CONFIDENTIAL DRAFT Freddie Mac Analysis of …online.wsj.com/public/resources/documents/042514Freddie...2014/03/26 · in the proposed structure and make it less attractive to new

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Freddie Mac Analysis of Johnson-Crapo Discussion Draft Confidential Draft: March 26, 2014

The purpose of this memorandum is to provide Freddie Mac’s preliminary comments on the Johnson Crapo discussion draft, the “Housing Finance Reform and Taxpayer Protection Act of 2014” (hereinafter referred to as “Discussion Draft” or “bill”). Detailed below are comments that seek to gain greater clarity regarding the relationship among the key market participants including the aggregators, guarantors, and the Common Securitization Platform, as well as comments regarding the transition to the new housing finance system. Our comments often focus on larger themes addressed in more than one title in the bill. In some cases, we have provided for consideration suggested technical or clarifying revisions to discrete portions of the Discussion Draft. Overall, our comments focus on areas of concern that should be considered before the commencement of the transition period. This paper is structured as follows: Section I. Aggregators Section II. Guarantor Execution Section III. Common Securitization Platform Section IV. Capital Markets and TBA Transition Section V. Servicing Section VI. Small Lender Mutual Section VII. Multifamily Section VIII. Credit Risk Sharing Section IX. Technical and Clarifying Considerations relating to the Transition and Termination

of Fannie Mae and Freddie Mac Section X. Improving Transparency, Accountability and Efficacy within Affordable Housing SECTION I. AGGREGATORS Issue: Relationship of aggregators, guarantors and CSP is not clear.

• The role of the aggregator is to acquire loans for pooling, arrange for a guarantee or capital markets execution and deliver pools to the CSP for securitization. If an aggregator has no skin in the game and is not subject to contractual supervision of the loan manufacturing process by the loan guarantors, it will have less of an incentive to deliver well underwritten loans.

• The Discussion Draft is silent on a number of key points regarding the relationships of and interplay among these major market participants. (We understand that some of these matters could be addressed through the promulgation of a regulation by FMIC.)

• It is unclear whether aggregators will have prearranged contracts that outline pricing and credit policies similar to current Enterprise guides and contracts. The absence of this structure would limit the forward nature of mortgage market for borrowers

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and/or increase the risk premiums that aggregators will pass on to borrowers for execution uncertainty. The Platform will need to create many of the standards found in the Enterprises’ guides and contracts to create a single security to preserve the TBA market.

• It is unclear whether aggregators will be subject to representation and warranty liabilities if an eligible loan is proven to have been originated inconsistently with the purposes of the bill. If so, in order to monetize the representation and warranty liabilities, what would be the aggregator’s capital requirements?

• It is unclear whether a guarantor will have a voice in the aggregator’s selection of a servicer, assuming the guarantor is not an affiliate of the aggregator. Will aggregators have the option to be the servicer and/or release servicing to another FMIC approved servicer?

• It is unclear whether all securities guaranteed by various aggregators will roll up to a common FMIC security that is backed by the full faith and credit of the federal government and is indistinguishable by aggregator or guarantor. Without a single security, the multiple guarantor model collapses. The single security makes it difficult to see through to aggregators or guarantors and this could help minimize fragmentation of the TBA market.

• It is not clear how capable aggregators will be able to execute credit risk transactions directly to the capital markets to meet the 10% capital threshold. Assuming aggregators can execute efficiently, such transactions are likely to give large aggregators an advantage over the small lender mutual or other small aggregators.

Recommendations:

• The approach of rebuilding automated underwriting systems, credit compliance technologies and note certification processes is long and difficult. Leveraging the Enterprises’ processes would be more efficient.

• Require the platform to confirm or seek certification that the guarantor has approved the loans that are going into the new FMIC security and, if confirmed, proceed to securitization.

SECTION II. GUARANTOR EXECUTION Issue: It is unclear whether the guarantors will be able to raise sufficient capital.

• Using the agency market as an approximation for the new government-guaranteed market created by the Discussion Draft, the “covered securities” market would be a $5 trillion market. With 10% capital required for the first loss position, this means the market would require about $500 billion of capital to meet anticipated demand after full transition to the new system. The combined capital for three largest banks (JP Morgan,

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BofA and Citi) was approximately $650 billion as the end of 4Q 2013. If $500 billion capital would be required for the first 10% loss, that is about 16 times what the entire MI companies/financial guarantors had. It’s not clear that this level of capital can be raised to support the new system.

• Several other issues impede the competitiveness of the business model of the guarantor in the proposed structure and make it less attractive to new entrants.

• With a 10% capital requirement versus, for example, a Basel III 5% leverage ratio for large banks, the guarantor is disadvantaged by cost of capital versus other financial investors in credit risk. This will create concerns about adverse selection, i.e., the guarantors will only get the least desirable loans.

• Under the Discussion Draft, aggregators can bypass guarantors through capital markets executions. Given that markets are cyclically favorable to mortgage risk (discussed more fully below), the credit-risk-transfer path will be more efficient than the guarantor business model, as the cost of capital via such executions will be lower. (Our experience with risk transfer transactions strongly supports this contention.)

• The entity level capital of guarantors effectively cross-collateralizes credit risk, compared to risk dispersed via credit risk sharing methods. Thus, the guarantor path would be a more durable capital structure across economic cycles.

Recommendations:

• Require all first loss to go through guarantors. Capital markets executions will still be done, but by guarantors. This will increase guarantors’ ability to earn a fair return and not be adversely selected. It also will provide a means for guarantors to disperse their credit risk. And, it will help mitigate the procyclicality inherent in the proposed system.

