May 13, 2015 Joshua Rosner 646/652-6207 jrosner@graham-fisher.com twitter: @JoshRosner

Please refer to important disclosures at the end of this report.

Has Senator Shelby Gone Corker? A Strange Twist to Mortgage Reform On Monday afternoon, when Senate Banking Committee Chairman Richard Shelby (R-AL) introduced the Discussion Draft of his regulatory reform bill, he reversed course on several longstanding positions and demonstrated that our largest and most interconnected financial firms stranglehold on Washington is as strong as its ever been. Given the Chairmans tendency toward a conscientious approach to legislation, one has to wonder if he has read what is in the bill or, more likely, if Senator Corker refused to support the Chairmans efforts unless he included Corkers prescription for the mortgage market. Regardless, if Section 7 of the bill survives markup, and a Republican President is elected in 2016, it will not only harm our community banks but lead to further concentration of risk in our largest banks, prevent the normalization of access to credit for consumers, eliminate any productive discussion of the best approach for delivering support for affordable housing and further expose borrowers and the economy to a future systemic crisis. The bill is theoretically intended to roll back the most burdensome and unnecessary elements of the Dodd Frank Act, while reducing the systemic risks posed by Too Big To Fail banks, a bipartisan ideal. But the bills handling of mortgage market reforms indicates that those goals have been abandoned. Moreover, since mortgage market reform was never included in Dodd Frank it seems curious that this bill would be the vehicle for addressing that subject, rather than calling for hearings on the oversight of the GSEs conservatorship and the Conservators compliance with the Housing and Economic Recovery Act of 2008 (HERA) i. Senator Shelbys bill would prevent the recapitalization, meaningful reform of and re-privatizing of Fannie Mae and Freddie Mac without congressional action. More important, it would give away their business to the nations largest financial firms. It would provide the 10 largest banks with the ability to compete1 with the GSEs on fairly even terms for the first time. This would also help these

1 Note: Competition exists where market participants set prices and providers respond with market based prices that reflects their ability to compete against each other based

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institutions reverse recent trends that have eroded their market shares from a whopping 80% in 2010 to a still oligopolistic 60%ii. As a result, even beyond the risks posed to the public, by Section 7 of the bill, it would also allow the largest banks to drive their small mortgage lender competitors into irrelevance through profit margin compression. This is true of both smaller depository institutions like community banks and small mortgage bankers that do not draw on federal subsidies like deposit insurance, access to the Federal Reserve window and were also not included in the Treasury Asset Relief Programs (TARP). Instead, these firms must rely solely on private warehouse lines of credit to fund themselves. Although Congress says the housing finance system needs more private capital, it repeatedly proposes legislation that would further reduce the ability of unsubsidized, or less subsidized private capital, from entering the primary mortgage market. Sen. Shelbys language regarding mortgage market reforms hands that huge and lucrative market to the TBTF banksiii. It seems he has not only been Corkerized and reversed his longstanding positionsiv as regards the GSEs but that he, knowingly or unwittingly, is helping to ensure that, in a crisis, there will be no way or will to resolve those banks. Legislation introducedv, in 2013, by Senators Corker and Warner supported the very same ideals that Senator Shelby has included in his bill. It would ensure that the GSEs are never reformed but are, instead, replaced by a bank-centric model in which the benefit would accrue to larger institutions that have better access to funding and the capacity to hold fully diversified portfolios of residential mortgage riskvi. Shelbys bill also includes perverse language included in legislation proposed, in 2013, by Corker & Warner and reads as if it was written by counsel to the Mortgage Bankers Association, a group that seems only to act on behalf of its largest members. The bill would transfer, to the largest banks and dominant mortgage players like BlackRock, control of the property of the enterprises, including intellectual property, technology, systems, and infrastructure (including technology, systems, and infrastructure developed by the enterprises for the Platform), as well as any other legacy systems, infrastructure, processes, and the Platform itselfvii.

on their respective efficiencies. This has never been expected, nor could it operate for the public interest, in a public utility-like function such as exists in the secondary mortgage market.

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This approach will allow are largest banks to become more central to our economy. It would ensure if any TBTF bank ever fails, even for unrelated reasons, the banks will be able to tell politicians: You cant resolve us, as Democrats and Republicans intended in Dodd Frank. If you do, access to mortgage credit will shut down harming both your constituents and the broader economy. We are too vital to the economy. These actions will recreate the comingling of primary market activities of mortgage originators and the secondary market activities of the GSEs that drove us to financial crisis. This comingling supported the excess liquidity in the mortgage market which drove down lending standards, supported a race to zero between those markets and led to the failure of many lenders and the GSEs as well as defaults and foreclosures of borrowers who should never have qualified for mortgages on homes they could not afford. Just as in the lead up to the crisis, the GSEs crept further toward and into the primary market, in the Corker Warner Shelby approaches, the biggest banks would creep further into the secondary market. Unless those markets are kept strictly separate the intended counter-cyclicality of the secondary market will transform into a pro-cyclical market in which mortgage credit swings between excessive and non-existent. In 2001, my report Housing In the New Millennium: A Home Without Equity Is Just a Rental With Debt warned of the reckless growth and increasing credit risks taken on by Fannie Mae and Freddie Mac (GSEs) and highlighted that those changes had occurred after the enactment of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992viii. This Act put in place inadequate capital standards, increased the ability of the GSEs to leverage their balance sheets for the benefit of shareholders and provided the GSEs with a conflicted regulatory structure in which safety and soundness was secondary to political interests. All of these elements came at the expense of the publics interest. As I warned at the time: The virtuous circle of increasing homeownership through greater leverage has the potential to become a vicious cycle of lower home prices due to an accelerating rate of foreclosures caused by lower savingsix. Between 2001 and the crisis, as concerns about the risks posed by Fannie Mae and Freddie Mac grew, Senator Shelby was one of the only legislators who understood that the problem did not result from existence of GSEs but by their poor regulation, weak oversight and unbridled political influence. As sides were taken, between those who sought to continue to use the GSEs as political tools by which they could claim to help their most at risk constituents gain access to homeownership, and those who were ideologically opposed to the

