Detoxifying Mortgage-Backed Securities

Have regulators realized mortgage-backed securities aren’t toxic after all? Source: Sean Gallup/Getty Images.

What to do about Fannie and Freddie? That question has swirled since the Federal government effectively nationalized the government-sponsored enterprises more than five years ago. Tuesday, Melvin Watt, the new head of Fannie’s and Freddie’s government overseer (the Federal Housing Finance Agency, FHFA) outlined a new twist in the agency’s 2014 Strategic Plan. Included were goals to boost credit access and launch a new housing initiative. But to us, one new goal stood out: Fannie and Freddie will have to triple the amount of mortgage-backed securities (MBS) they issue from $30 billion to $90 billion by the end of the year, with easier underwriting standards for loans packaged within. In our view, this highlights an important shift in global financial policy: Regulators are starting to acknowledge securitization may have some desirable aspects to increase credit access, but only if that access is closely monitored under tight regulation. At this point, developments are only talk, but if they come to pass, it could boost lending some—positive for the economy and stocks generally.

Tuesday’s announcement likely surprises some—for several reasons. For one, many of the plans Watt outlined were largely a 180-degree turn from his predecessor, Edward DeMarco. DeMarco supported legislation like the Crapo-Johnson Act, which seeks to dismantle Fannie and Freddie and replace them with one smaller enterprise, seeking a reduced government footprint in the mortgage finance industry. Watt targets keeping Fannie and Freddie separate and doesn’t seem to have the same end goal.

Further, MBS and other collateralized loans got a bad rap in 2008 when they were the “toxic assets” banks kept writing down and hedge funds dumped left and right. Requiring Fannie and Freddie to securitize more debt is a rather noteworthy sentiment shift.

Though, not an undeserved shift. Many MBS have regained the value they lost in 2008 as investors realized these “toxic assets” weren’t so toxic absent FAS 157’s fair value accounting rules, which required even illiquid securitized debt to be valued based on the last trade. Most dramatically, the same assets that took Bear Stearns down due to repeated write-downs proved profitable once on the Fed’s balance sheet—the Fed didn’t have to value assets at nonexistent market prices, instead holding them to maturity.

This shift in regulator attitude isn’t just happening in the US, either. Policymakers in the UK and eurozone are also looking to develop their securitization markets. In 2011, UK Chancellor of the Exchequer (in American English, Treasurer) George Osborne suggested boosting securitization as a way to goose small business lending. And ECB board member Yves Merch recently said regulations for asset-backed securities are too strict, noting “not all EU securitizations deserve the stigma attached to them for the past few years.”

Now, perhaps regulators around the world are starting to realize something that has a positive impact for investors: Securitization plays an important role in the world of finance. When banks securitize debt, they might sell assets to raise additional capital for borrowing. They might also use them as a way to defray the risk involved with extending credit to riskier borrowers—arguably, part of the mechanism to account for the reduced credit standards the FHFA seemingly supports. This could mean the tight conditions lower-rated borrowers have faced since the Financial Crisis ease. First-time home buyers may find more willing and able lenders. Overly cautious banks may loosen their purse strings some.

Of course, there is one big variable changing the way US banks use MBS: Dodd-Frank’s Volcker Rule. Under the Volcker Rule, banks wouldn’t be allowed to own some asset-backed securities like collateralized debt obligations (CDOs). Currently, banks have until July 21, 2017 to comply with the rule. Finance industry trade groups are pushing for guidelines to issue CDOs that would still satisfy the regulation, and a Congressional committee is conducting hearings on negative impacts of the rule, which could eventually lead to a more industry-friendly bill.

The kicker to allowing Fannie and Freddie to issue these securities is it may be partly an effort to mitigate what regulators see as a bigger risk: shadow banking. Since 2008, Fannie and Freddie securitizations have fallen dramatically. In any market, when a service isn’t provided by one firm, or they limit the service they offer significantly, others may step in to provide it. That’s exactly what happened in mortgage securitization. Non-bank entities stepped in. Mortgage servicing firms, hedge funds and asset managers—ominously dubbed “the shadow banking system”—started guaranteeing mortgages instead, potentially with an eye toward securitizing them. In the US, banks sold about $800 billion worth of mortgages to these firms in 2013.

Shadow banks aren’t subject to the same degree of regulation and oversight. Hence, the Dodd-Frank-created Financial Stability Oversight Committee (FSOC)—the regulatory supercommittee including Fed, Treasury and other officials—want to bring securitization out of the dark and into the light where they can see (and regulate) the activity.

Their thesis seems to be that MBS are needed—and likely will be issued—but dangerous. Having them issued by regulated entities means regulators can try to mitigate the threat—a lesser of two evils argument. It seems British authorities are taking a similar tack—Anthony Haldane, the BoE’s head of financial stability, noted the UK is looking to develop “simple and safe (MBS) structures, rather than the complex and shadowy ones.” By relaxing loan standards and incentivizing regulated lenders to securitize more debt, shadow bankers’ role may be mitigated. Globally, shadow banking has been in regulators’ crosshairs for some time—including the FSOC debating declaring large asset managers “Too Big to Fail” and subjecting them to increased oversight as a result.

For now, it remains to be seen whether the outlined plan becomes reality. At this point, they’re just words. Other reform proposals—including Crapo-Johnson, which moved out of committee Thursday—are alive but face significant opposition. The shape reforms take remains to be seen, but at this point, it looks to us like the momentum is with Fannie and Freddie securitizing more loans in the light.