• Adopt a flexible definition of the 10% capital requirement. The definition of capital is not specified. Because of that, investors in guarantors will hang back until it is specified, which may not be for some time. Indeed, it seems unlikely that new entrants will enter the guarantor space until the capital rules are determined – and determined to be favorable. This delay may undermine the viability of the system from its inception. Also, if too much of the 10% is required to be common equity (discussed more fully below) then the guarantors will simply have little ability to compete.

Issue: The servicing construct is inconsistent with the standard practice, in which the provider of the first loss controls servicing.

• Currently, the GSEs and FHA/VA/GNMA have the ability to manage their credit risk, and hence, protect their capital, through the master servicing arrangement they have with the servicers of the loans they insure. This capability was critical during the downturn: guarantor and servicer incentives are aligned through on-going contractual relationships

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(expressed in servicing guides and day-to-day contact) and through the ability to reward and penalize behavior, including transfers of servicing if necessary to protect the guarantor. FHFA has proven that this construct works today.

• It is unclear whether investors will want to capitalize monoline entities if the owners of the risk cannot actively manage that risk on a daily basis, and instead have to rely on a third-party whose incentives may be different than the guarantors’ incentives. At a minimum, aggregators would have to pay higher guarantee fees to compensate for the increased risk. Those higher fees will be passed onto the borrower, in the form of higher mortgage rates.

• In the end, removing master servicing from the guarantor would restrict access to credit

and make the guarantee business less attractive to potential entrants.

Recommendation:

• The bill should be clarified to include the concept of master servicing by a servicer and make it clear that the guarantor, as first loss provider, is the master servicer and has the ability to select the servicer, manage performing and nonperforming loan servicing, and has the unilateral right to transfer servicing from one FMIC-approved servicer to another if deemed necessary.

Issue: The system may be procycylical, resulting in greater taxpayer exposure than desired.

• As the recent experience of private capital leaving the housing market suggests, capital markets execution and other credit-risk-transfer mechanisms may not be available during portions of the economic cycle. As a result, monoline guarantors may get disproportionate market share when house prices are stagnant or falling and returns are depressed.

• There are three implications. First, the system may be unable to attract and maintain diversified and durable funding throughout all phases of a business cycle. Second, it may be difficult to attract new entrants to the guarantor space. Third, because guarantors have no duty to be in all markets and at all times, the system will be more volatile and the FMIC may have to exercise its unusual and exigent circumstances authority more often than anticipated. Participation of guarantors is critical to the success of the new housing finance system. In order to ensure guarantor participation, the bill must allow for the guarantor to control servicing, ensure that capital requirements are not so onerous as to make the business uneconomic, and make the necessary infrastructure available upon enactment.

Recommendation:

• Require all first loss to go through guarantors. This will increase guarantors’ ability to earn a fair return and not be adversely selected. It also will provide a means for

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guarantors to disperse their credit risk. And, it will help mitigate the procyclicality inherent in the proposed system.

Issue: G-Fees will increase under the bill.

• There is no question that g-fees and thus mortgage rates would increase under the bill because of the increased capital requirements. The question is by how much. Our preliminary estimates are set forth below.

• The Discussion Draft requires 10% first-loss private capital standing in front of “eligible securities.” FMIC has very broad discretion to determine what counts toward this capital requirement and how much to charge for the federal back-stop. In addition, guarantors and aggregators face a variable net cost for the Market Access Fund. Finally, markets will determine the cost of credit risk-sharing transactions and, offsetting higher costs, the yield benefits of an explicit federal guarantee. Depending on these decisions, the net effect on mortgage rates can vary widely. To illustrate this sensitivity, we created four stylized scenarios to bracket least costly-to-most costly combinations of assumptions (separate hand-out). The scenarios range from virtually no change to over 200 bps change, with the middle range between 60 and 140 bps increase.

• This analysis does not include any premium for losing control of servicing, as discussed above and assumes a reasonably representative mix of what the primary market originates; an adverse selection would raise costs by 5-15bps.

• This analysis also does not speculate on how the FMIC will use its authority to ensure capital equivalency among risk-absorbing executions. As discussed earlier, the guarantor execution diversifies across originations cohorts and, compared to pool-specific market structures, effectively cross-collateralizes risk. This lowers the risk to the SF MIF of the guarantor execution. This adjustment could be done in definition of eligible capital or in the MIF fee structure, or both.

• As a result of the increased g-fees, marginal borrowers, many of whom will likely be subject to risk-based lending fees, may lose the ability to obtain mortgage credit. That could lead to FHA being adversely selected and the government’s footprint in housing may actually increase rather than decrease.

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Scenario Assumptions

Low Cost Mid-Cost High Cost Extreme

Cost

Common equity

4.00% 5.00% 7.00% 10.00% After-tax cost of common equity

10.00% 12.50% 15.00% 16.25%

Pre tax cost of common equity

15.38% 19.23% 23.08% 25.00%

Return on Reinvested Capital

3.00% 2.50% 2.00% 2.00%

Net Pre-Tax Cost of Common Equity 12.38% 16.73% 21.08% 23.00%

Preferred equity

1.00% 1.00% 0.00% 0.00% After-tax cost of preferred equity

6.00% 7.00% 8.00% 9.00%

Pre-tax cost of preferred equity

9.23% 10.77% 12.31% 13.85%

Return on Reinvested Capital

3.00% 2.50% 2.00% 2.00%

Net Pre-Tax Cost of Preferred Equity 6.23% 8.27% 10.31% 11.85%

Risk syndication (STACR)

