The Federal Reserve has completed its
latest round of Quantitative Easing, the government sponsored enterprises
(GSEs) Freddie Mac and Fannie Mae are under orders to continue shrinking their
investment portfolios and significant constraints exist to keep private
investors from purchasing agency mortgage-backed securities (MBS). So who, the Mortgage Bankers Association
(MBA) asks, is going to pick up the slack?
A white paper written by MBA’s vice president
and senior economist Michael Fratantoni, lays out the conundrum facing the MBS
market. Fratantoni says both policy
makers and the housing industry have a common interest in bringing private
capital into the mortgage markets but the key question is how and in what form
that private capital can best reenter the system. MBA has advocated for private capital to have
a larger role in covering credit risk within the government guaranteed,
conforming portion of the market but we need to consider how to draw it to the
interest-rate risk of the conforming market and how to reengage it for lending
outside of the government guaranteed system.
For years, the GSEs’ ability to issue long-term
fixed-rate debt appeared to be a stabilizing factor for the U.S. housing finance
system. Long-term, fixed-rate debt
issued by the GSEs was a better match for funding long-term fixed-rate MBS than
other funding instruments but the GSEs’ purchase of fixed-rate MBS with minimal
capital turned out instead to be destabilizing because they did not have enough
skin-in the game.
The GSE’s investment portfolios which once
topped more the $1.5 trillion have been reduced under their post-crash
agreement with Treasury, to less than $1 trillion. Fratantoni said he is not arguing with that policy
choice but those portfolios did historically serve to channel global capital
into the U.S. mortgage market absent bearing the uncertain cash flows from
directly owning mortgages or MBS. Now it
has to be asked how the market can be structured to attract stable private
capital over time without GSE investment portfolios playing that role.
Confronting this issue has been delayed,
first by the Federal Reserve’s purchase of more than $1.7 trillion of agency
MBS over a five year period; in many months this accounted for the vast preponderance
of issuance. But in October the Fed stopped growing its portfolio although it
is likely to continue replenishing it until the first increase in the Fed’s target
short-term rate. Then, likely at some point
in the middle of 2015, this major investor will be leaving the MBS market, according to Fratantoni.
Second, modest supply has required little demand.
MBA estimates that origination volume in 2014 will be the lowest in 14 years with
correspondingly less MBS issuance. Reduced supply has kept spreads relatively tight,
even as the GSEs have been net sellers and the Fed has tapered its purchases.
Third, demand from banks has been relatively
strong. Banks have made up the difference
in their relatively low loan-deposit ratios by maintaining, even increasing
their securities holdings. However Basel
II standards have recently led larger banks to favor whole-loan over MBS
holdings, increase holdings of jumbo and near-jumbo whole loans, and to
preferentially hold Ginnie Mae rather than GSE MBS on their balance sheets.
Fourth, attention has been focused
primarily on policy steps to improve the efficiency of the secondary market –
i.e. proposals to issue a single GSE security to level the playing field between
Fannie Mae and Freddie Mac and as a step toward GSE reform. As the market continues to recover however
ensuring adequate investment will become more important.
As of June 30 2013 the Federal Reserve estimated
there was $13.3 trillion in outstanding mortgage debt, $10 trillion of it
residential mortgages. These mortgages
were held as assets by a variety of investors; $4 trillion by depositories,
$4.8 trillion by the GSEs and $76 billion by individual households. GSE MBS are held by the same types of
investors but the Fed’s holdings of$1.7 trillion almost match those of the
entire banking system. Post crisis MBS
holdings have fallen at the GSEs but increased among mutual funds, credit
unions, banks, and REITS.
Banks and other depositories have been
major holders of mortgages and MBS but adjustable-rate and shorter-term
mortgages are better matched to their funding than long-term, fixed-rate
mortgages. Consumer preference and
Dodd-Frank regulations have made fixed-rate products more common but the Savings
and Loan crisis remains a cautionary tale about financing long-term, fixed rate
loans with short-term liabilities (i.e. deposits) as in rising rate
The Federal Home Loan Banks (FHLBanks)
have helped banks support their financing of mortgages and hedge interest rate
risk. While banks are potentially a key
source of private capital their ability to invest in the mortgage market is
being restricted by regulatory and market limitations.
III and other rules have increased capital requirements;
has proposed new limitations on FHLBank membership
are likely to increase commercial and industrial lending, limiting funds
available for mortgages
rates rise it is likely that depositors will seek higher yields elsewhere.
coverage ratios (LCR) for larger banks penalize banks holding GSE MBS while
favoring Treasury and Ginnie Mae securities.
banking system’s role as counterparties in the repo market is coming under fire
by regulators and there are plans to shrink this market.
A second natural set of investors in
mortgages are institutional investors including pension and mutual funds. As of March the Barclays U.S. Aggregate Index
had a weight of roughly 31 percent for securitized assets (MBS, ABS and CMBS). Fratantoni says it is reasonable to assume
these investors would significantly increase their holdings of mortgage-related
assets in the aggregate only if mortgages became a larger share of all fixed income,
or if they delivered a better return on risk. Looking at U.S. budget deficit
forecasts it looks likely that mortgage assets may be a smaller share of the total
than in the past, as Treasury issuance ramps up once again although mortgage
asset yields may increase to attract more investment.
