ... " "" C'.,ln •. 

.. ",. ~d «""m 

M m ••• ~<r 51 ...... 1. nfU, Floor N.,. y",1<, NY tOOI1 htlll.l1U015 'a l 211 17~.~5 
50 

Pag~ 9 

Ih .:- rkcl 's ub ilily to atlract Rales im'cslolS 10 provide for Ih ~ lrillions rd 1! ~n; offunding 

Cll!Teluiy provided by aSE mortgage b~ d ~e"lI ri li <:~ . All illlpo"8m componc11l oflh t 

tremendous $UCC~S$ in ul'"..c ill g at s il1 stof!i to (JSE MBS is th ~ TBA ark~t. ~ Wal; the 

~~ bje.: t of ru lh er hemin!> of this c."lmmillCc 011 August 3, 20 11.) Al thai hc:lri~ S I SlIid Ihal Ihe 

sli ocess or lh" TOA mnrket Wilt; re lnted 10 four faclors. 

l. Government Guanmlce 

2. Slaud3Tdi1.uli,)n ofLoanslPools fmm GSEs 

3 ,\ larkel Slanw.ds from SIFMA 

4. Conlidi'11l"e arisin g from long hisl(lry of markel d.:\"~ (}J'l ~nl 

Chauga; 10 the TSA market a!feeling allY oflhesc could be delrimffilal to Ihe liquidit y 31td 

SI1 c.::CSS oflhe mo.rkct. In par!i~ul"', I belie"e Ihnl propt>sais that aliol"' ll1ultiple ~~ CJS olf 

molrtgage backed securities and eliminate Ihe go"emment U1lT~nl ee an: unlikely \() allrnellhe 

c.::css~ry l"o luJ11< olf Rat~'S inl"cslol"l' 10 Ihe TnA marKet. Such up roac ~ cOI!ld n::SIIII in SCI',!,-,: 

di l1Ipli s 10 f""dillg for mortgag~s during periods ofSlre~s . Even prupos.1.ls Ih31 m3inl:!in the 

o\'~:m lU nl ""W'l~e bUI SUbslantiall y alter Ihe fu"cliol1 ing oflhe TBA 111 rk I my not produl"\! 

a e. 'lu d mm..et, 

C"l"JIomt" uanll1' c~s and C .. llall'mllzt'd C ...... h Enhanct'lI1 l'1 lt 

As pan or any GSF. n::fonll. I "I e ('ongn:ss shQuld ro11lin ~ the \ISC of a go" "T111ncnt 

guam,,", .. to sllppon Ihe lrodin£ of MBS, buI should shidd ta I"' Ycrs from Ihe risk ofm,dil 

, Slau!menl of Andn:w Dav,dinn, US Scm!. 1JenkJ"lI Comm,u,"" "E'xarn uung w n"",,"Il Finar.or SysIcm The 

To.Jk..Ann<!w>o • .:I Mmkot," AajI, .... 3, 201 t 

A"" .... I) ".it4<1 ~ &. l: .... In •. 

"" .... ~d .......... PI 

r;s III .. <I«. SI . .. I, " it'll, Floor 

1' ... '~ rl<. ,,\, \11(I1l 

·l'<llL2.1R?O')S 

o~lt2.17 .~.j $ 
51 

Page 10 

lossC'!! by uli1izing privale capilall0 bear lhe credil risk orlhe IUldcrlyinl!. loall ~, ~ Gcm,'f"JlIylhis 

cr..od it <'III18ncemellt can be providro ~ilh er a~ a corporate guarant ~e based upall th ~ ClIpilllloflhe 

~"I;ty providing the gllarantw or as a colluternlized credit clihanccm,, 11 "ith perfomlanc~ 

Ul'J1ort~d by sp~~"fic as~ts or cash . .s EXllmples of COrp<:lrlllC guarlll1tees ar~ the GSF: credit 

gllaranwes 011 .\IUS and 11 11 guaran1~cs. Tn~c guaralll~.:s Ikpcnd primarily oilihe financial 

capacity afme irl!<"r~r as the pa)lIICIiI fo.-!h~ guanmlee comes lrom CQfjlOnue fund~. 

Examples ofcollatcra!izcd credit el1h:Ulc.!IIl~"11 include s.miorlsuiKJI\linated SIIUCilltCS and 

crcdil,linkcd nOles. "iliis fonll of credil ~nIIlUlc.:merll , which is also sometimes called "funded" 

c",(lit crrhallc<:rncnl, dcpcnd~ I'rimonl)' .", th~ pcnonnancc orlbe undcrlyillg loans ",!ali"'f Ii;> the 

~mOIlI1l of credil enh:\lIcclll~ lI t. The }illl amount ofpol~ntiall osses 10 Ihe gtmrnntor is fund.."tl in 

ad"ance; f.';CCSS cash flow nol r~luircd 10 co,'cr losscs ~ relUnted !o the invcslor owr time. 

Interestingly. l1ome 1..o3n BanI.: ad,·anc<l.';, ()I)e of 111( m<.lSl sl.1ble$otll"Ccs offundin g through Ihe 

financial crisis. bcuefited from both corpornlc guaranlces and collalcralization. 

'Ill e ~orpor.u~ guarnmec appro.1ch oflO!rs the benefil Ihallhcn:. can ~ flexible U1ilizJtion 

or~"I'hai o CO\ ~'f llmoy pot~01i31 ris};" !I is al o lrequ~nlly artuc'<lthal iflhe corpora'" 

ranl C~ i~ from a monolioe company. lh~ro will bc a continuolls supply of capilal 10 the marht 

since the C;lp;l8! cannot be redeployed to <Jlh~rmarkcts. Corpor~lc unr.ulh,"'C~ a! ~o aUow for 

,'ery flll.~ib!e contr3ct~ ,md the potellLial for reneg<llilllitln conlr'Jt.1S in periods of stress .. 

• In Fcbruary 201::' Andrew [Joyods:>n S: Co "l""'sored 8 rOU1<ltable di"" .... ron on the """ of nsl< !iharing rortht: mm. A ."",mory "r.he ",c""'11 con b<. fC<JRd " •. 

hnpJ/www od.m.rom'aMJyllcs_ doa.IOSliJ::rcdilStr.nngRoondIable ~ S\lIllmary pdf 

'In ....... ch thI. P""I Tm.r.da), 10 !he F<"kralJko;orvc Bank. oCQ>,ORgU Bank Structure Coof."",,,,,. FlIF A Drrector 

EdDtMarco Ib""o:;sed .. muor """""pta U1d .. criblJlg""·I ........ Basod Appoach·and. "StOlll1tlts BOISld 

AJlIYORCh· 10 llIiliW\l,pn vate cap,tal 

And ..... ' l)a,'k1""" & ell-, I",. 

.... ·w .• d·<U.< .. m 

liS 1l1 ... lo<cSIr .. r, nrlh . '1001" 

,'.w Vltck. NY HH)1l 

T.t ZIU U.'!'OiS 

F .. 2.17 ·Q ~~ 
52 

P~ge II 

Collaleralizcd credit enhancement offen th~ bend;t thaI th r( is no ne<:d to 1I10nitor th ~ 

I'iubilil}, rth~ cOIl1p.,ny prQviding Ihe uaranl~e to 3sseO!.S the Slren!,'lh orlhe u~r ntel!. ·ille 

lr~l\gth of the guaranlee is nllined ~o!1lpkldy by Ih~ :11110 U111 of "",,cess coll:1leI""JI or cash 

UPP rt;l1 g th~ guaranlee. Givel1lhe diffil1.llIy QfmonilQr;ng corrQrate balance sheets. il is 

surprising that most rcgulntion of guaTlllltecs in the fiunncial sector has ~n in th~ foml .1 f 

orp()r,ll~ guamntc<!j;: both thc FDIC and FHF A monitor the udequacy oflh .. n: \llnt~d fimls' 

ca 1 to cowr Ihe ri ~k. 

BollI corpnrate guar:ul1ees and collmcrali zed .,.edit enlmnC~111~1l1 clIn I>e ~ccuriti zcd and 

tr~nsr m.d to ditl"rent own",." . The securitized limn d COrpordtc guar:lIIlee ~ is Ihe e'lllil~· orthe 

guarantor. Such equity, howe ver, provides lillie tr~n parcl\c y into the value of the guar8ntcc s. 

During periods of stress. il II1lly be extremely difficult for the company to nlil; .. new equily as th~ 

IlllCert" in valli e of the <,,,i, ting oblig<ltions t3illt the new bllSin<lSS. TIle securitized fonn of 

llot rnli ~d credit enhanc.:menl is a boml Utat eon be tmded. This facilitat es liquidity alld 

trdn~parenc , even in distres""d mari<l1$, ill! new 'n.-e.t",!:nl is clearly ""p:rrated frolll prior 

dislI\."'Sscd bonds. 

·l1lC two SlructUTC8 also have tmdw lfs intcnlls of cos\. Corpor~t~ guardlllecs allow the 

gu~ranlor 10 spread capil~l over "'"hiple obligalions and maintain control ofth-cir as>; ~l . 'l1,cso 

gunr mt~'i:S , however. are usuall y hacked by high-C<>$t L"()uity. The in\'e~ tor ill ;1 collaunllizcd 

~redit f nhance1ll~llt ~cllril y do;:s 110t haw tOntrol lh ~ IS"~ IS uscd as l1ate-ra1 and often U'il$'" 

assd s call be ill \' d in oilly high -qu.ality a.~5e s with ow r retufTlS. Collatera)iu d cl"I.'tIil 

~"'Ihallccnw , how<:vcr, can Ix: strul1U1-.ld into b"nd.~ of \"uryillg credit mJ.: and then:forc ll'1\~ 

lower e(lSt pricing oflllc \\"~t risk portions of the support . Delllite these dill"'1"<!1l ees. Illthe ot)', 

Si111illl/" leve ls ofsnpport should have similar ro~ . In pT3i:l.ice. reguliltion can crente vcry 

,\ nd"w 1)3,·1<1><.1" &. Co., In(, 

,..,,·,...ad--t<LC<l 1M Ii~ rn ... "ktr St ... t, '"fII, '·lOCl" 

i"'" ' ''rl<,N' ' t llOll 

l.l7 .,9tI7~ 

F,, ~2\ U7J.O~ S 
53 

Page 12 

lT~~nl k vd g ofsuptKlrt (and th"r ro ~ ~"OS ) "'" wa.< th ~ cas" with the w",~asonahl y low capital 

requirement fOr the GSEs. 

Colinle.rulized Credit E"Io:lI1 ce",e"l: ..... nlorlSu bordhl3le a nd ~dll Linli(·d NOlrs 

Seniur/Suoordinaled Slmctllr,;,s :md Credit-Linked Notes hal'e been discussed M 

11l Challi ", s to deiiver private capital to bear ~ """dil risk of OSE MBS. From a bro..d 

CC<Jnomic perspective the two arc very similar. HowevC"l". due to $lIootantiaily dilT~""'11t 

regulatory treatment. th~'I"e is substanlial dilTe""'11Ce in their implcmcntalion. The main 

difrer",necs hetw",en these, and other similar SlnK111fCS, arc related to opcr:ttionaL legaL tll';>; and 

aCCOIQltiug SS llC .~ , All ~N·uriti 7 . .;uiol1 transaC1 icms r~ resent a particular pathway th ro ugh ~ 

thicket of regula lion s. In Ihc case ofUle GS\<: private capital transactions. the thick t has been 

dillicull 10 navigate. 