4.00% 3.50% 3.00% 0.00%

Cost of risk syndication 1.50% 3.00% 4.00% 4.50%

Present value of future g fees 1.00% 0.50% 0.00% 0.00%

pretax return on unlevered capital 3.00% 2.50% 2.00% 2.00%

Tax rate 35.00% 35.00% 35.00% 35.00%

Expected Losses

0.03% 0.05% 0.08% 0.10% G&A

0.06% 0.07% 0.09% 0.11%

MIF fee

0.05% 0.10% 0.15% 0.15% Market Access Fund

0.07% 0.10% 0.13% 0.13%

Full faith pick-up -0.25% -0.20% -0.15% -0.10%

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Low Cost Scenario

Capital Structure Return Cost

Mid Cost Scenario


Common equity 4.0% 12.38% 0.50%

Common equity 5.0% 16.73% 0.84%

Preferred equity 1.0% 6.23% 0.06%


Risk syndication 4.0% 1.50% 0.06%


Present value of future g fees 1.0% 0.00% 0.00%


Total Capital 10.0%

Total Capital 10.0%

Required return on capital

0.62%


1.02%

Expected Losses

0.03%

Expected Losses

0.05% G&A

0.06%

G&A

0.07%

MIF fee

0.05%

MIF fee

0.10% Market Acess Fund

0.07%

Market Acess Fund

0.10%

Full faith pick-up -0.25%


Total G Fee (excluding servicing) 0.58%


Current G Fee 0.50%

Current G Fee 0.50%

Low Cost Scenario Increase 0.08%

Mid Cost Scenario Increase 0.64%

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High Cost Scenario


Extreme Cost

Scenario Capital

Structure Return Cost

Common equity 7.0% 21.08% 1.48%

Common equity 10.0% 23.00% 2.30% Preferred equity 0.0% 10.31% 0.00%






Total Capital 10.0%

Total Capital 10.0%


1.60%


2.30%

Expected Losses

0.08%

Expected Losses

0.10%

G&A

0.09%

G&A

0.11%

MIF fee

0.15%

MIF fee

0.15% Market Acess Fund

0.13%

Market Acess Fund

0.13%





Current G Fee 0.50%

Current G Fee 0.50%

High Cost Scenario Increase 1.40%

Extreme Cost Scenario Increase 2.19%

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Recommendation:

• We believe the bill should incorporate a flexible view of what qualifies as capital to satisfy the first-loss position without prohibitive g-fees.

Issue: It is unclear whether guarantors would extend underwriting tools to aggregators individually or whether one automated underwriting tool would be permitted with multiple guarantor rules within it.

• Today’s “guarantors” provide their guarantee consistent with their own risk appetite, as communicated through their guides or their automated underwriting systems. The Discussion Draft seems to suggest that FMIC will dictate credit terms so that, in essence, all guarantors will be buying off the same “guide.” (The same appears to be true of servicing guidelines.)

• Some standardization is important for, among other things, maintaining the TBA market. However, if all credit (and servicing) decisions are taken from the guarantor, it will stifle innovation and, again, make the guarantor business model less attractive to some potential new entrants.

Recommendation:

• A guarantor will want both clarity and certainty with respect to the parameters of its credit policy and purchase eligibility requirements, including risk-based pricing. Consequently, we believe the bill should reinforce that, while the FMIC underwriting standards are intended to be substantially similar to the CFPB’s QM requirements, such underwriting standards are neither designed nor intended to supplant a guarantor’s ability to set its own purchase eligibility requirements, as long as such requirements are not in contravention of the QM rule, FMIC’s underwriting requirements and federal fair lending laws.

SECTION III. COMMON SECURITIZATION PLATFORM (CSP) Issue: Overall, the breadth and scale of the proposed securitization platform (taking its current state as a starting point) is considerably larger than what is contemplated by FHFA and may require a build that extends beyond the anticipated system certification date at cost far more than expected.

• CSP functionality/roles/responsibilities should be very clear to the mortgage finance market.

• As discussed above, it is unclear whether the CSP is responsible for checking purchase data and aggregator compliance with guarantor policies or if there is one guide for all guarantors. The technology required to check purchase data and

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compliance of one or multiple guarantors with credit policies is a far different scope than currently contemplated in the CSP. (Freddie Mac alone currently collects 400 data points and has over 10,000 automated rules checks to verify compliance with our credit policies.)

• Connectivity and front-end development to process all aggregator securitization inquiries are not currently in scope and would be a huge project. This could require hundreds of firms to be connected and trained as well as development of back-up capabilities, etc.

• Connectivity and front-end development to process all servicer reporting and cash management are not currently in scope of CSP and would be a very large undertaking. (Freddie Mac has over 1000 servicers that send us reporting and cash daily.)

• Collecting and separating g-fees for guarantors, g-fees for the government backstop, g-fees for affordable housing funds, etc., and to pass timely payments to appropriate parties are also not in scope of the CSP and would be a significant project.

• The Discussion Draft implies that the platform is responsible to certify the mortgage notes and to facilitate a new national mortgage note custodian. This would be new responsibilities for the CSP and it would be complicated to build, implement and operate on a timely basis.

Recommendations:

• We believe a guarantor should be able to set its own purchase eligibility requirements as long as such requirements are not in contravention of the QM rule, FMIC’s underwriting requirements and federal fair lending laws.

• Rather than creating an entirely new platform, leverage and build upon existing GSE infrastructure to perform functions such as loan purchases, loan compliance checks, note certification, and servicing oversight.

SECTION IV. CAPITAL MARKETS AND TBA TRANSITION Issue: Limited detail is provided regarding the manufacturing and trading of the FMIC single security.