Broker-dealers, while not significant long-term
mortgage holders, have played an important market liquidity role through their holdings
of inventory of various assets, and their ability to intermediate repo funding.
Regulatory changes have led many firms to
pare their inventories of MBS and regulatory focus on the repo market has also led
to uncertainty over the long-term availability of cost-effective repo funding and
which firms will provide such capital. Moreover, new rules with respect to margin
requirements for essentially all participants add further complexity to this market.
Support for mortgage markets has also come
from foreign investors. While the U.S.
has large trade deficits it has long run a capital account surplus with the
rest of the world – i.e. foreign investors save more in the U.S. than the
reverse – and a portion has been directed into the mortgage market with its depth
of liquidity and higher yield than Treasury securities. However, post crisis, there has been a notable
decline in foreign investors’ willingness to hold MBS without an explicit government
guarantee. Still there has been a very large
increase in funds globally seeking safe, fixed-income investments and there
have been repeated “flights to quality” over the past several years when there
are financial, political or security issues abroad. However, these global flows
will likely need to be channeled into mortgage assets through intermediaries, given
the hesitance by foreign investors to directly invest.
The MBA paper outlines the following
obstacles to foreign investors buying a larger share of MBS.
foreign investors are banks and asset managers under similar constraints as U.S.
banks and asset managers with respect to being measured relative to a benchmark
investors are even more likely to look for an explicit government guarantee before
investing in dollar assets.
are complex securities to hold, hedge and finance. Many foreign investors are looking
to intermediaries who can deliver more predictable cash flows from underlying mortgage
bank investors are constrained by Basel III and global systemically important financial
institution (SIFI) rules as well.
Real Estate Investment Trusts (REITs) are,
by virtue of the law that created them, subject to asset, income and
distribution requirements that require 75 percent of their assets and income be
connected to real estate and real estate finance. REITs can and some do have operating
subsidiaries that originate or service mortgages.
Most mortgage REITs focus on holdings of agency
and other MBS and use a combination of equity and debt to finance holdings of MBS.
However there are more than 20 sizeable mortgage REITs with varying concentrations
in agency and non-agency MBS, whole loans, MSRs and other mortgage assets.
Total mortgage REIT MBS holdings were roughly
$300 billion in midyear 2014 and their leverage is typically 6:1 contrasted with
40:1 for the GSEs or more than 10:1 for banks.
To grow their capital base, given the extreme limitations on retaining earnings,
mortgage REITs need to return to the market through follow-on offerings.
Today, mortgage REITs debt funding is primarily
from secured financing (“repo”) of their mortgage assets from banks and other investors. Any larger role they might play in replacing
the GSEs as owners of mortgage assets are restricted by a number of regulatory hurdles
and concerns, primary among them the aforementioned regulatory concern about
the stability of the repo market.
To increase the stability of their lending
base some mortgage REITs have become members of the FHLBank system, usually through
an insurance subsidiary. However FHFA has proposed eliminating this avenue of eligibility
even though it is clear that mortgage REITs are financing home loans in a manner
not dissimilar from other FHLB members.
Second, there are questions whether certain
assets represent “interests in real estate.” Failure to meet the required REIT asset and
income tests can result in significant tax and other consequences.
Third, regulators have questioned whether the
mortgage REIT model, utilizing limited leverage to realize an acceptable yield on
a portfolio of mortgage assets, represents a new form of hidden leverage that could
present a systemic risk. Fratantoni
finds this judgment “odd”. “A greater reliance
on mortgage REITs would mean a larger share of the market for a set of
institutions that have no government backing whatsoever, and hence represent truly
private capital. While they are leveraged
institutions, their leverage is less than that of other institutions investing in
the mortgage market. And their positions are hardly in the “shadows” – by law, REITs
must have a broad distribution of ownership interests, and many, if not most,
are publicly traded.”
That publicly-traded status means
counterparties, regulators and the public has access to financial data on
individual REITS and recent Commodity Futures Tracking Commission (CFTC) rules
have also resulted in many mortgage REITs being required to clear their hedge positions,
introducing yet another review mechanism. Moreover, mortgage REITs are overseen
on a daily basis by their counterparties and post margin to support their positions.
As organizing and capitalizing a REIT is a
well-understood process the sector could potentially be scaled up if some regulatory
hurdles were removed the paper says. They
are prime examples of private capital being deployed to hold and manage mortgage
exposures and while some will fail during severe market disruptions, this is part
and parcel of being fully private entities.
Fratantoni’s conclusion is that there is
no single player waiting in the wings to replace the Federal Reserve. The simple answer is that for sufficient
yield, investors will come to the market.
But perhaps we are headed for a new dynamic with higher and more
volatile mortgage rates because there is no investor focused solely on MBS and
other mortgage assets. Will this
potential volatility “thin the herd even further?”
“Rebuilding the housing finance system to
be both more stable and more competitive is a long-term endeavor,” he
says. “Identifying the barriers to private
capital increasing its ownership of mortgage assets, and moving to reduce those
barriers where feasible, should be part of the conversation and debate as we move