Srhenllllic of II Sen;orlSuboniinalNi Tr. ... s:oc1i .. n ... llh Go.-em"'l""nl Wrnp~d Senior n .. nd 

• c 

3 

i 

"Insured" joss amount is fully funded by the 

subordinate securities 

f or ~alllp l<-. ~!1iOl" lIbordi!1 :lli d tnlCtllr~ s allow inl'<:stment by -a "'i<le ll g~ offin115 

and are protected from lax31ion altitc tru 1 l~ cl by ~HC mles. However, the lise of 

,\ 1111,...,. ~"1dw11 & 0 . , lilt. 

,.· ....... "d -<Q.<o "" 

6~ IlI< ... k<di4r<tl. ~i(t " t'luor :-;~ ... ,'.,.k. NY 10011 

n 121Z-27U (175 

Q~ lU.274 ~5 
54 

Page 13 

5~n,or sulx:> rd,"ate tr;rnsa.:t'on, by the GSEs ",ould ""q"ir~ a siguifi"a11t change in the operation 

of the GSEs. Under current rules. the GSEs ClUlUut issue ~lIio s\lbordinatc transactions dire.:tly 

and inst"ad they provide guaf'Jmcl'!; on pril"ately issued transactions. "Illese transaCiiolis r(,quire 

SEC I\'gi~tration and those registr<llion requirements are not consisl':-nt wilh Ihe operntioll orlh~ 

·n3A mark,,\. Subordination based solution s arc also likely to imrodllCe additional heterogeneity 

inlo mor1gag< backed securities iS5UallCe. 

OIl Ihe olhLT hand, credit-link.:d notes wOHld altow the GSEs 10 cominue lhe currem 

oll"raliun of their ~IBS progr-~ms, and hem'e th~ TB,\ lliarket with lilll ... or no change. HOWCWf 

the bonds would nol be cOI1l;ider"d Rea l Eslal" Related [nvestmcntslbr RElTs and thet"C are 

other dctrim~l1lalla :.,; con~eqncllce~ since Ibes~ transactions do not qllalify:lS RE~11Cs. In 

addition. Credii-Linked Nole transaClions g~nCfall y require lUI ~ntit y 10 mlUlagc cr~dil risk, as 

they essential ly rc-insure =dit risk mther than bear credit risk di ~ct . 

Sdlt'lIIalic or a C redil-Liukt'd Nole 

Pnvale 

InvestOl"S 

PtiVIIIe 

Irwe5lolS 

Credlt linked Notes do not alter cash nows of MBS 

,\ndrow I)a,·kl",,, &. Co..lno. 

www.1Kl·<o.<om 

6511ltHk.orSjrrot. ~irlh Hoor 

Now Vork. :SY lOOt 2 

To ' 212.17~.1I07S 

n!I2 27HIS4S 
55 

Page 14 

OhslIli'les III lmrlemCn lUUQII 

My lLnd~rstllnding is Ih:u the GSEs tlnd FHFA Ill>! pUniuiug II. varidY of tlpprouch<.'S ~l1d 

varlalllll on these allP1'O.1ches. including inde.'1cd debt. 10 :tddr~ss ~s mUll)' ofthesc (·Ollc .. ms as 

p<)!i .• iol e, 'nIC path to bringing th ~s~ transactions to m:tn:ct has !>cell ddayed due to the 

complexity oflhe regulalion~ governing these types of,mnsactions Jnd the difrerent regulatory 

trea1tn~nl of transactions with v.:ry similar ~'Conomics. 

Capitalmarhts solutions will generally I:>.! moSI effcctivc if they ~lhlW the broAdest ronge 

Protection from double t~xatiol1. exemption fmm sccllritie5 n:gi~lnItioll .'lOpeciall y f<ll" the seni0r 

noles (to facilitate the TB}\ market), allowing KErr i1l\'estlllent from butll SEC Rnd la ... 

pcrsptctivc" Il iid conformingris}; retention roles pre necessury componcnt$ for ;tn clTc.1i\"e risk: 

slurring progmm. '111e ro[cQfCI'TC o\"Cf'Sight, and CFP13 Q1\-1 n:(luirelllcnts should also be 

addn:~scd. 

Clear, COnsistenl roles would ;ncre:ls~ liquidity and IO\lef Ihe CO><l ol'th.! s~ trnnsa~tions. 

llley w!)Illd also allow the GSr:.!! and FHFA 10 foclls on Ib~ opcnllional and e<;"o1lQll\i~ aspeels of 

thc'SC- tr.Hu;~c\ions rather th,111 eonllic1illg regulalory req uirements. 

Addressi:ng I\.l" reguhd<1l)' i!'. u~s would nOI "egat~ the m\"e$IOI'li' Ile~"<i for appropriate 

loan leyel disdtmllfe and assllrJnce~ as to IQlderwriling quality and servicing practices inclltdmg 

luss mili&aliml :lnd enforcement of yiolntiom ol"TCllI"CSl1l1aliollS :Uld warnultics. However, il is 

possible lhalrnwsloo; would require less di",~t ill\"olvcn ~nt wilh a wel! run stalld81"dizcd 

prOCCS8 from the GSEs Ih,ulthcy would from mher private issll':rs. FIIFA oV<.'rsight might 

provide the nc.:ded protection for inveslors. 

{\ndrt .. Uad,bolll!l C .... III~. 

.. · ..... ad·<o.<om 

M IIIt ~rSIr" . 1·1flll ~,,,,,,, . 

Nul' "ol1l..:SY 10011 

T.11U.l74.l1tl75 

Eulll.l74.tlS.tS 
56 

Ju£1 us Hom" Loan Ua!1k adv,"c~s "s~ :< bl"nd of cOI1'ol"3le gu"""dnl~s :U1 d 

colbleral :t~I OIl. Ihe priv,lIc capilal b~:trins Ihe credil ris!.: oflhe GSE '\!BS dlle$ nOi need 10 1:1<.\ 

enhall~emenl could work lmnd in hand. FOT c":Ullpl ~, ev~n with the use of ~.,.~,{]il·li nk d nOles il 

m!ly lIl~k e sellSC 10 conlinu() lit" lise of !l1or1gage insurance. 1A3n·by·loan mo,,!:'IS" iIlSllI:U1 ~'" 

"III> redu,,~ Ilw risk of d~rault :lrullower l""<,,s, Ib~refo~ mo"gage insuranc ... can ",d""" Ih .. 

amonnt of required fimded ~.,.cdi l enhancement In addili •. ,"" il may make gense to CllCOnrag~ 

finns focused "n mo"gage inl'eSlmenl>. like REITs and ~[O"g3ge Insurance companies. to 

pr()\'ide capilallhmllgh "ollale rali7.~d mech'luis111S such on; credit·linked noh'~_ Ihus gaining Ihe 

b~nct;\s ofpenll:mcnt capital and Ih" 1["~""fCrDbi1il y or wcur;Zite<i gUJUllnlee~. 

InduSlli al Organization of Ilouslnj! Financr 

T1lc w;e nf!;e"uriti:l;ed .:ollalerali7.cd guar:ll\lees su"h ru; subnnlin:,,~d OOIld!i and cr~'{];t. 

Imked nole>; "illlo ..... "r the risll to Ihe lax pay~r from govenunclll guar"l\l~es oP,H.lS. Ho"ev~r, 

the stabilily oflhe mortg'lge flnane~ and many OIher go.11s aso;ociatcd ",illt guwnunenl 

im·olv.:nlCnl in Ihe tl\ortgag~ mmk~1 depend more on the industrial urganiz31ion oflh~ mortgage 

nlMhl limn Ihe foml of credil enhancement '[hc sucre.~ of 'my 8yslenl of boo sing rU1all~e will 

also depend crilicall y on Ihe palh 1;'0111 lite current 5Iru,:1.U'e oflhe housing finance syslem 10 Ihe 

d...sired future 51(\'Clurc. 

On OtIC hllnd. there P[lp~al1< to be a broad con~nSIL~ d~,'CIo]ling that homoowners- seeking 

lIIor1gage financing would be beS[ served by a .yslem ihm altnw5 rnr mortgage_bad-oed 'ilCu11!ics 

with an explicil gO\',,"I1I1C1I1 "Tap and with pri\':IlC capil:.1 sllmding in fro .. [ orlhe govcnuncl\[ 

"'ml) for some ~gJl\c1l1 nfholnco"n=. 011 Ihe Dlilcr hand.lhcrc is linie C0I1S"115US alxlUl UIC 

1\"<1",,,,· 1h' ~I.on & <:O .. lnf. 

.......... ~d-<O.cv ... 

6~ 1\I.«l<or Slr..,t. Filth ',1 ...... .... .... \ 'Qr", .... '0' 10011 

T. I 21l.27~.9(l7S 

r~J luu.O!-'5 
57 

lIa/ure-o[the cntilies th.1t 'HR,ld provide the pri\'~te capital and the role of the govemm~t in 

providing stand3rds alld r<'glil/uinS tlte suppliers of pril'llte capital. On" possible Kl lution is to 

A C""potr"ti" eS"lm;/111 

On balance, [ ~liew that cooper'llivc~ II ill provide Ihe best JQe.:s ibl~ strucllLrc 10 dcliwr 

priqLl~ ~api al to the mortgage mar~cl afld prl)mol~ stability. Whcn Fr~ddk !l18~ was 

cSlllblished. it was owned by the Fcd~ml :lome Loan Bank!< which it, lum lYere Oll'ned by the 

SavitLgs mId Loan~. '11111S, Freddie ~ bcg;Ul it~ life ali a cooperative whose goal was to ~'J.1ble 

its mcmbcn:: to acces. the securitization market. Utilizing cooperativ<'S as II r~Jllaceme:n1 for the 

publically owned GSE.s wOllld wum the market to Ihis st~ "~. The Home Lo:U1 Bank System 

slIrviwd the eri,is "ithoul the need for a capital infusion from the gllvcmmcnt. [n fael, w; I will 

d;!Scrihc hdoll', Ihe [lome l.oan Banks wen: a oonrcc offiquidity for Ihe mQngag~ market during 

Ih..: crisis. Another wmmpkofa slIc.:css.ful coopcTlltive is DTCC. DTCC pro\'ide~ dearing 

~rvic..'5 for b.,)nd trading alld many other m~rkcts and has m<,~hani!lms lhaLenSI'J"e thaI ils 

mcmb.!rs ~ 3ppropri.1l~ly col1ater!llizing their Irnnsacrions. 

Securil ~atiQII oooperntil'<:s should e~wb!i.~h st:mdards for securiti1-'lllon :md promote risk. 

~haring. 10 ~l1Sllrc lI\at the risks of tile sc.:urilized mortgages an: transkm:d to III.: capilal 

lI1ark"iS. At tll~ saLl1~ time. the CooplTali>'e II1USt ensure thallh~N is appropriale disclosure of 

risks nnd quality !Usnrant<'trol $<..,(: lIriliz"d loalls flW'" u!lderwriliflgslandards. AIlQlher 

imponanl consid"rntion is the ability of tile S<!cnrilizaliol1 infnmmcl1lre of mongagc finance to 

survive a filla'lCi;!1 crisis. 

,\ndl'f'" i)3\'I(lJ<)n & C .... ln . 

,.,. ... ~d-<t>.~ '" 

6~ W.ukI'di'l'fpl, j!h tl"". 