• It is unclear whether the Office of Securitization will be the sole authority for TBA eligibility and trading practices. It also is unclear whether the Office of Securitization will have the authority to set or promulgate rules regarding the common security. For example: Will the Office of Securitization set boundaries for pooling and servicing practices? Will it hold surveillance and enforcement authority over TBA eligibility? Will it determine “good delivery” rules for TBA trades?

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• It is unclear whether underwriting guides, servicing guides and offering circulars of the contributing parties to the single security must be identical. If not identical, will differences result in a fragmented TBA market? If identical, is there sufficient room for competition among guarantors?

• It is unclear whether the single security will apply to both TBA and non-TBA markets.

Recommendations:

• The creation of a common security is necessary to expand liquidity and competition in the marketplace. Program parameters, oversight and enforcement authorities are critical to the success of the new markets. All these powers need to reside in the Office of Securitization. TBA “good delivery” rules, such as on the ones currently practiced, should transition to the Office of Securitization, with SIFMA becoming an advisory voice. Pooling policy should similarly be under the authority of the Office of Securitization.

• For TBA markets, underwriting, pooling and servicing of the underlying loans needs to be consistent such that investors do not experience idiosyncratic differences in the single security. Unless the FMIC set detailed standards for the TBA market, market fragmentation will result if aggregators, guarantors or servicers conduct their business differently, as those differences manifests themselves in prepayments differences. Market fragmentation will result if aggregators, guarantors or servicers conduct their business differently, as those differences manifests themselves in prepayments differences. Differences can exist more readily in non-TBA securities and in loss mitigation efforts, once the loans are pulled from the securities.

• Align the FMIC security underwriting, pooling and servicing, and offering documents to those of the legacy TBA markets.

• Addresses investor homogeneity concerns.

• This limits the potential fragmentation of the market.

• The new FMIC securities need to include both TBA and non-TBA programs. Standardization, scale and transparency create the foundation for successful, liquid markets. These ingredients apply equally to TBA and non-TBA market. The necessity of one standard need not be as stringent in non-TBA markets (pools that are not eligible for TBA, even on a de minimis basis), where trades occur on a pool-by-pool basis.

Issue: Transition risk and market disruptions are possible, particularly in forward trading markets.

• It is unclear whether legacy securities require an exchange in order to be fungible with new FMIC securities.

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• If an exchange is required, the new FMIC market begins with no liquidity, no dollar rolls and no forward pricing. Also, if an exchange is required, the new FMIC would compete with existing Fannie and Freddie markets.

• If no exchange is required, the existing legacy markets and the new FMIC are immediately fungible, with a common tradable supply.

• All prices should converge and forward markets should be liquid.

• The intent of the exchange is unclear.

• Will the exchange be open for the life of legacy securities? How will exchange fees be set? Who pays the exchange fee?

• Do Fannie and Freddie pay a fee unlike other investors in the marketplace?

• Does that asymmetry create unintended consequences?

Recommendations:

Managing transition from the current model to the new model is critical. Freddie Mac’s experience in 1990 offers clear warnings:

• Do not require existing holders to exchange legacy securities for FMIC securities. Make them all fungible day one, through the TBA “good delivery” guidelines.

• This creates a collective liquidity, rather than competing markets.

• It provides buy-and-hold investors the FMIC guarantee without accounting or tax consequences.

• It allows Freddie Mac and Fannie Mae retained portfolios the same exchange options afforded the market. Different treatment for the same security will result in unintended consequences. It is in the market’s best interest for the retained portfolios to be used as transition agents, rather than limit them from the process.

Issue: Credit risk transfer securitizations could potentially obstruct the liquidity of the TBA market.

• True senior/subordinate deals do not result in senior tranches that would work within the current TBA construct.

• Derivative securities, such as STACR, are very compatible with TBA.

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Recommendations:

• The Office of Securitization should be the authority over coordination of existing TBA markets and the emergence of new credit transfer markets.

• TBA-compatible senior/sub structures should be explored.

SECTION V. SERVICING Issue: It is unclear from the Discussion Draft when the servicers’ obligation to advance P&I ends and whether they hold delinquent loans on their balance sheet.

• In the agency space, servicers advance P&I until the borrower is 120 days delinquent and then Freddie Mac or Fannie Mae buys the loan out of the pool. In the PLS space, servicers exercise their own judgment as to when to cease advancing P&I.

• The bill could be read to require the servicer to advance P&I until foreclosure and hold the loan on its balance sheet to disposition. Servicers will not have the capability to purchase loans out of pools especially during stressful economic times.

Recommendation:

• The FMIC should set standards for advancing timelines/balance sheet but allow for some flexibility as a matter of contracting between the servicer and first loss provider. The Discussion Draft should make clear that guarantors should take delinquent loans onto their balance sheets early in the delinquency stage (<180 days) and act as asset managers of such delinquent loans.

Issue: The FMIC, for cause, may require an approved servicer to enter into a “subservicing” arrangement, which the Discussion Draft later refers to as a “transfer” of servicing rights.

• Subservicing arrangements and transfers of servicing are two distinct concepts. In a subservicing arrangement, the approved servicer retains the mortgage servicing fees, rights and obligations. In a transfer of servicing, the transferor servicer's mortgage servicing rights are extinguished and the transferee servicer becomes the servicer of record and not a subservicer.

Recommendation: • Require the FMIC to clarify which path it is taking. Guarantor should have the flexibility

to require a transfer of servicing if subservicing is not an adequate remedy. The FMIC should consider requiring the terminated servicer to be liable for costs associated with the failure to adequately service.

