The Obama administration proposal on GSE reform reiterated the importance of the securitization market in the future of housing finance.

The Treasury's white paper said that securitization, alongside credit from the banking system, should continue to play a major role in housing finance, although with greater risk retention, disclosure, and other key reforms.  

The administration believes that the securitization market requires meaningful reform so private investors can confidently participate in the housing market and provide an alternative funding source for mortgages outside of the traditional banking system and government-supported institutions.

The proposal reiterated the government's stance on risk retention and said that the administration continued to work with federal regulators to set rules requiring securitizers or originators to retain 5% of a security’s credit risk when sold to investors. Rules are expected to be finalized in 2011 and become effective in 2012.

"Combined with an exemption for mortgages that meet high underwriting standards (Qualified Residential Mortgages [or QRM]), this requirement will improve alignment of interests between mortgage originators, securitizers, and investors," said the proposal.

The Treasury further emphasized its stance on improving transparency for all market participants and highlighted the Dodd-Frank Act provisions that set stricter disclosure and reporting requirements so that regulators and investors can more easily understand the underlying collateral and risks of securities.

The Securities and Exchange Commission (SEC)-backed Office of Credit Ratings would provide dedicated compliance resources with the ability to improve disclosure for ratings methodologies, set new requirements to prohibit conflicts of interest, and authorize the SEC to de-register ratings agencies that perform poorly.

"We are encouraged by the plan’s objective of creating a level playing field through an increase in guaranty fees that removes Fannie’s and Freddie’s capital advantages, " American Securitization Forum (ASF) Executive Director Tom Deutsch.

He said that  this unfair advantage has restricted private capital availability to fully support the country's housing finance system and shifting that burden to the American taxpayer. He added that the ASF also supports the plan’s recommendation to let the higher conforming loan limits expire as scheduled in September. "Those two measures could significantly reduce the GSEs’ market share and should be implemented over the short term while Congress decides the long-term fate of the existing GSEs,” Deutsch said.

The ASF, Deutsch said, is carefully weighing the government’s report to Congress and will focus considerable attention to review the options contained in it.

"We are pleased the administration understands the importance of proceeding thoughtfully and deliberately in reducing the government’s role in the housing market," Deutsche said. "We also want to make sure that whatever emerges from this process enables the private sector to fully utilize securitization vehicles. Securitization is key to ensuring the housing market and American homebuyers have access to adequate liquidity at a reasonable cost.

Analysts' View on White Paper

The white paper does not contain any major surprises versus Barclays Capital analysts expectations. The Treasury offered three longer-term plans for successors to the GSEs. Each of the alternatives had some form of government involvement, although nationalization was not one of them.

The key operating principle, analysts said, is  making sure that minimal market disruption by prematurely constraining the GSEs' ability to "guaranty loans or precipitously winding them down."

There are no specific timelines for action in the paper, and regardless of the Treasury's recommendations, ultimately it will be up to Congress to enact fundamental housing finance reform, Barclays analysts said.

More significant to investors its that the Treasury reiterated several times that it is committed to keeping GSE debt and MBS obligations performing, Barclays analysts said. For instance, they cited that the Treasury stated that it will keep its commitment to ensure Fannie Mae and Freddie Mac have enough capital to honor any guarantees issued presently or in the future and to meet any of their debt obligations.

More generally, the Treasury wants to set in place conditions to "crowd-in" private capital. One way is to devise methods to remove "unfair capital, oversight, and accounting advantages."

Although a broad statement, Barclays analysts said that the advantages enjoyed by the GSEs include the fact that banks might hold their securities in any amount, at a preferentially lower risk weight. There are also no risk retention requirements when originating GSE loans.

The white paper also recommended increasing guaranty fees so that private capital is not disadvantaged from the GSE subsidy.

Additionally, Barclays analysts cited that the goverment suggested increasing down payment requirements over time, recommending also that the GSEs should require at least a 10% equity requirement.

The prospects of a decreasing loan size, increasing guaranty fees, and reduced net supply should all be positive developments for the basis, Barclays analysts said. Lowering loan sizes and rising guaranty fees imply an improved convexity profile for the mortgage universe over time, they said.

Efforts to limit the GSEs' market share should also act to lessen net supply, which should be a positive technical as well, analysts added.

From a credit perspective, "the Administration will not pursue policies or reforms in a way that would impair the ability of Fannie Mae and Freddie Mac to honor their obligations." Treasury believes, and Barclays suggested, that the existing Preferred Stock Purchase Agreement (PSPA) structure is adequate to ensure an orderly wind-down of the GSEs.

Barclays analysts noted that the Treasury made a subtle language change regarding the retained portfolios: "The PSPAs require a reduction in this risk-taking by winding down [FNM/FRE] investment portfolios at an annual pace of no less than 10%."

The proposal offers to work with Congress to consider alternative sources of mortgage finance, "including potentially the development of a covered bond market." Barclays said that this seems to be a clear call to develop a legal framework for U.S. covered bonds.

Limiting Federal Home Loan Bank System (FHLB) activities in advance lending and portfolio investment is presented as a way to reduce their risk profile, but would also help make room for a covered bond market: "The administration supports allowing each financial institution to be an active member in only a single FHLB Bank. We also support limiting the level of advances."

This would force large banks, Barclays analysts said, to be less dependent on the FHLB for funding. This would also pave for bonds, analysts said. Given their previous assessment, such a market could eventually grow to $200-$300 billion.

Positive supply technicals to continue. Not only is there a chance Fannie Mae/Freddie Mac will shrink more quickly than the 10% requirement, the FHLB advance business could also be subject to pressure. Additionally, analysts said the FHLB investment portfolios, which are worth $180 billion, might also be restricted.

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