Senate Sends Housing Finance a Lifeline: How Will It Affect Investors?

To the welcome relief of U.S. senators, and even many from both sides in the House of Representatives, leaders in the Senate Banking Committee have reached agreement on the “essential elements” of housing finance reform legislation. Those elements, the committee’s communique says, are largely consistent with the proposals in the Corker-Warner bill, introduced in the Senate last year with broad bipartisan support. While fealty to Corker-Warner greatly improves chances for a bill getting signed into law this summer, it does little to ensure the plan’s ultimate commercial success.

From a political perspective, using the Corker-Warner architecture ensured that the process was able to retain the support that proposal has generated over the past year. That includes not only the more than 10 co-sponsors, but the bipartisan imprimatur of the bill’s namesake senators.

For taxpayers, the bill retains Corker-Warner’s overarching, but potentially conflicting, aims of protecting taxpayers from future bailouts while ensuring the availability of affordable, 30-year, fixed-rate, prepayable mortgages. It also means a Senate bill would conclude the business activities of Fannie Mae and Freddie Mac and replace them with a mortgage insurance fund supported by participating lenders and securitizers.  (A list of the principles and some of the details of the agreement can be found on the Senate Banking Committee’s website).

For investors, though, the agreement retains many of the flaws that CFA Institute has raised in meetings with staff on Capitol Hill. For one, the structure appears to retain Corker-Warner’s heavy, if not comprehensive, reliance on the willingness of private investors to acquire a first-loss position equal to 10% of each deal. Unless investors are willing in large numbers to step up for this high-risk venture, the whole structure could collapse.

Worse, the agreement says nothing about ensuring these investors have information about the underlying mortgage pools into which they are expected to invest. Instead, it appears, they will have to rely, in turn, on the continuing piety of lenders and politicians to strong underwriting standards established when the bill is signed into law. Sure, the yields should be significant, but is it really worth the political, operational, and interest rate risks implied by such a system?

Need for “Skin in the Game”

The creation of the insurance fund gives a faint-hearted nod in the direction of “skin in the game” for lenders and securitizers through mutualization. Indeed, intermediaries will retain a portion of the risks they create because of the mutual structure. But the amount of risk they will retain will be infinitesimally small, particularly in comparison with the risks that third-party investors are expected to assume, sight unseen.

To this end, CFA Institute has gone on record, and will continue to go on record, calling for market participants to have meaningful skin in the game. By that, we have suggested that up to half of the 10% first-loss position should be retained by the parties orginating the risks. As you might expect, this view isn’t terribly popular with lenders or other intermediaries.

One important change that the agreement contemplates in comparison with Corker-Warner, however, is a plan to exclude affordable housing goals. Instead, it appears to seek creation of “transparent and accountable housing-related funds” focused on ensuring “sufficient decent housing.” In one sense, this would alleviate concerns that loan pools would include large percentages of subprime loans.

All in all, prospects look good that a bipartisan housing finance bill will be on the President’s desk for signature by summer. It’s taken more than five years to get here, but the politicians and the intermediaries have finally produced a bill to their liking that the President can sign.

That’s when investors will take center stage. Or not.

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Photo credit: iStockphoto.com/drnadig