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Issue: The Discussion Draft allows private market holders of the first loss position to petition FMIC for a change in approved servicers for individual mortgage loans, if the private market holders can demonstrate that its investment was not appropriately protected by the current approved servicer.

• Because securities holders can be a wide range of constituencies, FMIC could be subject to resource-intensive reviews, even on individual loans, concerning the placement of servicing.

Issue: All existing GSE servicers will be grandfathered as approved FMIC servicers.

• This would, immediately upon enactment, transfer to FMIC the oversight of over 1,000 GSE servicers.

Recommendation:

• Approve servicers during the course of the transition period rather than upon enactment.

Issue: The Discussion Draft requires the FMIC to create loss mitigation options to “prevent, to the greatest extent possible, the need to trigger a claim on insurance offered by the Corporation . . . by establishing by rule a consistent process by which a borrower will be evaluated . . . for an affordable loan modification…”

• The first part of this requirement suggests that only NPV-positive economic loss mitigation options will be considered, so it is unclear how this could be reconciled with “affordable” loan modifications for borrowers. In addition, there is no "official" NPV-positive economic loss analysis; only “estimated” NPV-positive economic loss analysis, based on assumptions.

Recommendation:

• Modify the phrase “to the greatest extent possible” to provide more flexibility for servicers to work with borrowers.

Issue: The Discussion Draft requires the FMIC to consult and coordinate with the OCC, the Fed, the FDIC and the CFPB and separately consult and coordinate with State regulators in developing and issuing servicing standards.

• This may prove unduly bureaucratic and could slow change that might assist or protect borrowers.

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Recommendation:

• Clarify that such consultation should not prevent FMIC from establishing servicing standards that serve the purposes of the bill.

Issue: The FMIC would be obligated to consider more relaxed regulatory requirements for servicers that service fewer than 7,500 loans.

• It would be difficult to administer such distinctions among servicers.

• It also could lead to inferior servicing by smaller servicers.

SECTION VI. SMALL LENDER MUTUAL Issue: Capital demands, operational constraints, and capital market execution may threaten the success of the small lender mutual.

• The presumption is that the small lender mutual will not take credit risk. We estimate that the mutual will purchase up to 20% of the market. With a $1 trillion mortgage market, that equates to $200 billion in annual purchases for the mutual. If 1% capital is required to serve as a cash window, the GSEs, per the bill, will need to provide $2 billion in capital at startup. If the mutual also serves as a guarantor, the required capital levels may be prohibitive.

• If the GSEs are assessed in order to raise capital for the mutual, that translates into the Treasury - at the margin - turning over that much net worth to the private sector, i.e., a "transfer of wealth to the private sector."

• The members of the mutual are required to repay the funds used to capitalize it in no more than 10 years. It is not clear what happens if the institutions or the mutual cannot meet those obligations. It is clear that because the mutual is debt-funded (100% debt structure), it will not be able to attract sufficient capital. It is unclear where the representation and warranties responsibilities reside. The credit risk taker should be supervising the lending practices.

• Assuming the mutual does not become a guarantor, the bill should ensure that the mutual will not be treated unfairly by a guarantor.

• Will the ability of certain market participants to vertically integrate into originators, aggregators, guarantors, cash-window operators, etc., threaten the viability of the mutual, which is likely to be limited to a cash-window function?

• Can the mutual exclude certain institutions?

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Issue: There are operational and other transition risks associated with the potential transfer of GSE infrastructure to the Small Lender Mutual. • The Discussion Draft requires FHFA to value elements of the GSEs' respective infrastructure

and potentially transfer or sell that infrastructure to the Small Lender Mutual. That provision assumes a level of modularity that does not exist today. It also ignores the fact that the "infrastructure" at issue includes human capital.

• It is not clear that the transfer of the relevant infrastructure could occur seamlessly. It also

is not clear that the GSEs will be able to retain and or "transfer" the human capital needed to ensure the infrastructure is functional. Even licensing of the infrastructure, permitted under the bill, carries attrition risk.

• As with the initial capitalization by the GSEs, the transfer of infrastructure amounts to a

transfer of wealth from the taxpayer (Treasury) to the private sector.

Issue: The intellectual property of the GSEs is valuable. Recommendation:

• FHFA should ensure in the disposition process that the value of the property is

preserved, but take steps to ensure that no monopoly over that property is created.

SECTION VII. MULTIFAMILY Issue: Further clarity and certainty is warranted regarding the future state of the Enterprises’ multifamily business. Recommendation:

• Include a statement of intent regarding the transition of the subsidiary into an approved guarantor, aggregator and servicer.

Issue: The Discussion Draft calls for the creation of an Office of Multifamily Housing within FMIC. Recommendation:

• The role of this Office should be expanded to manage the transfer of the GSEs’ multifamily business lines into to be formed subsidiaries, approve those entities as multifamily guarantors and otherwise administering the multifamily business.

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Issue: The Discussion Draft calls for the creation of a single Mortgage Insurance Fund covering both Multifamily and Single Family. Recommendation:

• Two separate uncrossed Mortgage Insurance Funds should be created, one for Single Family and one for Multifamily, to avoid a situation where one business is used to subsidize the other to the detriment of investors in the subsidizing business.