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very existence of the GSEs, Senator Shelby understood the key issues and refused to move legislation that claimed to solve problems that it wouldnt solve. Historically, the activity that most threatened to bring about the insolvency of either firm was the use of their portfolios as drivers of leverage and income. Until the period between 1992 and 2007, Freddie Mac purchased mortgages from originators and securitized them, selling the risk to investors, while Fannie tended to retain significant portions of their purchases in portfolio. It was this inappropriate use of their portfolios, to generate high but risky returns for the benefit of management and shareholders, that had brought about the near failure of Fannie Mae in the late 1970s and early 1980sx and finally led to the failures and Conservatorship of both firms in 2008. So, with an understanding of the dangers of undercapitalized firms building increasingly leveraged risks on their balance sheets why has Washington failed to recognize that they could be properly reformed and restored to their intended function? In 1939, after massive bank failures and resulting household foreclosures, Republicans and Democrats alike supported President Franklin Roosevelts efforts to create an independent secondary mortgage market to prevent future liquidity crises in the mortgage market. Why abandon this mechanism rather than perfect it? Why would we choose not to recognize that the concept of a separation of church (countercyclical) and state (pro-cyclical), in which the secondary and primary markets are separate, is vital to our national interests? It seems clear that many in the affordable housing crowd, who previously wanted to protect the ability of the GSEs to provide off-budget subsidies to borrowers are now convinced that they need to find a new horse to ride to deliver these hidden subsidies. It also appears that many in the anti-GSE crowd, who fought against the companies in 1999-2007 because they abhorred the notion of an implied government guarantee fail to recognize that they are conferring that same costly guarantee to our largest and most interconnected banks and asset managers. If we stripped the politics from the policy it would be as apparent to Washington as it is to most market participants that near elimination of the GSEs portfolios and strict (rather than arbitrary) pricing of guarantee fees, as supported by HERA, have given the Federal Housing Finance Agency the power it needs to address most of the remaining risks the GSEs could pose through the authorities to set meaningful capital standards. Moreover, if the Obama administration placed the outstanding GSE warrants that the government holds as a result of the

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bailout the issue of affordable housing could be addressed with no further appropriations required and in a way that would eliminate political wrangling. The more well capitalized the GSEs became, the more valuable the warrants and affordable housing subsidy will become. This would align the public interests of safety and soundness and affordable housing with private interests of well-capitalized and viable firms. Instead, the Obama Treasury chose to siphon off all of the companies profits, ensuring that they have no capital and positioning taxpayers for another rescue, Congress should take up much narrower and less-politically charged legislation to ensure that the GSEs operate as relatively unleveraged secondary market utilities, with stable funding, significant capital and strict requirements to transfer risk into the market rather than transferring it to the public. Unfortunately, Congress seems a willing accomplice to the big banks interest in the mortgage business, an approach that will come at the publics expense. i http://www.gpo.gov/fdsys/pkg/PLAW-110publ289/pdf/PLAW-110publ289.pdf ii http://www.fanniemae.com/resources/file/research/datanotes/pdf/housing-insights-120513.pdf (See: Between 1998 and 2010, the share of the market held by the top ten originators grew from just below 40 percent to nearly 80 percent. However, since 2010, top ten lender share of originations has fallen below trend and retreated to slightly more than 60 percent in the first half of 2013.) iii (See: Section 705 at the direction of the Agency, the enterprises have established a joint venture called Common Securitization Solutions intended to facilitate the issuance of mortgage-backed securities through the Platform; at the direction of the Agency, the development of the Platform is currently geared toward the issuance of mortgage-backed securities by the enterprises; as soon as practicable, the capacity and functionality of the Platform should be expanded to facilitate the issuance of mortgage-backed securities by issuers other than the enterprises. iv http://www.bloomberg.com/news/videos/2015-01-29/iran-nuclear-talks-is-survival-question-shelby-says (When asked about GSE reform efforts Senator Shelby stated:We will address that, well see how far we can go. We need bipartisan support in the Senate to do it, but I dont want a bill just for the sake of a bill, it has to be a strong one. Im not interested in any bill with explicit guarantees. Id like to get F/F up and running on their own without the government help. Is that possible? I dont know. Its a big [bipartisan] lift. v http://www.corker.senate.gov/public/_cache/files/1bc94e87-5a8a-4f07-a709-30bb19f15873/06-25-13%20BILL%20TEXT.%20Housing%20Finance%20Reform%20&%20Taxpayer%20Protection%20Act%20.pdf

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vi http://www.housingwire.com/articles/33740-leaked-treasury-memo-on-fannie-freddie-fuels-fire-for-sweep-critics vii See Section 705 viii http://www.fhfa.gov/Government/Documents/Federal-Housing-Enterprises-Financial-Safety-and-Soundness-Act.pdf ix http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456 x See: p.6 http://www.cbo.gov/sites/default/files/12-23-fanniefreddie.pdf

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