"'0 .. \'orll,/Ii\' t OOIl 

rot Ul.lH.'I075 

ranll.lH.Us..s 
58 

I'age ]7 

In lighl oflhese co side r.uio,, ~, Ihen: should l>ea 1"'0 li(:f~d Iruclure for tile 

cooperatives. hllh" fi n;t l'eT, OOg,nalon; would 10nn ~ cQOP~nll'\'i.' Ulal w<l'lld $~ t struld:trds for 

nt ortgag~ originalion$ and seCul"ltiUlion, 1llis tier wo .. ld also own :tlld conlro] the IlHlngagc 

"ecuri li z~tion infraslIllcturc. 11lis approach is 5imil~no lit" FHFA securili13lion illfrdSlructun, 

pl'()j~c l which recognizes Ihe ne<'d fOI" opcrJti()llal C<l Il:ii,K lOy and Slabilily inlhe lUart .. 1 that i~ 

disli,":1 from the risk b~;iring tlm .. 1ion. 

In Ihe se..."T!n d lier, fiml" Ihat have loans 10 ~ecuril ze 1I'0uid sdl loans 10 Ihe coopernlil'c 

and prol'ide ~Ol1le amount of cquil~' Funding Ihal 1I'0uid "erve:lS ri~k relention. 11,,, loans \\onld 

be pololcd and sold ;nlQ lhe martel, nl~ gQl'enll1l ..,u would provide a wrdp on the mongage 

bocked sccuriti es and Ihe ~ooperali\'e would retain a ponion rlh~ tirs! os~ oblig:llions nn 

~c"ufiti e •. 'Ole coopL'f"ati vc w<)U ld al5<' ulilile eollateruliled ...... -dil enhru,,,cmenl tr.nL~a cliO!l$ 

SLt ch :1S credil-I in k~d nQIC$ ;md sut)()T(litl:tl~d bonds 10 sell :l ~igl1ifi .,. "t portion of the credit risk 

inlO Ihe marh!. Buck~ling md insuring 10allS by inta ~ will make c1~nr ",hal risks afl! as~"",ed 

by Ihe coop.:ral;w mId wh~t riskJ; 'lTll umed by Ihe gOl'ernment s uarantor, Rather Ilwn 

triggered. il would be I,!L11er ,fthe gov,,"uncnl gtLl",,,,lec were triggc red whe" the coll:llcraJ ruID 

credit enhancement asSQc iated witll it particular vint.1gc arc exIL1ustcd, Su<:h un """roach would 

provide a mudl gr~:I1Cr IC"d ofsl abiJit)' to tile financi~1 s.VStcm. Any diffcl\'nc~ in ri~k to the 

govenmu,m guaranlor could be rcnect .. >d in tile anlount of e",dit nh (tnc~tncnl f~><luired alld the 

COOp"r'li w~ also g""H~ra ll y are le~s itlnOI'alil'e tI' :111 ordinary cO'llol"dlions bUI 3nl 

genernl1 y more im'O\'alil'c Ihan gO\' .. '111m~~1I entities. While Ihe middle posilion may be 8 l'irt,1C 

in man y gi luali,)tl.~. there may be difficnlti eli in periods where ~ Of less ;nnOI'Dlion is r"fluir;:d. 

A'IIl ..... ' IlUl'Id ... " & C .. " ,, ~, 

.. -....... ~d· .... ,c~'" 

6S 1I1 ... ku Sir .. !. mflh "'''''c 

N .... \'orl;. N\, IOOll 

T.llll,17~"1fl7~ 

' 111.1 7~.IlS 4.< 
59 

Page 18 

Gcn~r:dlr the most signifkant cllallenge of CQopl'rati",'5 i~ maintaining ~n ellective gownHl"c", 

rncdmnisrn when its members h31'" difiering go.1is. To Ihis ... ml r.'gulalioH and ol'crsight \\'il l be 

n!'luircd to ensure adC{luacy of capit~1 and access to all qualified participlUlL.'I . 

.'\~ lh~ eoop~ral; \'''S wQ\,ld be in a ~ltral position illlh~ UlOJ1gagi.l indl/Slr)' Iher¢ would 

h~ multiple dimensi()Us of g()vernrnl~ll regulation, For ~)(a1l1pl~, th., CFPB would be ro.lcem.:d 

wilh Ihe underwriting. servicing, and di~c QSure n<le~ as th.:.y relate to borroWer.!. As guararltor, 

the gowmmcnt would he conccmcd about till' credit quality of the lo.H1s that W'~ originmed mx! 

the adeq'18cyof capital suppm1ing the first loss po~ition. A.~ ~ecurilie s rcgulalOMi. Ihe 

gOllemment would b~ oonccmed about the npproprimc diSClosure nf risk 10 in\'eslor$ and 

coordinate disclosure requirem"nl. w'lh S"curili~~ ~nd E.>;change Commission 1111 .".. ~v"n if 

lb~"" ~"ti tics w~ru not ubj~ .. 1 to full r~gistrali<m '-~'luircmcl1l~_ In addiliou, Tr~:L~"ry tll1d tl;l~ 

Fetleral Resen'., System would wnnt tl) monitor ,s)'Slemic risk ass<x· i~t~d wilh (,'Ql1(,'t'ntratctl or 

undisclo8ed risk from mortgage ~ecuriti7,ation. 

Because of the complexity of regulating the eooperatil'Cs. r believe il would be prcfcrabk 

to have fewer cooper:ltives. Two or three would probably hi: the idcru number; some havt" 

arguctl for 0 ".,,6 ~I th<l private-label market. W~ found h~llllullipk iS~'ICn; Can l~atI to a "t:\ce 10 

the 0010111." as ;1\I-estOrs fOllud it tlilli~lIltto asseS$ Ihe con.1antly varying d~al slnl(,1ures frOIll 

multiple issuers. Th~ a1tematiw to ~ r ... w coopemt;'·cs wOI.ld he a much more invasive 

• T""" Dechano, Pm",:!. ~i=. Joseph Tracy. '1liiie< v,dc'Yr Rlld J<>:5/I,.; Wnghl. "A Pn.1It~ L.ndcr C<><>p<nl!V~ 

MD<k1 for RC$llknlu.1 Mort "\I:" Fino""", ~ F .. ltrol H,"nY HDnkofN .... I·"'*~·t.;JJ!R~pol1$. no. 466. A4,;U$! 21.1 11) 

http"'''''''''" _ne ... y.".I;ftd.~cM;llIffJ.p:lIUI.r466.pdr 

,\,0<1 ...... D~"id.,'" &: Co .• \0,0. 

.. -....... ~d ...... <"1II 

6s OI ... k.rSIr .... Fifth Hmor 

N.,,· York. NY t 0011 

1'<l 111.17~.9'07s 

Fu21l.l7~.05.l5 
60 

Page 19 

regulatory sdH:me 10 C'StHbtis h standards. Such gowmmc'll! slandlU"ds would likely be "ubje.:t to 

political rnanipulnlion and insufficient innoJv"Lion. The FHFA ~"()ml11on infmstrucntre projel1 

appears to be based uPQn the id.::a thai. at Least for the cl~ural plumbing of the mark.ct. 

prolilerulion of issuen: wilh tiirrcr~nt appmachl"S 10 mortg~g~ ~~curitiz:ttiol1 is not tlesimble. 

Time wiLltdl wl1<.1Ilcr or not Ihe gowrnment-led infrnslmClur~ pfoja l will achkvc ils goals. 

Many issuer bllScd proposals favor u large number of is.~uc-n; ~o a.~ I" allow one or more 

10 fail w,lhoutlhreatening t.he viabilily of the S}'Siem. Fewer coopcmlives would 001 pose the 

same ri~k 10 lhe financial S},!;lCm bccnu.<e the risk bearing funcl;oH would be scpamle from Ihe 

Op"rnlional tOll1po"~nl, "nd Ihe IL~ e or ri ~k Rhu ring trnn~8ctiot\S could llh!;;I'Ulliall y redu .. .., Ihe 

risk of insolvency. Fo,)wcr cuopcr~ti\ cs \\ould subsl1tniiaLly ro:duct' Ihe cosl of monitt,ring cap;t"l 

ad~quacy. as a large ll11mbcrof issuers would Tc'tiu ire a sigl'lificam regulatory siructure 10 monilor 

the a,1ivilies of t'ach ... nlil)". 

A S,aMe /loMing Fimllll::t !»)·srem 11.a, Sen-lIS lIre NeM6 of all Cotwi/llemin 

Th ... oOllrhinatiOIl ~ccurili lPlioll c<l-Operat;vc>;, "ollut.eralilcd credit i.'lIh.111C~rn~'rl 1 and a 

gt)\"cnuncllt wrap o[high quality I\!BS will ~nable Ih~ housing lilIan,\! ' ySlcrn 10 function 

cfrec1i\"cly for borrow~rs, origirmtors. il1\"est01"ll IIntita);pay ... rs. 

For OOlTowC"r.;. this syst~m Ql1o\\'s Ib~ cont;nu.:llioll ofli)(.:-d ·rnt ~ kndillg pi a l">';\Sonable 

cost. 1·ligh risk borTowers. such as high-LTV. first-time homcburcrs. \\"onld prob~bty st.it! need 

IU lllil;-.:<.' 1'11<1\ g",u>mte.:d lendiu!:. l-ljgh in~or1Je borrowers aud OuITOWL"fl; ~ed.jng spt.'Ciali-.:cd 

would s<I markt:t sta"tiards subj~ct 10 govcmnu."nl review, thus allowing siandaroizalion \lflo~n 

und~n\"ritingre'luif»ments anti s~ T\·ici ll g n.lle'S. thus providing protc.1ions 10 bOrTowcf!l from 

"n" ..... · D"vkI.on & CII., In<, 

w .. ·"_,"I·.". ... m 

6~ BIoe<ktr .sir'." ~lm, ~loor 

N~w Vorl<, N\' 1I~m 

To t 1. "Z7.lJI07~ 

fnlIU7J O~~5 
61 

Page 20 

unfair practices. In 'lddition, iflh~re w~re any ~xcc:ss profits that result from a centrali:!cd credit 

fllndillll, Ihc:>se profil.'i \\'I)uld f~ed hll~" into th ~ mortgage fi1\.111C<' sysl~m ralh~ thall b~illg 

cap!Llr.!d by the privale share hold.::rs as we c"1'cTIcnced lI"ith JImmie l.-!ac lind Fr.!ddie III:. 

For originators, coop.!rativcs would provide II mechanism for all finns to panicipate in 

sccuritiz.1Iion. as Ihe govcnnllcnt can monitor mcmbcn<hip ru( llI ircm~nts. Cooperatives would 

also provide a m~chani~m for ri~k l-.:1el,t;oll. while still allowing 5ale treatment for origilJato[$. 

Under man)" mher propos,Js, se;:lIrili~ation risk rctcmiun re(luir~l11enlS might r<'4nire 

consolidatiOln ofSl.'curiti:;;:at;ons on the issuers' b.,lance sheet While the eOOp.!ralil"c II"l)uld likely 

nlX'd 10 cOlnsolidate the si!Curitizatioll', the originating fimls would Oln ly shOl\\" their e(luilY 

illl'cstmcnt in the cooperative 011 their b.,IIlIlCC ~hCCL 

For investors, Ihe ~1n1ctllr<! described here would lI.lIow Ihe continued functioning of tile 

TI3.'\ marht that hIlS ho:ell 50 allnu:tive tQ R'Iles ilm:stQl1;. In addition the ~e of credit·linked 

nfit<!S mId Olther risk sharing transactions would create a new martel for Credit inwstOfS. The 

high qu~Jity IOlans ~nd clc~r slmld~rds ofth.:.eoopernli'"t' wi)uJd .re~te II mark~t where ;Il\"(j;ton; 

could focus onlhe il1l'cstnlCllt ri~ks r.l1hcr than Ihe difficult y of eumplex ;md incOltt~iSlent 

Ol tf~Tin g documents and divergent servicing I'racticc8. 

iI.~]lay~rs will be protected from liJtls by multiple l~vell; orrcquircments. Clear 

underwriting st:Uldards describing what is allowed in gunr:ullced pool~ would be the Jirsl line I)f 

dcfcns,," Properly capitalized and nOln·rescindable mongagc in~urallc,: .;Quid bc Ll~ed to cxpruld 

Ih~ cr.:dii bo.~ 10 indlld~ ow~r dOlwn,pU)11lt:'l11 IOl~ns without fillhjc.:ling Ihe laxpaycrtc excess;" .. 

ris!... Coo[>t'Tali"es \\Ollid ~ p.1tIi""ul:trly dfc"Cliw HI insuring thaI repr<'Senl3tiOlns and warrantil"!i 

are enfufCed;lS the m~mbcrs lVould b.: on the IJ{)IIk fOlr violatiOlns and the Illcmocrs are inlhe besl 

i\ na,..· .. IJ .id ..... & CIl., Itlf. 