Issue: An approved multifamily guarantor may not engage in any insurance activity other than the insurance activity permitted under the Discussion Draft. However, the Discussion Draft does not clearly state that new guarantors should be restricted to the same activities approved for the subsidiaries. Recommendation:

• In order to create a level playing field as well as ensure an adequately capitalized set of guarantors, the “rules” of competition have to be reasonably established in advance. For example, if the guarantors are intended to be monolines, then some more prescriptive guidance as to permitted forms of ownership and/or affiliation restrictions should be stated. Otherwise, it is likely that most new guarantors will, in the interest of realizing competitive advantage, be affiliated with or subsidiaries of large, diversified financial institutions. This would place the multifamily subsidiaries in an uncompetitive position. If there is no intent to restrict the guarantors to monolines, then stating as much would clarify the competitive landscape for prospective investors, and it would be likely that the subsidiaries would ultimately be acquired by larger financial firms. It is critical that the bill ensure both a competitive market, and a level playing field.

Issue: The bill requires FHFA to direct the enterprises to transfer all of their multifamily businesses into subsidiaries, except certain legacy assets. Section 702 gives FHFA the authority to dispose of the multifamily assets. As drafted, Section 702(a) could be read to give FHFA the authority to sell off the multifamily business in pieces. Recommendation:

• If the intent of the bill is to require the enterprises to put their multifamily businesses into a subsidiary and then sell the subsidiary as a whole, then the language in Section 702(a) should be tightened to reflect that intent.

Issue: The bill appears to grant FHFA the ability to license a multifamily GSE’s proprietary systems. This could present an issue as Freddie Mac multifamily has spent many years developing and refining these proprietary systems and they are part of the value of the to be created multifamily subsidiary. Furthermore, these systems are not a necessary part of the

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market “infrastructure” – rather they are more like conventional proprietary business systems used by commercial mortgage banks.

Recommendation:

• Delete section 703(b)(3)(B).

Issue: The bill allows FMIC to consider the extent and amount of risk sharing and risk mitigation when determining whether an approved multifamily guarantor has meet capital requirements. Recommendation:

• The bill should be revised to take into account that Freddie Mac’s securitization model is not risk sharing or risk mitigation but rather “risk transfer.” We believe that a specific identification of subordination as a permissible form of risk transfer to satisfy the 10% requirement is consistent with the purposes of the bill.

Issue: The bill establishes a requirement that at least 60 percent of the rental housing units within the eligible multifamily mortgage loans were, at the time of origination, affordable to low-income families. Low-income is defined as income not in excess of 80 percent of area median income (subject to adjustment for family size). The bill also allows FMIC to adjust the 60 percent requirement in certain circumstances. Two issues are presented. First, using area median income can skew affordability away from high rent to income areas such as New York. Second, discretion is built into the language to adjust the 60 percent threshold. Recommendation:

• A different measure could be used that would more accurately measure affordability. At a minimum, consideration should be given to high-cost area adjustments that adjust the rent-to-AMI metrics based on actual housing burden in specific high-cost geographic areas (e.g. where households spend in excess of 30 or even 40 percent of their income on rent). The discretion to adjust the 60 percent threshold should be narrowly drafted to avoid inconsistent results and inconsistent application to different guarantors.

Issue: Section 701(b)(2) should clarify what Freddie Mac will be contributed to the subsidiary. Recommendation:

• Lines 5 through 15 of the section should be revised to read as follows:

Notwithstanding the provision under title VI or any other provision of law, effective on the date on which the multifamily subsidiary is established under subsection (a)(2)(B), all employees, functions, activities, infrastructure, intellectual property

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acquisition, servicing and securitization platforms shall be transferred or to the subsidiary.

Recommendations of a technical or clarifying nature:

• We suggest clarifying the bill to enable FMIC to allow approved multifamily guarantors to commence operations on a guarantor by guarantor basis rather than conditioning such approval on the readiness of unrelated guarantors.

• The name of the Freddie Mac multifamily product is “K Series Structured Pass Through Certificates” (K Certificates). It is misidentified in various places.

SECTION VIII. CREDIT RISK SHARING Issue: The phrase "fully funded" may limit the use of reinsurance deals.

• Would this also mean any type of recourse structure would need 100% collateralization? If so, it does not appear that partially-collateralized reinsurance transactions would be viable. For that matter, the traditional mortgage insurance model would be gone as well.

Recommendation:

• To solve for reinsurance deals, add "or well capitalized" immediately after “fully funded.”

Issues:

• The bill is unclear with respect to whether every risk share transaction needs to be diversified on its own, and whether there can be diversification in the aggregate. (Flexibility should be allowed in this context.)

• It is unclear whether the bill intends to require a first loss position of greater than 10% under certain circumstances.

Recommendation:

• The bill should provide flexibility for the diversification standards for each risk-sharing transaction, and should not require a first loss position greater than 10%, at least for covered securities.

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Issue: The penalty provisions seem overly punitive, including imprisonment of up to 20 years. This provision could have a strong chilling effect on industry adoption and credit risk-sharing mechanisms. Recommendation:

• The bill should provide for a safe harbor on risk sharing penalty provisions.

Issue: A “covered guarantee transaction” will not be a commodity futures transaction or a swap and will not be subject to CFTC jurisdiction.

• The drafters appear to address Freddie Mac’s concerns expressed during a congressional hearing with respect to risk sharing transactions and the CFTC. However, if the investment vehicle isn’t a commodity pool, but issues interests that are considered to be swaps, then the investors are subject to the commodity pool operator regulations and all of the provisions of Title VII, such as clearing.

• The “exemptions” from CFTC (as well as SEC) are subject to approval by CFTC and SEC, so in reality they aren’t really exemptions.

Recommendation:

• Since the bill addresses CFTC and Conflict of Interest issues, it should also address the REMIC/REIT issue by having a statement that credit risk sharing securitizations that are used for the purpose of reducing risk on single family mortgages be deemed a REMIC for investment purposes.

