The recent financial crisis and its aftermath have raised fundamental questions about the future of the U.S. housing market and the GSEs.

With broad implications for homeowners and the country's financial system, the Obama administration has started to seek input on what the future roles of Fannie Mae and Freddie Mac should be in housing finance. A few options are being explored by mortgage market players including the creation of a single agency mortgage security as well as bolstering a covered bond market to replace the agencies.

Comment letters on the future of the GSEs were due to the Treasury Department the week of July 12. More than 300 individuals, businesses, and trade associations voiced their opinions on the issue.

While the consensus was far from united, most industry participants agreed that some form of government support is still necessary to maintain a viable framework for the U.S. housing market to thrive.

An instructive example is an industry hallmark - the 30-year fixed rate mortgage. The future of this product is dependent on the existence of a government guarantee, most market observers agreed.

The Single Security

The creation of a single agency mortgage security, according to several market sources, would foster competition among lenders and bolster market liquidity.

If a single security model similar to that currently used by Ginnie Mae were applied to all of the GSEs, there would be fewer barriers to entry for smaller mortgage issuers who have had a difficult time competing with Fannie and Freddie.

"If we move to a common security, a new conduit could be formed that would open the doors for potential competitors," said Ann Schnare, president of A.B. Schnare Associates. "In Ginnie Mae, an issuer could go under, and no one would even know."

Schnare does not believe that simply adding more stringent regulatory standards to the current system would yield the most beneficial result.

"If we stick to the status quo and Fannie and Freddie continue to operate as they do now, but with stricter requirements, the government would still have to step in if something goes wrong," she added.

Christopher Killian, vice president of the Securities Industry and Financial Markets Association (SIFMA), said that the proposal for a single security could add homogeneity to the system. "Right now we have three securities. Having one would help with liquidity in the market," Killian said.

"Much of the business in this market is based on liquidity," added Richard Dorfman, head of the securitization group at SIFMA. He cited several pros and cons of the idea, but he believes that having one kind of security would mean a, "more universal delivery with the advantages of liquidity."

Killian and Dorfman stressed the importance of a thoughtful transition into new housing policies regardless of what these will eventually entail. "This is only the first round of questioning," Dorfman said. "This is an enormous and crucial task, and should be handled professionally. Anyone who claims to have the answers is not being serious - we need to do all that we can to come up with the right solutions before taking the next step."

 The Covered Bond Alternative

A fully developed covered bond market has also been proposed as an alternative to the GSEs. Coincidentally, last week the House Financial Services Committee approved legislation to establish a regulatory framework to support a U.S. covered bond market.

The bill was sponsored by Reps. Paul Kanjorski (D., Pa.) and Scott Garrett (R., N.J.) and received substantial support from industry trade associations, the American Securitization Forum, the SIFMA and the CRE Finance Council.

Bert Ely, president of Ely & Co., referred to himself as the "champion of covered bonds" at a SIFMA panel on GSE reform held in early July. During the discussion, Ely said that the sector is a means to achieve safer and more efficient markets in place of direct federal government involvement.

He noted that covered bonds have a higher credit rating and entail lower funding costs compared with MBS. However, he said that GSE reform legislation should be kept separate from any attempt to promote a thriving covered bond market.

Covered bonds, however, have certain disadvantages. Schnare said that covered bonds are not particularly well suited for funding 30-year fixed-rate mortgages and would likely pose certain limitations to potential homebuyers.

Conflict of Interest

One reason for finding an alternative paradigm for Fannie and Freddie is that there is an inherent conflict of interest between their public mission and their status as private companies that need to make a profit for their shareholders.

"Fannie Mae and Freddie Mac have been overwhelmingly successful in what they have been tasked to do over time," Dorfman said. "They have had tremendous success in bringing liquidity to the mortgage market through securitization. Fannie, Freddie, and Ginnie have been a triad of successful securitization mechanisms, performing a landmark job of providing additional sources of investment."

"The biggest thing to sort out," Killian continued, referring to the mission of the GSEs is finding "a clearly defined goal. There is not necessarily one best way to address the problem. It will require a lot of careful consideration, but some have suggested a regulated utility model with a cap on the profit motive, or graduated capital standards."

Aside from sorting out their mission, distinctions must be made, experts said, between the GSEs' MBS holdings and their debt. "Many believe that the guarantee needs to be made explicit and only applied to MBS issuance and not to their debt," added Schnare."This would reduce moral hazard for the GSEs. Some also suggest that their portfolios should be limited and restricted to operational purposes."

"The fundamental problem," Ely said, "is the question: who is going to own them? I've been arguing for a long time that this business model just doesn't make sense."

Ely went on to draw a parallel between Fannie, Freddie, and the Food and Drug Administration (FDA), arguing that the government could do away with the wrap without completely giving up its regulatory capacity.

"The FDA doesn't guarantee drugs," he quipped. "Just because you regulate something doesn't mean you have to guarantee it. If something goes wrong with a drug, it's the company that manufactured that drug that's liable, not the FDA."

Additionally, Ely suggested that if homeowners were required to put more skin in the game, a significant amount of the need for the government wrap would also dissipate. Bringing down LTV ratios is one potential option for achieving this objective and could help to lessen the dependency on taxpayer support.

TBA Markets

SIFMA also placed considerable emphasis on the importance of the TBA market. In the association's comment letter on GSE reform, it stated that some form of government support would be required to maintain TBA market stability.

"The TBA market is the most liquid mortgage market there is - it's up there with Treasuries," Killian said. "Underpinning this liquidity is homogeneity. The securitization you're going to get two months from now is the same that you'll get today, so you're comfortable with forwards," he explained.

"The biggest threats to the TBA market are actions that would reduce the actual level or perceived level of homogeneity," Killian added.

In making future decisions, SIFMA's comment letter to the Treasury urged policymakers to consider the following: secondary market liquidity for loans and MBS; product variety being offered; lender capacity to extend credit; sustainability of national lending markets; reappearance of regional pricing differentials; and cost and affordability of credit to consumers.

The Politics of Housing

The future of the GSEs is an issue mired in partisan politics, Schnare and Ely both noted. Fannie and Freddie became headline news during the financial crisis, and both Democrats and Republicans have been eager to point the finger in assigning blame to these agencies for the housing market's ills.

"What happens to the GSEs will depend largely on the upcoming elections," Schnare said. "This highly charged issue could be a stalemate in Congress. Fannie and Freddie have been the face of the housing blow up in the minds of many Americans, and maybe unfairly. Regardless, there is a lot of passion surrounding these issues and they will definitely come into play politically."

"You're going to run into a lot of problems with Republicans," Ely added. "If Democrats lose seats in 2010, the question will become whether a Republican leaning Congress will go along with this. Even among liberal Democrats there isn't consensus on what should be done."

Schnare and Ely also seemed to agree with SIFMA's public statement that transitioning the GSEs out of conservatorship would be a difficult task in moving forward. Each cited a likely "good bank, bad bank" scenario. "The process will involve spinning off that which is good from the corpse," Ely said.

SIFMA's comment letter stated that the government must clearly express its intentions with respect to legacy GSE issues before and during any transition process.

Policymakers should avoid bifurcation of markets into pre- and post-reform markets, the trade association advised. "Abandoning an existing market would have serious and long-term consequences for the global flow of capital to the U.S., " the association said in its comment letter.



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