.. · ...... l'd.cll.<oll1 

6~ m..ck.r SI .... l •• ·if1!, ~l oor 

i\"." Y"rl<, NY !{IOU 

Tr12U.174.'.I07.!' 

t·p, lU.17H.J~4$ 
62 

Pag;:o 21 

position to assess pOOl" pr~cticC8 of other originmors. r1\Xpayens would also be protected by 

equity pN\'ided by c<)<))XT:dive l11emb~rs a;;so.:i:ll~d with their u:re of~o:'Curitiza . Fin.any risk 

sharing transal"lions such as credit-linked notes \\"ill bring in a subst.antial amollnt or (,'lpital to 

Liqllidity {/lid Swbilily 

Pt:l"haps moot imp<Jrtantly, a system which oombines a govcl1nnem guaramee on ~IBS. 

with a cooperutiw that 1',", utilize capitalmarkel.!l funding uf lTl,(/it risk has a gr ... at pot<.'mial rur 

OpL'r\l.tillg through a financ.ial crisis. As a..l ~)(amp!c. the-HOIne IAllil Ban~ SySlem [lr<)vidoo 

liquidity t.o th ... 11llHlgngc murl;ct by CQllIbil\;l1g c~ess to debt capital ",ar~~\l; with bQmJw~r 

t'Wreolialcraliz3iion. Ashcrnll. lkch. and Franle

' wroie: 

During the ~cc'lIld half ()flU07. the FHLI3 Sysl~m increased it~ advance lending by $235 

billion tu S87~ biUion by tile end of tha! y~ar. AdvancC$ have cont.inued to grow into 

2008. albeit at a slower ratc. al.d stood at :5914 billion as of June 30. 2008. 

As finns utili ~ed the FHU3 ~ys tem they proVided additional equilY and .;olbter-II 10 ~lIppor1 \h~ir 

lending. Similarly, s~'C urili ati n coopcrJt;vcs would allow origin<ltu~ 10 pn.widc more capital 

to Ihe coopcf'Jliw t.o meet credit support requirc1nel11s during stress periods, rather Ihan the 

gUan'llIQr rel);n!; un new utferillgs in the Sloe\.: market. Th~ sc~uriliZ3tion stnl<1L1res wuuld 

allow distress locus.:<! inwslu!""S to take ad\·a...tag~ of!c\'cnge provid"d by gU\ .. ~nllm:l1t guarantee 

by pliTohasing Il~\\' risk sharing oonds. (n fact., as ~ r~ult uf a flight to (Iuality. the tightcnillg or 

spreads (high"r price'S) 011 th .. gol'l'Tflmenl gu.mmtccd ~tl3S by Rnl~~ investors during a crisi .•• 

Illight otrset the wider spreads (lnIVer pric~s) n:quired by Credi\ Inl·eston;. 

7 Adam B AshaIIfl. Manen L. a..,h. aroi W ScQn Frame, "Tho Fodtral Home LocI" BILIlL: Sy,stom The L.nd<r of 

Ne:-u.to-LII$I Re-'ll:lrtr I'M,nll Rtsirw BlltJro{,YI"' ron- SrQjJRtporo.1I<I 3)1. Nov<mbo..'T J!108 

ht1 r /lwwwnrwyprkf<ll-pn; ', __ rdliJll!ff rQl9!l!Jp3~7 !>II[ 

,\nd ....... O»I·k .. 'oo & Co., 1 .... -. 

........ 3U ... 0 .• 0 ." 

6~ W.""l;tr SI ... ... Fillh nll(ll" 

1\" ... ' "r1<, 1'\'\' lOon 

Tot U ·ZP4.907S 

h. 11l.17t.~-IS 
63 

Pnge 22 

Tratuuioll to ClHJpt'rflfi,'e't 

'!ltcre is a rduivc!y slmig!l1 forward transitiLt11 lro!1l looily's market to a l'Qop.:r:ui vc 

based system, A ~ystcm for administering Ih ~ government wrap 1I'0u!d ne.::d to be established. 

but ,'O\I!d prolr.l hly b~ hullt upon the cum:nt fo\uldntion;l1 G NMA. Fanni.' Mae and Freddi e 

Ma.:.could be Iransfon11Cd imo cooperati ves, fi rst by stripping ,)ul th~ IUmec~ssary and Ull1 \1lnt~d 

fun~tiolls. such as the retained JlO"folios. and b~' lowering 104/l imjl~ and limiling loanl),pcs. 

Fallnic "lac ,lIld Ff(.>(Idic ~1"c oould also u[ilize rhk sharing tral\!i3clions 10 ..... >(1111.'<: Ih~ir ri~k 

exposure. -TIle stripped dOlm ro iti~s could thell be SQld 10 qualilied c~ra[i v~ tlial woultJ be 

subje~ o upproprilll<l kwis ofrcgulalion. 

\vilh Ihe appTOl?riate government guara nI ...... in plac~. the m ,\ mark~1 cl)uld ~ontinue 

unchoUl gcd Ihrough I~ tl"llilsilillil I)fthc GSEs from conservnllll1lhip to coopcmti,'c o\\' hip . 

" lost Olllet GSE ref()l1n and housing linance proposals do nOI ~r such 3 enr path from here II) 

Olldu ioll 

The CWfCTIl GSE MBS m(Uk~1 provides trillions of doll an; of linancing to the mortgage 

mark~1. GownunC\lt Gtlarmlt~es aud olher stn.K1nrJi fealll!"<'S nrc requ ir d 10 m~in ain thi ~ 

market. Coll atemlized Cionr:lIIlees in the fonn of credit-linked notes can be used to reducc the 

ri~k to la.xpaycn; from govemmenl provided guaralllc.:;o; on " IBS. Securitization roopemtives 

may be th~ besl fonn of organization to tJdi\ r standartli %3ti(ln rum risk shariug. llic eXiS!lug 

GSE8 could be tramfoTmcd into originator-owned cooperatives with lillie di ~nlpli ol1 to IlIC 

llIortgage Jiuance 5)'!itent, 

AIIII....,. ,>..,,'iIl ... u & Co,. ille. 

w ....... ~d.( <o n 

,S llItockorst .... I. ~lflh t·l....,. 

NowYort.. NYtOO12 

T,12IU74.9075 

u 112.27~ 0S4S 
64 

Page 23 

I wo uld I;ke 10 thank the comm;uee for gi,';ng me this opponun;ty 10 expres. m y ,<;ews on 

I'I:tumiu8 private capital to ,he mongage marL:t1$. I have b.:cn inl'olved with Mongagc-&d,.:d 

Se<:uriti;:s (MBS) since 1985. I was ~ managing director at M~,,;Jl Lync h r~ OMibl~ f<lr ~Ia." 

research and risk 1113nagemf"nt for th~ir ag~ trading dcs!.:. In 1992. I founded Andruw 

])3,id~ " & Co., a New Yon.: ba,;ed !lml, pc"ia!i;o;j llg in 'he do.l<eIO],1lIc1ll and uI'Plicaiioll of 

anal~ ti ca ll ools for the 11 113S nlarL:ct ,h,u 'cr .... o:!; over 150 fjnuneinl ins';lUIioos. ! have a broad 

view ofholljing finance as 011r dieots ill~lude o rigina,QI"S, scrv;"cn;< f1g~ge insurcfS. OS£';, 

iIlVCS' ors, dcalers .. nd I"\'g n11ll01"5. 1= als<) oothc execut;vc rommiuec of the newly limned 

Structured Fin:UI"~ lndus1ryGroop (SF10) which i~ dedicated 10 maintaining the role of 

struclUrcd !l1I.ance .. nd sccnritiz31ion as a rore f"nn of financing for the ,x'i)nomy. The opil'lions 

ill this stal"m,,"t are my oWn. 

A'o.d ... ,,· U .. IdOl)II "" Co., [nr. 

......... a .. ...,Q.<O .. , 

6~ w. ... ~~t S'rHt. ~"111 ~l ""r 

Now 1"urk,1'il' tOOl2 

T.tlt 17~.901! 

r .. ltU74.Q545 
65 

1February 28, 2013, Senate Banking Committee hearing on ‘‘Addressing FHA’s Financial Condition and Program Challenges, Part II.’’ http://www.banking.senate.gov/public/index.cfm?Fuse 

Action=Files.View&FileStorelid=6283a07f-b4c3448a-82e0-d62cfb06bf61. 

PREPARED STATEMENT OF PHILLIP L. SWAGEL 

PROFESSOR, INTERNATIONAL ECONOMIC POLICY

MARYLAND SCHOOL OF PUBLIC POLICY, UNIVERSITY OF MARYLAND

MAY 14, 2013 

Chairman Tester, Ranking Member Johanns, and Members of the Committee, 

thank you for the opportunity to testify on the vital topic of returning private capital to mortgage markets. I am a professor at the University of Maryland’s School 

of Public Policy and a faculty affiliate of the Center for Financial Policy at the Robert H. Smith School of Business at the University of Maryland. I am also a senior 

fellow with the Milken Institute’s Center for Financial Markets and a visiting scholar at the American Enterprise Institute. I was previously Assistant Secretary for 

Economic Policy at the Treasury Department from December 2006 to January 2009. 

Bringing private capital back to fund mortgages and take on credit risk is an essential element of housing finance reform, particularly with respect to reform of the 

Government-Sponsored Enterprises (GSEs) of Fannie Mae and Freddie Mac. Housing finance reform should ensure that mortgages are available across economic conditions, while shielding taxpayers from taking on uncompensated risk and protecting the broader economy from the systemic risks that arose in the previous system. Bringing about increased private capital as part of housing finance reform will 

help protect taxpayers and improve incentives for prudent mortgage origination by 

lenders and investors with their own resources at risk. 

The situation in housing finance today is that taxpayers fund or guarantee more 

than 90 percent of new mortgages through the GSEs and through Government 

agencies such as the Federal Housing administration (FHA). Fannie Mae and 

Freddie Mac stand behind virtually all new conforming mortgages through the two 

firms’ guarantees on the mortgage-backed securities (MBS) into which the two firms 

bundle the home loans they purchase from originators. There is loan-level capital 

to absorb losses in the form of homeowner downpayments and private mortgage insurance (PMI), but no private capital at the level of the mortgage-backed security 

(MBS) ahead of the financial resources of Fannie and Freddie. With the U.S. Treasury committed to ensuring that Fannie and Freddie remain solvent, the U.S. Government effectively backstops conforming loans, leaving taxpayers exposed to considerable losses in the event of another housing downturn-and this risk remains 

even while the two firms are now profitable. Taxpayers further take on credit risk 

in housing through the Government backstop on the Federal Home Loan Bank 

(FHLB) system, and through guaranteed mortgages supported by the Federal Housing Administration (FHA) and other Federal agencies. I have previously testified on 

reforms to the FHA that would better protect taxpayers while focusing the agency 

on its mission to expand access to mortgage financing for low- and moderate-income 

families who have the financial wherewithal to become homeowners.1 I thus focus 

here on GSE reform. 