SECTION IX. TECHNICAL AND CLARIFYING CONSIDERATIONS RELATING TO THE TRANSITION AND TERMINATION OF FANNIE MAE AND FREDDIE MAC Issue: The wind down provision provides an exclusion from “new business” that may have unintended consequences.

• Section 604(d), page 377, provides an exclusion from the definition of “new business” applicable to Fannie Mae and Freddie Mac, respectively, effective on the system certification date, for any “new issue of an obligation,” provided that the “aggregate of such obligations does not exceed 120 percent of the amount of mortgage assets permitted to be owned by the enterprise under section 605.”

• The use of the term “obligation” doesn’t work here. It is undefined and potentially

could include the unpaid principal balance of our entire guarantee portfolio, meaning that the issuance of any new obligation would cause the aggregate amount of such obligations to exceed the limit on “mortgage loan assets” prescribed by Section 605.

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• This section appears to be aimed at limiting the amount of unsecured debt we issue to fund mortgage assets, similar to the limit under the senior preferred stock purchase agreement, which limits our “indebtedness” to 120% of permitted “mortgage assets.” Under the senior preferred stock purchase agreement, the amount of our “mortgage assets” and “indebtedness” are both determined without giving effect to Financial Accounting Standards 140, 166 and 167. (These accounting standards, which became effective after we entered into the senior preferred stock purchase agreement, require the assets on our balance sheet to include loans underlying PCs held by third parties. Previously, these loans were “off-balance sheet” items. The senior preferred stock purchase agreement was later amended to preserve the “old” accounting for purposes of the asset and indebtedness limits.)

• Consider whether this section should be revised to track the definition of

“indebtedness” in section 1 of the senior preferred stock purchase agreement. Note that the definition of “mortgage loan assets” in section 605 is similar to the definition of “mortgage assets” in the senior preferred stock purchase agreement and appears intended to follow the “old” accounting rules, although the definition in section 605 excludes “mortgages” (it is not clear why) and refers only to FAS 140.

• Finally, note that the limit on “mortgage loan assets” in section 605 applies only to single-family assets. If multifamily assets are excluded from this asset limit, the unsecured debt funding multifamily loans (in an amount equal to 120% of the multifamily assets funded, for consistency with how the debt limit under the senior preferred stock purchase agreement works) should similarly be excluded from any indebtedness test under section 604(d)(1)(C)(ii).

Issue: Technical corrections are needed to clarify the wind down provisions.

• Section 604(d)(2)(C)(iii), page 384: The reference to issuing mortgage-backed securities to "refund or replace" outstanding issues is unclear. This is a concept that seems more applicable to unsecured debt. We also are not sure what is meant in Section 604(d)(2)(C)(iv) by "transfer of guarantees.”

• Given the broad range of “obligations” within the scope of the section 604(d)(4)(A) guarantee, it may be difficult to determine when the enterprise charters would be revoked. Since the charters are not revoked until guarantee obligations under section 604(d)(4)(A) are fully extinguished and those guarantees apply to obligations issued to refund or replace obligations outstanding on the day before the certification date, revocation may not occur for many decades.

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• Under section 604(f)(1)(A), the FMIC may, after the agency transfer date, provide insurance “on outstanding enterprise mortgage-backed securities issued by the enterprises.” It is not clear why enterprise securities would need any such insurance, at least prior to the system certification date, since all such securities are backed by the full faith and credit guarantee provided by section 604(d)(4)(A). Moreover, refunding/ replacement transactions effected after the system certification date (effectively, the only securities issuance activity that would not be prohibited new business at that time) also benefit from section 604(d)(4)(A).

• It is unclear how the maximum return would be measured. Would it be on a gross dollar basis? A present value? Perhaps this is left to the discretion of FMIC, to be applied along with the other somewhat elastic standards in this section. The same issue is posed by the sale of assets provisions in section 604(i)(2)(iv).

Issue: The bill relies critically upon the GSEs during the transition period yet creates significant disincentives for employees and Directors to remain with the GSEs.

• As the five-year wind-down period progresses, it will become increasingly difficult to maintain the size and makeup/stature of the current board of directors. Board membership may not continue to be attractive to current directors or others of similar stature and expertise as the business of the Company contracts and is sold or otherwise disposed of. As a result, the Company may not be able to retain and/or recruit enough well qualified board members to fully operate the board and its committees, particularly the functions of SEC reporting, audit and risk oversight. Board members currently operate in an environment where they are required to follow the Conservator's mandate, yet their exercise of their fiduciary duty is challenged by private third parties. Under a wind-down scenario, this challenge would likely continue, particularly as it relates to properly disposing of the Company's assets, and combined with the wind-down, may make board service increasingly less attractive.

• Likewise, during the transition period it will become progressively more difficult to retain qualified employees and the ability of the GSEs to assist with the transition could diminish. Additionally, loss of employees could degrade the value of the GSEs’ assets, reducing the potential returns to Treasury as well limiting the value and effectiveness of the infrastructure transferred into the newly created entities.

• Priority of Expenses and Unsecured Claims would make retention significantly more difficult.

• These provisions establish third and fourth priorities for claims against the Enterprises for wages, severance, sick leave and contributions to employee benefit plans. These provisions appear to be based on comparable employee priority provisions in Section 507 of the Bankruptcy Code, and follow the Code’s limitations

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on prioritized payments to any individual to an inflation-adjusted maximum of $12,475. However, Section 603 provides that priority only for wages, etc., earned and services rendered “not later than 180 days before the date of the appointment of the Agency as a receiver.” This is inconsistent from the Bankruptcy Code, which allows priority for wages earned and services rendered within 180 days of the appointment of a trustee or a debtor-in-possession. It is, of course, far more likely that there will be earned but unpaid compensation within 180 days of the appointment of the receiver than in the period beginning 181 days before such appointment and stretching backward, and it seems likely that the bill was intended to mirror the bankruptcy law provision. In addition, it is not clear why restrictions on priorities for employee claims are necessary. As conservator, FHFA currently has authority to manage the extent of such claims and could set precise employee expectations.

