A question posed by Sen. David Vitter last week has sparked fears among investors about what exactly two top administration officials meant when they responded to whether the GSEs would be exempted from pending risk-retention requirements.

To many, Housing and Urban Development (HUD) Secretary Shaun Donovan's statement that there were no plans for any exemption was ambiguous at best, leaving open the question of whether the GSEs will have to hold more capital as a result of the rule or if they will instead be largely unaffected.

But the eagerness of the market to parse Donovan's and Treasury Secretary Tim Geithner's words at a Senate Banking Committee hearing underlines the anxiety over the forthcoming plan, the potential adverse impact of a narrowly tailored definition of risk-retention and a lack of consensus among regulators about how to move forward with the proposal.

"It's the nature of the absence of concrete information that things are left to interpretation," said Douglas Harter, an analyst with Credit Suisse. "It's just tough, and it's going to remain that way until the different agencies come out and put out the initial proposal."

Another analyst, who spoke on condition of anonymity, said he had received multiple calls from clients requesting clarity after Geithner and Donovan testified last week. "We're just trying to make sense of how a GSE exemption would work? Why was it put on the table originally? How does that interact with this idea of a 20% down-payment requirement that everyone is talking about?" the analyst said.

Donovan and Geithner were responding to a question from Vitter, R-La., who has been steadily raising concerns about the issue.

"There are proposals to exempt GSE loans from risk-retention. Do either of you support that?" he asked the two officials, who were testifying on the administration's white paper on the future of housing finance released last month.

"I actually do not think there are discussions about exemptions," Donovan said. "Everything we've said in this discussion today about reform of the GSEs would suggest that we are very much in favor of ensuring that the GSEs are holding adequate capital against their commitments."
Responding to the same question, Geithner said the administration's objective is to have "private markets — the banks and the investors — bear more of the risk in housing finance, not less of the risk. So absolutely we want to make sure as we design these draft regulations that we're meeting that basic objective."

"At issue is a provision of Dodd-Frank that requires lenders to hold 5% of the risk of any mortgage they sell to the secondary market, unless the loan meets certain criteria designating it as a "qualifying residential mortgage." The regulators were supposed to finalize the rule by April laying out how the process would work, but have yet to release a proposal.

When regulators first struck a deal in early March, sources said the GSEs would be exempt from the rule while they were in conservatorship, prompting concern by Vitter and others. Donovan's comments appeared to say the opposite, indicating the GSEs would not have any exemption. Confusing the issue further was what an exemption means in the context of the GSEs. Fannie Mae and Freddie Mac do not originate loans and retain all of the credit risk of mortgages they purchase from other lenders.

To many, it's clear the GSEs already comply with the risk-retention proposal because they place a credit guarantee on every loan they purchase and securitize.

"To me, it's intuitively obvious that a 100% dollar-for-dollar guarantee is retention of risk," said Karen Shaw Petrou, managing partner with Federal Financial Analytics.

But Shaw Petrou said regulators such as the Federal Deposit Insurance Corp. (FDIC) disagree, viewing the guarantee as an off-balance-sheet obligation that does not necessarily translate into holding higher capital to protect against the risks of the loan. "The logic may be it's an off-balance-sheet commitment that might not be capitalized," Shaw Petrou said. "It isn't good enough. I agree that capital is sometimes not sufficient for off-balance-sheet obligations, but it's still a dollar-for-dollar guarantee. It's more robust than holding back $5 for every $100."
Under that scenario, the GSEs would have to either hold more capital against any loans they securitize or ensure they are "qualifying residential mortgages," which face stricter underwriting requirements.

In a note to clients last week, Shaw Petrou said Geithner's and Donovan's "vague answer" just confounded the issue further. While Donovan said the GSEs would not receive an exemption, his answer left room for the idea that Fannie's and Freddie's existing guarantees would constitute compliance with the risk-retention. The key, she said, was how regulators define risk-retention.

"If a guarantee — whether from a GSE or another guarantor — is risk-retention, then loans securitized by Fannie and Freddie meet the law's standards and need not find succor in the arms of the QRM," the note said.

The question is critical and has spooked many in the mortgage market. If the GSEs have to raise capital, that would increase the potential cost of the convseratorship. "If they don't exempt GSE securitization, all they do is deepen the hole at Fannie and Freddie," Shaw Petrou said.
But other analysts argued that if the GSEs do not have to hold additional capital or ensure compliance with QRM, their unfair market advantage will persist, preventing the return of private capital to the mortgage system.

"Eighty percent of the market share is made up of GSEs, and the rest is [the Federal Housing Administration], which is already exempt by statute; so then you have 100% of loans exempted from risk-retention," said the analyst who spoke on condition of anonymity. "The entire section of Dodd-Frank is voided basically until full private-label securitization returns."

But if the GSEs are significantly affected by risk-retention, it could cripple the still-recovering mortgage market. As a result, some said that whether its dubbed an "exemption" or not, the Obama administration will ensure the retention plan does not spur higher losses at the GSEs or damage the market.

"They don't want to advantage the GSEs too much by giving them special rules, but at the same time I don't think they want to do anything too quickly," Harter said. "To me, it makes senses if you exempt the GSEs and then you have a plan whereby you are reducing the GSE size in the market. To that extent you are then sort of reducing that exemption, therefore allowing the market to absorb these changes more slowly."

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