Bringing back private capital into housing finance would mean that private investors would absorb losses as some mortgage loans inevitably are not repaid. In some 

instances, this could involve mortgage loans with no Government guarantee, while 

in others there could be a secondary Government guarantee that kicks in only after 

private capital absorbs losses (or the guarantee could be alongside private capital, 

with losses shared). Private investors would be compensated for taking on housing 

credit risk, so that it should be expected that mortgage interest rates will increase 

as housing finance reform proceeds. This interest rate impact reflects the facts that 

the previous system was undercapitalized and provided inadequate protection for 

taxpayers. 

It would be useful for reform to allow for a diversity of sources of funding for 

housing, and for private capital to come in a number of forms and through a variety 

of mechanisms. This will help make the future housing finance system more resilient to economic and market events that affect particular parts of financial markets 

and thus impinge on the availability of funds for housing. 

At the level of the individual loan, capital for conforming mortgages will continue 

to be present from a combination of homeowner downpayments, private mortgage 

insurance, and the capital of originators that carry out balance sheet lending. The 

recent housing bubble and foreclosure crisis highlighted the importance of homeowner equity as a factor in avoiding foreclosures, as foreclosure rates were especially elevated for underwater borrowers—those who owed more on their mortgages 
66 

than the value of their home. As reform proceeds, it is vital to ensure that meaningful downpayments remain a central aspect of underwriting and a requirement for 

mortgages to qualify for inclusion in MBS that benefit from a Government guarantee. Similarly, regulators must ensure that private mortgage insurers have adequate levels of their own high-quality capital to participate in mortgages that receive a Government guarantee. 

The larger changes involved with the return of private capital to mortgage origination will come at the level of the mortgage-backed security. With nearly all 

securitization of conforming mortgages going through the GSEs, there is essentially 

no capital at the MBS level. The so-called profit sweep agreement between the 

Treasury Department and the two GSEs prevents Fannie and Freddie from building 

up the capital that would be the norm for an insurer. Housing finance reform should 

involve changes on all of these dimensions so that private capital is present at the 

MBs-level. These changes are discussed next. 

Fannie and Freddie are setting up risk-sharing mechanisms to allow private investors to invest in securities that will take losses ahead of the firms’ guarantee 

(that is, ahead of the taxpayer guarantee). There is still little securitization of mortgages taking place without a guarantee (private-label securitization of non-conforming loans), and firms other than Fannie and Freddie are not allowed to compete 

in the business of securitization of conforming mortgages with a Government guarantee. 

Risk-sharing by Fannie and Freddie on guaranteed single-family MBS 

Risk-sharing could be implemented by having the two firms sell non-guaranteed 

tranches of MBS that take losses either before or at the same time as MBS tranches 

that receive the guarantee. This could be seen as selling off subordinated tranches 

of guaranteed MBS. This would be an incremental approach for bringing in private 

capital that could proceed ahead of legislative action; indeed, work on this is under 

way at both Fannie and Freddie as part of the FHFA strategic plan. Fannie and 

Freddie both already share risk in different ways on their MBS for multi-family 

properties so there are extant examples of such a mechanism. 

Risk-sharing would translate into higher mortgage interest rates. The yields on 

these non-guaranteed tranches would be higher than on securities with a guarantee—after all, investors will demand to be compensated for taking on housing 

credit risk. Even so, these securities would still be protected from losses by postcrisis underwriting standards (which some would say are too careful), and by homeowner downpayments plus any PMI. The interest rates on mortgages facing homeowners would reflect a blend of the yields on the guaranteed and non-guaranteed 

MBS, along with costs such as the fee (g-fee) paid to the Government for taxpayer 

backing. 

An important consideration as risk-sharing proceeds is that the initial volume of 

non-guaranteed MBS likely would be modest. Yields on the non-guaranteed 

tranches could thus be elevated by a liquidity premium (that is, by investors’ demands to be compensated for the lack of liquidity in these new securities). It would 

be useful to spread any interest rate impact across mortgages that are bundled into 

all conforming securities until the risk-sharing program has proceeded enough to 

provide a liquid market for the non-guaranteed MBS tranches—or more likely, until 

all guaranteed MBS are protected by first-loss tranches. 

As envisioned in the FHFA strategic plan, selling subordinated tranches of guaranteed MBS would allow for a return of private capital to conforming MBS even before housing finance reform clarifies the long-term status of the GSEs. A larger role 

for the private sector and a receding Government guarantee could be brought about 

by increasing the size of the subordinated tranches and thus providing more firstloss protection ahead of the firms (and thus ahead of the need for the Government 

to make good on its contractual obligation to keep the firms solvent). Note as well 

that the appropriate guarantee fee to charge on the senior MBS would eventually 

decrease as more private capital takes losses ahead of the Government. 

Capital brought in by firms that compete in conforming securitization 

A fruitful avenue for housing finance reform would be to allow other firms to compete with Fannie and Freddie in the securitization of conforming MBS. Firms undertaking such securitization would be required to maintain appropriate levels of 

capital, both their own and that of other investors, to take losses ahead of the Government. All firms would then pay for the Government guarantee that is secondary 

to considerable private capital. 

Allowing for such competition would be beneficial to ensure that any inadvertent 

(but likely unavoidable) underpricing of the Government guarantee is pushed 

through to homeowners in the form of lower interest rates rather than allowing 
67 

2See David Scharfstein and Adi Sunderam, ‘‘Concentration in Mortgage Lending, Refinancing 

Activity, and Mortgage Rates,’’ April 2013. http://www.hbs.edu/faculty/Publication%20Files/ 

ConcentrationlinlMortgagelLendingl20130407ladfb023e-3c76-42df-9ede-312925dae538.pdf 

MBS securitizers to profit from an elevated spread between (low) interest rates on 

MBS and (high) interest rates on mortgages. Indeed, Scharfstein and Sunderam 

(2013) document that a lack of competition results in just such an elevated interest 

rate spread, to the detriment of potential borrowers.2

Fostering competition would further help address the problem that Fannie and 

Freddie are too important to be allowed to fail. If enough additional firms enter in 

the business of mortgage securitization, then any such securitizer could fail while 

others continue to undertake securitization. Entry and competition as part of housing finance reform could thus help to avoid a situation in which mortgage financing 

is not available to American homeowners, with potentially serious negative impacts 

on the U.S. economy. 

Two steps are vital to allow for entry and competition. The first is the completion 

of the common securitization platform now being developed jointly by Fannie and 

Freddie as part of the FHFA strategic plan. A common securitization platform 

would unify the markets for MBS packaged by the two GSEs—both are effectively 

guaranteed, but they trade separately to the disadvantage of the less liquid Freddie 

Mac securities. A common securitization platform would facilitate entry by new 

firms that securitize guaranteed MBS in competition with Fannie and Freddie, since 

the MBS of new entrants could trade in the same market as MBS issued by Fannie 

and Freddie rather than trading separately and facing a considerable liquidity disadvantage. In developing the common securitization platform, it will be important 

to maintain the TBA (‘‘To Be Arranged’’) market that facilitates desirable features 

of such as the ability of homeowners to lock in interest rates. 

The second step would be for the Government guarantee that now backstops 

Fannie and Freddie as firms to switch instead to a guarantee on qualifying MBS 

(rather than on the firms themselves). This step requires Congressional action, since 

it would formalize the Government guarantee on housing that is now merely a bilateral contract between the Treasury and each GSE. The Government guarantee on 

housing would be formalized, but only so that the guarantee could shrink by requiring increased first-loss private capital before the guarantee. In other words, the 

guarantee would be made explicit so that it could recede. 

Housing finance reform must ensure that smaller financial institutions have access to the housing finance system on terms equal to those for the larger firms that 

dominate mortgage origination. The reform discussed here meets this essential criterion in two ways. The first is that the use of a common securitization platform 

would allow regulators to enforce non-discrimination provisions that require firms 

that obtain the secondary Government guarantee for their MBS to purchase qualifying mortgage loans on equal terms from qualifying lenders. That is, regulators 

would ensure that the system is open to all conforming loans. At the same time, 

it would be natural for smaller institutions to join together to form a securitizer on 

a mutual basis. As an observation, the securitization and guaranty businesses of 

Fannie Mae and Freddie Mac are generating substantial profits, reportedly on the 

order of $20 billion per year combined between the two firms. Forming a mutual 

securitization company would thus give smaller institutions a share of these profits 

while ensuring that they do not need to rely on larger firms for access to the housing finance system. 

Firms competing in securitization of conforming MBS could have several forms of 

private capital ahead of the secondary Government guarantee, including both their 

own equity and capital arranged with other private entities. For example, 

securitizing firms might purchase MBS-level insurance from other private firms, 

much as individual homeowners purchase private mortgage insurance. As with any 

such insurance product, a key consideration is to ensure that the firms providing 

MBS insurance maintain appropriate amounts of high-quality capital. 

An alternative to MBS insurance would be for MBS securitizers to issue creditlinked securities in which private investors provide funds to the securitizer in return for a yield (as usual with a fixed-income security), with provisions that specify 

the losses to be apportioned to the outside investors in the event of housing credit 

losses. Such credit-linked securities would bring in private capital in a similar fashion to the subordinated tranches of MBS discussed above. 

The market for conforming MBS would thus include securities with and without 

a Government guarantee. The common securitization platform would again be important to ensure that the guaranteed securities trade together in a liquid market 

for all issuers. The non-guaranteed MBS tranches could then trade separately for 

each securitizer. Indeed, investors willing to take on first-loss housing credit risk 
68 

would be expected to demand considerable information on the characteristics of the 

mortgages in the MBS. A useful feature of the structure discussed here is that the 

amount and high quality of the private capital is clear—the non-guaranteed securities take losses up to the amount of capital at risk. 

Private label securitization 

An increase in mortgage lending without a Government guarantee would constitute a direct return of private capital to housing finance. Housing finance reform 

along the lines of the process discussed above would gradually increase the incentive 

for some mortgages that could qualify for a Government guarantee to choose to go 

without one. The increased incentive to avoid the Government guarantee would reflect the costs that correspond to a requirement for an increasing amount of firstloss private capital (risk-sharing), along with a higher fee charged by the Government for the secondary guarantee on conforming MBS. As an increasing amount of 

first-loss capital is required ahead of the Government guarantee and as the g-fee 

insurance premium rises, so too will the incentives rise for a larger-scale restart of 

private-label securitization. At some point, if enough private capital is required and 

the g-fee pricing is set high enough, some conforming loans that qualify for the 

guarantee will choose not to purchase it and prefer instead to arrange for non-guaranteed financing. This could include securitization of non-guaranteed (private label) 

conforming MBS. 

If the Government no longer provides a guarantee for every conforming mortgage, 

then an auction mechanism could be used to set the price of the Government insurance. This would help to address the difficult challenge of setting the price for the 

guarantee. One way to achieve this outcome in which not all conforming mortgages 

are covered by a guarantee would be to gradually reduce the amount of insurance 

capacity offered by the Government. A safety valve mechanism could be put in place 

under which the Government would offer additional insurance capacity at a higher 

guarantee premium that market participants would find unattractive in normal 

times and thus prefer to arrange for private-label securitization but remain available in the event of a future crisis in which funding for non-guaranteed 

securitization dries up (as has been the case since the collapse of the housing bubble 

in 2006). 