• Relegation of wage and related claims of senior executives and directors to eighth priority, beneath those of even subordinated unsecured creditors is inconsistent with Bankruptcy Code priorities and, not justified by any wrongdoing on the part of those administering the Enterprises. The low priority will complicate retention of key personnel when they are most needed. Management of the extent of senior executive compensation claims already is fully within FHFA’s control.

Issue: The bill would replace statutory language regarding conservatorship and receivership that is clear and objective with terms that are undefined and ambiguous.

• These provisions embody a series of changes eliminating any reference to the ability of an Enterprise to rehabilitate by becoming adequately capitalized, deleting references to under-capitalization and critical under-capitalization, and substituting references to insolvent or near-insolvent regulated entities. The new terms – solvent or near-insolvent – are not defined. The statutory terms they replace are defined and have clear and objective meaning.

• Section 603(b)(10)(B) would have a limited life regulated entity established pursuant to a receivership of the Enterprises succeed to the “registered status” of the Enterprise instead of the Charter of the Enterprise. However, the term “registered status” is not defined in the statute or elsewhere under existing law; and is unclear.

• Section 603(b)(10)(F) would eliminate the present restriction on the Director’s

authority to obtain secured credit for a limited life regulated entity (LLRE) that is otherwise unable to obtain credit by issuing debt secured by a senior or equal lien on property of the LLRE that is already subject to a lien. At present, this provision does not apply “for mortgages that collateralize the mortgage-backed securities issued or guaranteed by an enterprise.” This provision purports to eliminate this restriction on the Director’s authority. However, this violates the statutory

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understanding that such mortgages have been sold and are outside of the receivership estate. It also would threaten to de-stabilize the market for such securities.

Issue: The portfolio reduction provisions are unclear.

• Section 605(a)(1) states that an enterprise may not own single-family mortgage loan assets in excess of 85% of the amount permitted to be owned as of December 31 of the preceding calendar year. However, note that section 605(a)(2) does not require the FMIC to set the amount of permissible assets necessary to facilitate the wind down of the enterprises until the system certification date.

• Additionally, this section does not provide the initial amount of “single-family mortgage loan assets” from which the annual reductions would be computed. Section 605 applies only to "single-family mortgage loan assets." Since the Preferred Stock Purchase Agreement mortgage assets limit applies to both single-family and multi-family mortgage assets, it is not clear how a separate limit on single-family mortgage assets should initially be determined.

• Section 605(a)(2)(B) says FMIC will establish an amount of single family loan assets to be

held to allow “appropriate loss mitigation on any legacy guarantees of the enterprises.” It is unclear what this means and how holding loan assets helps mitigate losses on other assets. In addition, it is not clear how an appropriate amount would be determined and measured and what is meant by “legacy guarantees.” If these are PC guarantees, what loss mitigation is needed or possible, and how would holding other loan assets help that? If it doesn’t mean PC guarantees, it is not clear what other guarantees are addressed.

• The definition of "mortgage loan assets" tracks the definition of "mortgage assets" in

the Preferred Stock Purchase Agreement as restated on September 26, 2008. This definition was subsequently amended on December 24, 2009; however, the bill does not use the amended definition.

SECTION X—IMPROVING TRANSPARENCY, ACCOUNTABILITY AND WITHIN EFFICACY AFFORDABLE HOUSING Issue: Section 501(b) calls for a fee of 10 bps for all during the first effective year, with incentive-based fees to start in the second year, based on performance during the first 12 months. The performance measurement framework is very complex—each guarantor or aggregator is to be judged in as many as eight underserved markets, based in each case on performance relative to peers, performance relative to market, and the degree of “under-service”—but the framework may not be known until six months through the first

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performance year. Guarantors and aggregators need to know the “rules” in advance and have time to adjust business plans. Recommendation:

• Consider a multi-year tiered implementation approach as follows: During the first 12 months after the effective date, charge all 10 bps and promulgate the performance framework. During the second 12 month period, charge all 10 bps and allow guarantors and aggregators time to adjust business models. During the third 12 month period, institute the incentive system, initially based on the performance during the second 12 month period.

Issue: Section 501(b)(3) presents the opportunity to “opt-out from incentive-based fees” by agreeing to pay “the highest fee charged by Corporation for the 12 month period under the ranking [framework].” The opt-out parties still must report performance. Structured this way, the opt-out option may have unintended consequences (ignoring any intangible reputational cost for opting-out). First, the party which expects to perform the worst under the performance framework may be motivated to opt-out because its fee will then be based on the worst performer who does not opt-out; in other words, the opt-out worst performer will be able to “free-ride” on someone else’s better relative performance. At the extreme, if all parties follow this “game theory” logic, everyone will opt-out and everyone will pay 10 bps. Second, inclusion of opt-out parties’ fees in the calculation of the average fee which is capped at 10 bps may (unintentionally) narrow the range of incentives that apply to those who do not opt-in. Is this a desirable feature? Recommendation:

• Eliminate the opt-out feature, or set the cost of the opt-out at either a multiple of the maximum due under the rankings, or absolute fee above the maximum.

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Documents

CONFIDENTIAL DRAFT Freddie Mac Analysis of …online.wsj.com/public/resources/documents/042514Freddie...2014/03/26 · in the proposed structure and make it less attractive to new