Steps that make guaranteed MBS less attractive would similarly boost the incentives for increased usage of private-label securitization of non-conforming loans— 

mortgages that do not qualify for the Government guarantee. This is because as 

costs for (conforming) guaranteed loans increase, some borrowers who might have 

taken out a conforming loan will instead turn to mortgages with non-conforming 

features such as a principal amount above the conforming loan limit. Even so, a 

broad restart of non-guaranteed securitization likely requires further progress in reducing the uncertainties regarding the regulatory environment and legal liability for 

loans that do not qualify for the safe harbor in the CFPB’s qualified mortgage (QM) 

standard. Private-label MBS issuance was $4.2 billion in 2012 according to data collected by SIFMA (the Securities Industry and Financial Markets Association)—compared to more than $1 trillion in MBS issuance covered by a Government guarantee. 

Policy Levers to Foster a Return of Private Capital into Housing Finance 

The various channels through which private capital could return to the housing 

finance system involve four main policy levers: 1) raising the price of the Government guarantee; 2) reducing the quantity of insurance offered by the Government 

or otherwise narrowing the scope of mortgages eligible for the Government insurance; 3) opening the housing finance system to new competition that brings in private capital; and 4) requiring firms that securitize Government-insured MBS to arrange for first-loss private capital to take losses before the Government guarantee. 

Reducing or eliminating the Government role in housing finance involves going 

further with these four policy levers. The jumping-off point for reform is the current 

system in which there is no first-loss private capital and taxpayers stand behind essentially all conforming loans. It is instructive to consider the steps to move to a 

private system in which there is no Government guarantee on conforming mortgages (leaving aside the FHA and other smaller programs). To reach a private outcome, the housing finance system will first transit through the alternative in which 

there is a secondary Government guarantee behind first-loss private capital at the 

MBS level but all conforming mortgages continue to be insured by the Government 

(which now provides a secondary guarantee). This first alternative is precisely option three from the February 2011 Treasury-HUD White Paper on ‘‘Reforming 

America’s Housing Finance Market.’’ That is, Treasury-HUD option three is a necessary first step in the move toward a private housing finance system. 
69 

Moving further toward a private system from Treasury-HUD option three involves 

additional increases in guarantee fees and a requirement for yet greater first-loss 

private capital ahead of the secondary Government guarantee. As these policy levers 

are utilized, eventually only a modest share of mortgages will be included in MBS 

that receive the secondary Government guarantee. Instead, most mortgages will be 

funded privately, at least in normal times. In times of credit market stress, a greater share of mortgages would avail themselves of the Government guarantee, even 

at the cost of the higher g-fees and increased private capital. This outcome is precisely option two from the 2011 Treasury-HUD White Paper. Again, the second option in the Treasury-HUD white paper is a necessary stage on the transition to a 

private system. 

Eventually as the policy levers are fully utilized, the pricing of the guarantee fee 

will be so high that no MBS securitizers will purchase the Government guarantee 

(or more simply, the amount of first-loss private capital required in front of the 

guarantee is set at 100 percent, eliminating the guarantee). This outcome is option 

one in the 2011 Treasury-HUD White Paper. 

In other words, ending up at a housing finance system that is fully private involves a transition through intermediate steps in which there is first private capital 

in front of a secondary Government guarantee (Treasury-HUD option three) and 

then a stage in which the share of guaranteed MBS declines and the share of private-label securitization and non-guaranteed balance sheet lending increases (Treasury-HUD option two). Rather than seeing the three options in the Treasury-HUD 

White Paper as separate proposals, it is useful to note that they differ by the settings of the policy levers of the price and quantity of the Government backstop, the 

scope of conforming mortgages, and the amount of required private capital. These 

levers in turn determine the share of conforming mortgages that will be covered by 

the Government insurance and thus the choice between the three Treasury options. 

In other words, the seemingly distinct policy options often considered in the debate 

over housing finance reform are better seen as points on a spectrum that differ by 

the share of credit risk taken on by the Government and by private investors. This 

approach is depicted in the figure below. 

Moving forward with Housing Finance Reform that brings back private capital 

The key question in housing finance reform remains the degree of Government 

involvement, and especially whether there should be some form of a Government 

guarantee on some housing credit risk, even if one that takes effect only after private investors take losses first. I have written previously that I see it as a political 

and social reality that future U.S. Governments will intervene if potential home 
70 

3Phillip Swagel, 2012. ‘‘The Future of Housing Finance Reform.’’ The B.E. Journal of Macroeconomics, volume 12 issue 3, article 11. 

buyers cannot obtain mortgage financing such as during a financial crisis.3 An implication is that a housing finance system that is notionally fully private will inadvertently recreate the implicit guarantee in the previous system that failed so badly 

and that left taxpayers with a costly bailout. It would be better in my view for the 

inevitable Government involvement to be made explicit. Taxpayers would be compensated for taking on housing risk, with considerable private capital ahead of the 

secondary Government guarantee. 

Housing finance reform that brings back private capital can proceed without resolving the question over the eventual role of the housing finance system. This is 

because the policy levers required to move forward with reform are the same ones 

to reach any system with a smaller role for the Government than today, including 

the system with a secondary Government guarantee and the alternative in which 

there is no role for the Government (at least no explicit role). Indeed, as noted 

above, to reach the system with no Government guarantee, a partial guarantee will 

be in place during a transition. 

Whether it is possible for housing finance reform to arrive at a system that is 

fully private (at least notionally) will depend on the societal and political reaction 

to the higher mortgage interest rates and reduced availability of credit that correspond to the increased protection for taxpayers from a system with a greater role 

for private capital. It is unclear whether a private housing finance system is politically and socially feasible. But the way to find out is to start by adjusting the policy 

levers that bring in private capital. 

This implies that (the sometimes passionate) disagreements about the role of the 

Government at the core of the policy debate over U.S. housing finance reform are 

misplaced. The next steps are the same for all plans now under serious consideration; namely, that the price the Government charges to insure mortgages should 

rise, the volume and scope of mortgages that the Government offers to insure should 

decline, and the amount of private capital should increase. 

The disagreement is over how far to turn the policy levers affecting the price and 

quantity of the Government insurance, and how that in turn will affect the interest 

rates and types of mortgage products faced by American home buyers. How far to 

go toward a private system will ultimately reflect a societal and political judgment 

about the role of home ownership and the degree to which Americans support public 

efforts to foster home ownership. 

The alternative is to wait for reform until there is agreement over the end point. 

Waiting to start with housing finance reform is a choice in itself—to keep Fannie 

Mae and Freddie Mac in Government control and to have little role for private capital. The longer that conservatorship continues, the more likely it is that it becomes 

permanent, with Fannie Mae and Freddie Mac in Government hands forever. This 

would mean a long-run housing finance system that most acutely puts taxpayers at 

risk while missing out on the possibilities for innovation that are most likely to 

occur with a system driven by private sector involvement and incentives. Such a nationalized housing finance system is a default outcome if no reform is undertaken. 

PREPARED STATEMENT OF ROBERT VAN ORDER, PH.D. 

CHAIR, DEPARTMENT OF FINANCE AND

PROFESSOR OF FINANCE AND ECONOMICS, GEORGE WASHINGTON UNIVERSITY

MAY 14, 2013 

Getting private capital back into the mortgage market is clearly an important 

goal. Right now almost all mortgage lending is done via Fannie Mae and Freddie 

Mac, which are under Government control via conservatorship, and FHA and 

Ginnie, Mae, which are Government owned. It wasn’t always that way. Forty years 

ago the industry was dominated by Savings and Loans, and more recently by Fannie 

and Freddie as privately owned corporations. Beyond that, in the years after 2000 

the market in which mortgages were securitized became increasingly dominated by 

‘‘private label’’ securities. All of these institutions have, to varying degrees, collapsed. 

Appearances can be deceiving, and what is and is not private capital can be difficult to determine. Indeed, whether capital is private or not is not the most important question. What is most important is who ultimately bears the risk and how 

it can be controlled. In the cases of both the Savings and Loans and Fannie and 

Freddie the Government provided (explicitly in the first case, implicitly in the sec-
71 

ond) guarantees to shareholder-owned institutions, and these guarantees subsequently required very large cash outlays. In the case of private-label securities collapse in value caused a financial panic, which provoked other bailouts and was the 

impetus to the Great Recession. Making mortgage markets work again will require 

an understanding of who is taking the risk. 

It is very likely that any system that we end up with will have a role for the Government as guarantor at the end of the process, and that what we mean by having 

private capital in the market means having private capital taking risk ahead of the 

Government. This requires decisions regarding both the quantity of capital ahead 

of the Government (e.g., capital ratios) and the types of incentives used to keep risk 

under control. Discussions regarding risk-taking in the residential mortgage market 

often focus on the risks presented by specific mortgages or the risk inherent to the 

institutions that originate or fund mortgages. As discussed below, this focus is misplaced, as it is not obvious what specific properties make one mortgage more risky 

than another and institutional form (or name) matters less than specifics about the 

capital they hold. 

A central point is that all this is very difficult. Many of the things associated with 

the huge increase in defaults in the Great Recession were close to unpredictable and 

certainly not easy for regulators to control. As a result we need policies that provide 

automatic solutions and incentives for those closest to the operations of financial institutions, their management, to control risk-taking. After reviewing some of the lessons learned I will focus on work done with Rose Neng Lai at the University of 

Macau on the use of contingent capital, both as a source of new capital in tough 

times and as a way of providing incentives to the mangers of financial institutions 

to take on less risk. 

In the next section I review some of the issues involved in guarantees. This is 

followed by a discussion of what data so far tell us about what is important, followed by ways, including contingent capital, of improving capital standards. 

Market Structure and Guarantees 

For decades almost all American mortgages have benefited from some sort of Government guarantee, e.g., directly via FHA insurance, or indirectly from deposit insurance for banks and Savings and Loans or guarantees for Government-Sponsored 

Enterprises (GSEs) like Fannie Mae and Freddie Mac. If financial markets were 

perfect, or close to it, and transfer payments were easy to make, there would be little economic justification for the Government to have a role in financing housing 

and certainly no need to provide guarantees to get people into good housing. Anything that needed to be done could be done with housing vouchers or direct provision of housing services, letting the financing take care of itself. 

Guarantees can make sense outside of housing policy—deposit insurance and GSE 

guarantees, for example, as a way of stabilizing financial markets—and they can be 

justified in a ‘‘second best’’ sense as a way of promoting housing and home ownership when transfer payments are hard to make or there are inefficiencies in financing housing. But guarantees also have important incentive effects. 

Basics of Guarantees 

Guarantees have two principle effects: 

• If not fully priced and regulated they lower the cost of housing and alter resource allocation, redirecting investment into housing and away from other 

uses. When targeted they promote housing for particular classes of households. 

This is ‘‘good’’ to the extent that housing is under produced, which is a hard 

case to make, or when targeting is important, for instance to encourage home 

ownership. 

• They help prevent financial panics, by removing the motivation for ‘‘bank runs.’’ 

However, if they are not well regulated, they lower the cost of risk-taking and 

promote excessive risk-taking. 

The first effect is most closely associated with housing goals; the second is indirectly 

associated with it but also has broad macro effects. Both have costs, in terms of 

misallocated resources and ‘‘bailout’’ costs when institutions getting the guarantees 

fail. 

The two costs are related; the bailout costs typically go along with misallocated 

resources, but even without misallocation bailout costs are disruptive and unpopular. In the United States a bailout of the Savings and Loans insurance fund ultimately cost taxpayers around $150 billion. For Fannie Mae and Freddie Mac cost 

is not clear because they appear to be making money again and may pay back most 

of what the Government injected, but still there was a bailout. 
72 

1This is probably because when dealing with prices falling by 40 percent in some regions, 

even downpayments of 20 percent provide much less protection than might be thought at loan 

origination. 

Guarantees have many of the characteristics of financial options in that the owners of guarantees get the upside from risk-taking but have limited liability on the 

downside. If a guarantee is not priced or regulated properly, then recipients get 

downside protection at below cost, essentially an underpriced insurance policy. This 

provides incentives to take on risk to maximize upside returns without having to 

worry about downside losses. Indeed, absent other factors, like reputation or franchise value, maximizing wealth will tend to involve maximizing the value of the 

guarantee, which in turn means maximizing risk. As a result the subsidy that 

comes with guarantees changes incentives. Because risk-taking is hard to observe 

and control, the subsidy is hard to control, as are bailout costs once the guarantee 

is in place. 

Effects of guarantees and bailouts have been mixed. For instance, while they have 

received considerable support, neither banks nor Fannie Mae and Freddie Mac were 

a source of systemic risk, not because they didn’t take risk, but because their guarantees kept the values of their deposits or debt from falling. That is the paradox 

of guarantees. They make it easier to take on risk, but they also limit systemic risk 

and bank runs. It’s hard to have one without the other. Sometimes you can’t live 

with; sometimes you can’t live without them. 

Probably more important than bailout costs, however, are the economic costs that 

come with recessions and Great Recessions. In the Great Recession systemic risk 

happened mainly in the private ‘‘shadow banking’’ system, which was not guaranteed (and because it was perceived as not guaranteed), but which still took on excessive risk and saw something akin to bank runs as investors lost confidence in the 

ability of the system’s assets to cover its liabilities (See Gorton (2009) and FCIC 

(2011)). 

Recent History 

I have attached as an appendix a summary of some work on mortgage default 

done with a colleague at George Washington, Jason Thomas. It summarizes some 

of the data for the performance of loans (both those securitized by Fannie and 

Freddie and those securitized through the private-label channel) originated in 2003 

and 2006, along with a simple analysis of the risk of requiring low-income lending. 

I am putting it there because I think a few pictures can summarize some important 

trends in defaults, and because some of what has been thought to be true about the 

surge in defaults is not true (or incomplete). 

Major points are: 

• The usual suspects matter. Looking at 2003 and 2006 vintage default rates, 

lower downpayment meant higher defaults if credit scores are held constant, 

and vice versa for credit score with downpayment constant. 

• There are tradeoffs. A low downpayment can be offset with a higher credit 

score. What does seem to matter is low downpayment combined with low credit 

score. This is an example of risk layering. 

• Economic conditions were very important. Loans originated in 2006 had 

much higher defaults than those in 2003 for all categories (of credit score and 

downpayment) and for both Fannie/Freddie and private-label mortgages. 

• The Channel is very important. Private-label securities had much higher default rates, even controlling for credit score and LTV, than did Fannie/Freddie 

mortgages. 

What is Risky? 

The above describes things that were the case all the time. A more important 

issue is what things were risky in the sense of causing bigger changes in defaults 

from the good years (e.g., 2003) to the bad years (e.g., 2006). Main results are: 

• Low downpayment, by itself was not especially risky. This was especially 

true for loans that were not risk-layered. In particular, there is no clear relation 

between downpayment and increase in default rate, holding credit score constant.1 Furthermore most of the loss for low downpayment loans sold to Fannie 

and Freddie was taken by private insurance companies. 

• Low credit scores did matter, as did risk layering. This was true for both 

channels. 

• Loans with LTV from 75 percent to 85 percent had the biggest increase 

for every level of FICO. This might be because loans involving moral hazard 
73 

were more likely to have downpayments right at 20 percent, and these loans 

were more sensitive to declines in property values. This ‘‘hump’’ in the risk profile is entirely from the 2006 vintage (see Table 2 in the appendix); there was 

no such hump in the profile of loans originated in 2003. 

• The channel mattered; Private-label loans had much bigger increases across 

loan characteristics, by roughly twice. 

• The housing goals added little to the risk of the GSEs. 

• Size is ambiguous. The biggest intuitions (Fannie and Freddie) had the lowest 

default rates and the lowest increase during the recession. The private-label 

market, which was served by a wide range of institutions, was much worse. On 

the other hand Fannie and Freddie were very big, and the market was clearly 

sensitive to their behavior. A hard to quantify dimension of size is that it can 

generate ‘‘franchise value’’ (aka monopoly power), which has a tendency to 

produce risk aversion to protect the franchise. 

Institutional performance 

The above focused on defaults by loan product, channel, etc. An interesting question going forward is what type of institution structure do we need? I am inclined 

to think that while this is important, it is not crucial and that the key questions 

are incentives. A question behind all of this is the role of fixed-rate mortgages in 

our economy. They tend to have lower default rates that do adjustable-rate loans, 

but leave many intuitions subject to interest rate risk because their value fluctuates 

with interest rate changes. The GSEs and private-label markets both provided access for fixed-rate loans to bond market investors. This was less the case with private label because it securitized a considerable amount of adjustable-rate mortgages. 

In any event, because the overall size of the mortgage market (around $10 trillion 

in outstanding balance) is about the size of all the assets in the banking system it 

is likely that some sort of securitization structure will be needed. This can be done 

in a lot of different ways. Here I outline some things we have learned lately: 

• The best source for private capital still might be Fannie and Freddie (or their 

clones-bond market institutions with the Government at the back end). They 

are currently profitable, as evidenced by combined net income of $13 billion per 

quarter (before accounting for the change in deferred tax assets). In any event 

it long run net outlays by Treasury may well be close to zero; that is it is possible that the residual value of Treasury’s stake is at least as big as the amount 

of money it has put in. 

• Private-label security issuance was hugely dependent on Collateralized Debt 

Obligations (CDOs) to buy the riskiest parts of their deals pieces. There are important information asymmetries in this market, which were behind the huge 

losses in it. Investors would need huge coupons to be willing to buy such ‘‘information-intensive’’ pieces. These costs would flow through directly to borrowers. 

• It may be more efficient if the loss-bearing private capital layer is an equity 

claim to a mortgage insurer or GSE. Raising capital on a deal-by-deal basis, as 

in the private-label market, through subordinated tranches is less efficient because of information costs. 

• Gross business volumes in 2012 between Fannie and Freddie were $1.4 trillion. 

It is unlikely that the private-label market could replace these volumes at current mortgage interest rates. Mortgages are complex instruments with multiple 

embedded options. Fannie and Freddie absorbed most of the mortgage credit 

risk and reduced the interest rate risk through retained portfolios. Maybe this 

didn’t work perfectly, but we don’t have any historical evidence that banks and 

capital markets can manage these risks better. 

Comment 

A problem with all of this is that a lot of went wrong was very hard to predict, 

and some proposals, for instance limiting low downpayment loans and low-income 

lending, are not likely to help much. The structure going forward is probably going 

to be something like GSEs, maybe more of them, maybe as co-ops or specially chartered mortgage banks, but with as much private capital as possible and with Government stepping at the back end. 

This is because having the Government as final risk-taker is going to be hard to 

avoid, and probably shouldn’t be avoided. That role can provide stability, but it 

leaves open a lot of questions about the details of risk and capital. 

Capital and Contingent Capital 

Whatever we do, we’ll need better capital rules. Capital provides a cushion that 

protects debt holders and guarantors, and it provides incentives to control risk be-
74 

2 A relatively early example of CoCo bonds is the first issue of the ‘‘Enhanced Capital Notes’’ 

by the Lloyds Banking Group PLC in November 2009. These are subordinated debt that will 

be converted into equity if the core capital falls to 5 percent of its risk-weighted assets. Other 

examples of CoCo bond issues are from Rabobank in May 2010, Credit Suisse in February 2011, 

and the more recent ones from Barclays Bank in April 2013. By classifying into Tier 1 capital, 

the mandatory leverage ratio required in the Basel Accord can be met easier. 

cause more investor money is at stake. Before the crisis, Fannie and Freddie had 

two capital rules applied to them: stress tests that simulated company performance 

under stressful conditions and required that enough capital be held to survive them 

and a minimum capital requirement that applied even if they passed the stress 

tests. Clearly they did not have enough capital to withstand the Great Recession. 

There are limits, however, to how far we can get by relying on capital ratios and 

shutting down insolvent institutions. It is very difficult to know whether or not institutions are really insolvent. This is in part because that is a difficult problem, 

but especially because accounting measures of capital are not up to the task. They 

tend both to overestimate and underestimate net worth, and they tend to be procyclical, requiring institutions to raise capital at exactly the times when this is most 

difficult. This leaves us with stress tests and manipulating incentives. I shall leave 

stress tests, which I believe are an excellent way of improving on required capital 

ratios, for another time and focus on incentives in the form of contingent capital. 

Incentives: Contingent Capital 

You don’t have to agree with the recent bailouts to understand the difficult 

choices facing the Fed and Treasury when institutions like AIG, or Fannie and 

Freddie or a slew of banks get into trouble and threaten the rest of the financial 

system. In a well-ordered world there would be clear rules for resolution via bankruptcy: rules for settling claims would be clear and acted on quickly; bondholders 

would take over, and there would be no need for panic. This is something that happens relatively easily in structured securitization deals, but not for actual corporations. Bankruptcy is costly and time consuming. Uncertainty can breed panic and 

bank runs, and leave us with a choice between a bailout and a meltdown. 

The current debate about financial regulation is largely about avoiding that choice 

in the future. It has focused on making insolvency less likely by making financial 

institutions hold bigger capital cushions and on making insolvency less costly by setting up resolution systems. These are daunting tasks. However, there is a relatively 

easy way of starting to address the problem: We can require banks, and other financial institutions, to issue contingent capital, for instance in the form of Conditional 

Convertible (or ‘‘CoCo’’) bonds. This can be done by requiring issuance of bonds that 

look like regular bonds most of the time, but which are automatically converted into 

common stock when capital levels are low.2

The automatic conversion gives CoCo bond investors a strong interest in risk 

management (they can’t assume a bailout). If mandated as a part of pay, the bonds 

give management incentives to control risk, and movements in the market price of 

the bonds will provide daily evaluation of banks’ risk. CoCo Bonds also limit concern 

about institutions being ‘‘too big to fail;’’ because conversion avoids bankruptcy it 

mitigates concerns about disruptions. 

Why do this instead of just requiring more equity and less debt? One reason is 

that debt has advantages. It is easier to evaluate than equity, so it attracts a wider 

range of investors. Meeting debt payments imposes discipline on management, and 

debt has tax advantages. 

A second reason for liking CoCo bonds is that they address a problem that higher 

capital ratios cannot easily solve: the problem of banks that are still solvent but 

with low capital ratios. Suppose that the minimum capital ratio for banks is 5 percent of assets. Banks will keep a cushion above the required level, but not by much 

because equity is more costly than debt. If a bank’s capital ratio falls to, say, 3 percent, it will either have to raise capital or lower assets (lend less) to get back to 

5 percent. It will be solvent but in trouble. 

During a period when large numbers of banks are missing their ratios and there 

is a great deal of uncertainty, raising capital is difficult, putting banks in the position of having to cut back assets. In the extreme, getting back to 5 percent by 

shrinking the balance sheet would mean a 40 percent cut in assets. This problem 

will exist even with higher capital ratios as long as banks keep their ratios just 

above the minimum. With suitable triggers the decline in stock price that accompanies banks’ declining asset values will convert CoCo bonds into equity, providing 

an automatic and countercyclical cushion. 

CoCo bonds are not entirely appealing to holders of the bonds, who will want a 

higher interest payment on their bonds and will worry about premature exercise. 
75 

A way of handling some problems is to make the shares convertible back into bonds 

if the company subsequently recovers. 

It is important to emphasize CoCo bonds as a tool of monitoring and management. 

Traded bonds will provide a market read on the state of the banks, which will not 

be clouded by questions of bailouts. Including them in management’s compensation, 

can provide some disincentives for risk-taking. To the extent management is compensated with stock and stock options (or close substitutes) it has the incentive to 

take on risk in much the same way as shareholders. Imposing CoCo bonds as a part 

of their package forces them to take on some downside. Furthermore, these do not 

have to be traded, which mitigates some of the criticism around the trading of CoCo 

bonds. They can be designed in very specific ways (for instance by tying conversion 

to the bank’s asset value), which can unravel most of the disincentives that come 

from the asymmetric of outcomes to owning shares. 

Comments 

There are lots of structures that can work in principle. Given failure of the private-label market to provide market stability, having Government ultimately be a 

guarantor is probably necessary and not as scary as it might sound; it can enhance 

affordability and liquidity in the market where mortgages are traded-making a TBA 

market readily available. But there needs to be capital and incentives to limit risktaking. While there are several ways of doing it I think that contingent capital can 

move incentives in the right direction. 

References 

FCIC, FCIC, ‘‘Report of Financial Crisis Inquiry Commission,’’ Jan 2011 http:// 

fcic.law.stanford.edu/. 

Gorton, Gary. 2009. ‘‘Slapped in the Face by the Invisible Hand: Banking and the 

Panic of 2007.’’ Working Paper. New York: National Bureau of Economic Research. 

Lai, Rose, Neng and Robert Van Order, 2013, Remuneration Packages and CoCo 

Bonds: Providing Disincentives For Risk-Taking. 

Stanton, Thomas, 1991, A State of Risk: Will Government-Sponsored Enterprises Be 

the Next Financial Crisis? Harper Collins. 

Thomas, Jason and Robert Van Order, 2011, ‘‘Housing Policy, Subprime Markets 

and Fannie Mae and Freddie Mac: What We Know, What We Think We Know 

and What We Don’t Know.’’ 

Van Order, Robert. 2000. ‘‘The U.S. Mortgage Market: A Model of Dueling Charters.’’ Journal of Housing Research 11, 2: 233–55. 

Van Order, Robert and Anthony Yezer (2011), FHA Assessment Report, Third Edition. http://business.gwu.edu/creua/research-papers/files/FHA2011Q3.pdf. 
76 

3Prepared for Conference on ‘‘The Future of Housing Finance,’’ cosponsored by George Washington University and PWC, May 14, 2013. 4More important, but not possible to cover here, is the notion that risk applies to a whole 

portfolio, not just individual asset types, which means diversification should count too. 5 See http://www.fhfa.gov/Default.aspx?Page=313. 

APPENDIX 

What Is Credit Risk and Where Does It Come From?3

ROBERT VAN ORDER

OLIVER CARR CHAIR IN REAL ESTATE

PROFESSOR OF FINANCE AND ECONOMICS

GEORGE WASHINGTON UNIVERSITY

MAY 2013 

The last decade has provided us with some great data on credit risk-across product types, origination channels and risk characteristics, because the market has experienced both good times and, especially, bad. Most of the data we have are for 

loans that have been securitized, by the Federal Agencies (Fannie Mae, Freddie 

Mac, often referred to as Government-Sponsored Enterprises or GSEs) or in the 

‘‘Private Label’’ securities (PLS) market. Much of the data has been proprietary. The 

following sets of pictures from available data sets provide some summary information on where the risks have been. While obviously just a snapshot of a much wider 

set of data, they capture some important stylized facts. 

A key point is that risk is not about the level of defaults; rather it is about dispersion.4 We all know that some types of loans default more than others, but those differences can be priced, and they may not be especially important. If, for instance, 

pools of low downpayment mortgages always have the same very high default rates, 

we could readily price the loans to at least cover losses, in which case the pools 

would not have any risk and would have a fixed, risk-free return. 

That does not happen often, of course, but the example is illustrative. What matters regarding risk is how far default rates (more broadly, default costs) vary from 

what is expected when conditions change. From this perspective, from the data presented, there are some surprises: Low downpayment loans, by themselves, were not 

especially risky; nor were ‘‘affordable’’ loans that Fannie Mae and Freddie Mac were 

mandated to buy. 

Defaults and Risk 

The following three pictures, set up as tables, summarize some of the data supplied by the Federal Housing Finance Agency (FHFA).5 Here the focus is on fixedrate mortgages. (Adjustable-rate loans have similar properties but worse experience 

in general.) The data set covers loans bought by Fannie Mae and Freddie Mac and 

those put into PLS. The tables present matrices that show performance of the loans 

for different origination years, controlling for two important measures of credit risk: 

loan-to-value ratio (LTV) and borrower credit score (measured by the Fair Isaac 

(FICO) statistical credit score). 

The four LTV classes include: 

• 75 percent and below, the safest category 

• 75 percent–85 percent, the most common category, which clusters around 80 

percent 

• 85 percent–95 percent, high LTV loans, which cluster around 90 percent 

• 95 percent, which contain 95 percent and higher 

Credit scores range from low 500s to 800; they are put into discrete buckets. 

While there is not a clear definition of subprime, a reasonable definition for our purposes is that subprime covers anything with a credit score below 640 and anything 

from 640–680 with a loan-to-value ratio over 85 percent. 

Performance is measured by the share of loans of that year’s originations that 

were ever 90 days delinquent from the time of origination through 2009. Table 1 

depicts defaults on loans originated in 2003, a good year because property values 

rose rapidly in the following 3 years. For instance, the table says for loans with LTV 

less than or equal to 75 percent and FICO score below 640 6.9 percent of the loans 

originated in 2003 ever had at least one spell where they were 90 days delinquent. 

Table 2. looks at the same measure for loans originated in 2006, a bad year with 

sharply declining housing prices. Table 3. presents the differences between Tables 

2. and 1. 
77 

Table 1. Default Rates: 2003 Vintage (Ever Seriously Delinquent) 

Table 2. Default Rates: 2006 Vintage (Ever Seriously Delinquent) 

Table 3. Differences between Table 2 and Table 1 
78 

6This data set only tracks defaults through 2009, so it is not possible to have comparable 3- 

year periods of exposure. 7For Fannie/Freddie loans risk is even lower for high LTV loans because most of the losses 

have been covered by private mortgage insurance. http://fcic-static.law.stanford.edu/ 

cdnlmedia/fcic-docs/2009-06-04%20Freddie%20Mac-%20Cost%20of%20Affordable%20Housing 

%20Mission.pdf. 8This is probably because when dealing with prices falling by 40 percent in some regions, 

even downpayments of 20 percent provide much less protection than might be thought at loan 

origination. 

As can be seen by looking at the tables, default rates have varied greatly by product, vintage and mortgage characteristic. Major points with respect to the first two 

tables are: 

• The usual suspects matter. Looking at 2003 and 2006 vintage default rates, 

higher LTV meant higher defaults if FICO scores were held constant, and vice 

versa for FICO with LTV constant. 

• There are tradeoffs. For instance, in Table 1, for Fannie/Freddie data, 95 percent or greater LTV loans with credit scores in the (680–720) range had about 

the same default rates as those loans below 75 percent LTV loans with low 

credit scores (6.5 percent vs. 6.9 percent rates). What looks to be worst is not 

simply high LTV or low FICO, but high LTV combined with low FICO score. 

This is an example of risk layering. 

• Economic conditions were very important. The 2006 vintage had much 

worse defaults than the 2003 vintage for all categories and for both Fannie/ 

Freddie and private-label mortgages. The story is worse than the tables suggest 

because the 2006 loans had only 3 years of exposure until 2009; whereas the 

2003 loans had six.6

• The Channel is very important. Private-label securities had much higher default rates, even controlling for credit score and LTV, than did Fannie/Freddie 

mortgages. 

What is Risky? 

But what about risk? Risk of default is not the same as expected level of default. 

As discussed above, we know that high LTV loans have high default rates, but to 

be riskier they must have more volatile losses, rather than simply higher losses. If 

losses on loans (more broadly on portfolios of loans) are more volatile, then the risk 

of insolvency is higher even if the loans are correctly priced. 

The data sample depicted above is too narrow for complicated measures of volatility or dispersion. But it does depict a very severe sort of ‘‘one-shot’’ volatility from 

the extreme differences between 2003 and 2006. This measure of risk is akin to 

analysis from a stress test. If two products both have their losses increase by the 

same amount in the face of stress, then even if their losses are quite different on 

average, they are equally risky (and have the same implications for insolvency 

under that particular stress). 

Consider Table 3. It depicts differences between the first two tables. It shows sensitivity to the very poor economic conditions after 2006, relative to the good conditions following 2003. It is a natural stress test. 

Main results are: 

• Low downpayment loans were not especially risky.7 This is especially true 

in the middle of the matrices; for most elements of both the GSE and PLS matrices there is no clear relation between LTV and increase in default rate, holding FICO constant.8

• High FICO scores did matter, as did risk layering. This was true for both 

channels; moving northeast from southwest in the pictures lowered the lift from 

2003 to 2006. 

• Loans with LTV from 75 percent to 85 percent had the biggest increase 

for every level of FICO. This might be because loans involving moral hazard 

were more likely to have LTVs right at 80 percent and these loans were more 

sensitive to declines in property values. This ‘‘hump’’ in the risk profile is entirely from the 2006 vintage (see Table 2); there was no such hump in the profile of loans originated in 2003. 

• The channel mattered; PLS loans had much bigger increases across loan 

characteristics, by roughly twice. 

The last two points are suggestive of moral hazard being associated with 80 percent LTV loans after 2003, being in PLS pools, and being sensitive to property value 

changes. 
79 

9See ‘‘Cost of Freddie Mac’s Affordable Mission,’’ presented to Freddie Mac Board, June 4, 

2009. See http://fcic-static.law.stanford.edu/cdnlmedia/fcic-docs/2009-06-04%20Freddie%20 

Mac-%20Cost%20of%20Affordable%20Housing%20Mission.pdf. 

Low income and targeted lending 

The above does not separate out low income and other types of ‘‘affordable’’ lending products that have been blamed for defaults. Again, the question is not whether 

they had higher default rates (they did), but whether they were riskier. Here I look 

at some data and analysis provided to the Financial Crisis Inquiry Commission,9

which compares actual performance with expected for various loan types, using 

Freddie Mac data. 

The picture looks at three types of loans: those that did not qualify for housing 

goals (blue line), those that did qualify but were not done via special programs (yellow line), and those done via programs designed to attract goals-rich loans (green 

line). The horizontal axis has default rates estimates before the fact (from Freddie 

Mac models) and the vertical axis is corresponding actual default rates. 

The lines show that all three types did considerably worse than predicted. However, the blue and yellow lines (regular business and special affordable programs) 

are very close, indicating that the reaction to the Great Recession shock was the 

same for regular as it was for affordable loans. This bit of evidence suggests that 

the housing goals added little to the risk of the GSEs. 

In summary, the news from the two sets of pictures is that two types of loans 

that might be thought to have been risky, low downpayment and ‘‘affordable,’’ have 

not been especially risky. Risk, in the Great Recession stress test was largely due 

to economic conditions, the channel through which the loans were made and layered 

risk loans. http://business.gwu.edu/creua/research-papers/files/FHA2011Q3.pdf.