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Our Guest today is Andrew Davidson and he's the head of Andrew Davidson company
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which is a a risk analytics company uh and they do consulting services around Residential Mortgages and mortgage back
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Securities yes thanks for joining us thank you um we want to talk about the state of play with fenny May and Freddy
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Mack which are the two huge government agencies uh that uh help to securitize mortgages um and uh pass them on into
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into the market so they provide liquidity for Residential Mortgages um and a huge percentage of US Residential
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Mortgages passed through those two entities at some point uh they blew up in 2008 along with a lot of mortgage
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related things um uh the government bailed them out as I understand it most of that bailout has been repaid or more
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than repaid uh but nevertheless it was almost $200 billion involved and of course there's a lot of interest in
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preventing that from happening again and so um while they were taken over the thought was always that well they were
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quazi owned uh or quazi run government entities before they had a government Charter but really they were run as a as
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private companies but when they blew up the government had to come in and take over uh and the idea has been that
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someday that would get reversed and there's been lots of plans put forth and
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none of them have seemed to have worked out um and we may be getting to a point there's a couple of new papers out by
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folks like Mark xandi who's with Moody's Analytics who you were just uh involved
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in a seminar with so you would you you'll be fresh on this topic and I understand you have a new paper coming
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out and I think what might be different about these papers is that there're starting to be a realization that maybe
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these entities can't be run as as private companies and maybe the government really needs to be involved
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and I'll let you take it from there sure so uh you know in 2008 when these entities were shut down secretary
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Paulson at the time said there should be a timeout and I think now the timeouts seems like the game instead of the
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timeout but uh you know he was sort of hoping that people could reexamine how these entities were run and say you know
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how do we make some adjustments um so we went through a process after that where
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different people had you know a wide range of proposals um on how to change Fanny and Freddy uh some to make them
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more private some to make them closer to the government um but so of none of these proposals really sort of could
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capture sort of a large percentage of Congress you know supporting them um in the meantime uh the regulator of Fanny
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and Freddy fhfa um has actually made a number of changes to these organizations and uh I think some people are starting
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to realize that the changes that have been occurring are maybe gsse reform and that this is sort of a path Way Forward
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is to look at what's happened already and say you know can we do something to
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continue to change the entities rather than throw them out and start all over because that was been that's been one of
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the suggestions like they're irretrievable we just have to start from the ground up yeah I think if you look
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at almost any of the proposals from 2008 through last year they all started with
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either wind down the gsse or shut down the GS or eliminate the GSS and I think this sort of new round of proposals The
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xandi Proposal as well as my proposal say let's start with what we have and how do we take what we have now and turn
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it to what we want so there's some fresh thinking around this I think it's worth
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pointing out that gsse government sponsored entity which Fanny and Freddy are or
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were it's it is this quazi this is this hybrid thing so even back before 2008
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before the financial crisis although they were considered private companies most people thought yeah but if they get
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in trouble we all kind of know the government's going to bail them out other people would say no no no they're
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private they're you know the shareholders will take the hit but when push came to shove and and things were
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collapsing not just them but so much of the financial system um the government did come to the rescue so those who
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thought that would happen ended up being correct so it's not that much of a stretch to say now I mean is it really
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so different what you're talking about from the way things were run for probably decades so I think think think
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about is that the shareholders actually did lose you know almost all their money
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or all their money depending on how litigation comes out so the government did not rescue the shareholders but what
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the government did do is step in and protect the bond holders so those people who are investing in the mortgage back
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Securities in the secondary markets right or the debt of these instrum of these entities and I think almost
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everyone thought that the government would step in okay on that so um the rating agencies for a long time have
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said that you know due to government sponsorship we view the debt instruments of Fanny and Freddy to view the highest
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credit quality and based on the capital that those entities had there's no way
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that they would have thought that otherwise so so I think you have to sort of separate out the equity investors
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from the bond investors okay and U so one of the important things in gsse reform is to just be explicit about that
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rather than sort of have a wink relationship sort of a fudging going said um oh you know no we don't
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guarantee any of those assets you know it's in big bold letters on the front
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page of the Fanny May and Freddy Mac bonds these are not government guaranteed bonds but s you know
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privately saying oh sure you know we're not going to let those fail and the the
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rates were set in a way that reflected what would happen if they were guaranteed correct exactly right so the
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market said they're really yes they're really guaranteed and so rather than
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live in that world why not live in a world where you say yes the government will guarantee certain instruments
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created by these entities because we recognize that in order to have a giant real estate market and housing market
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like we do in the United States we like to have a 30-year fixed rate mortgage and a 30e fixed rate mortgage functions
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much better with a government guarantee than without one and so if you believe that then you say we need the guarantee
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and so let's start from the idea that we will have a guarantee and it will be
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explicit but we still have to figure out who the entities are that are going to create these loans which is kind of
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where your paper probably starts so tell us the title of your paper and where where people can find it and then tell
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us what's in it please so the paper I don't think it's up yet but it'll be on
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the uh Urban Institute website um it'll also be on our website my company Andrew
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Davidson and Company ad- zoo.com uh the paper is called uh I believe uh four steps forward and the
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four steps are to streamline share risk wrap and mutualize so by streamline says let's make these entities smaller
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than they are now by share risk it says that we don't actually have to put all
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of the capital for bearing credit risk into these two entities that they've actually started to sell off their
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credit risk through these what credit risk sharing trans transactions which are basically ways where Fanny and
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Freddy buy insurance from the market and then they're also buying some insurance
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from reinsurers and maybe some insurance from the mortgage insurance industry and
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so that program is now $30 billion or so of money that actually now stands in front of the taxpayers if there's credit
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losses on Fanny and Freddy mortgages uh so that program should be expanded uh the third step is w and that's what
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we were talking about before which is there needs to be an explicit government W and that W has to be structured in
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such a way that the government only is liable if there's catastrophic losses so
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you have to have very bad performance in both the housing market and unemployment
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before the government would need to pay something but the government will know that's when they've got to put the money
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in but that government is taxpayers taxpayer bailouts right right but the so you know I don't know if I'd consider it
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taxpayer bailouts so the the government would be running an insurance program it's going to be collecting premiums for
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that you know when the FDIC makes good on Deposit Insurance we don't call that
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a bailout um when they make good on saving a company maybe that should have failed maybe that's a bailout but you
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know it's an insurance program and they're paying the money you know that
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they've been earning premiums on so they're creating a reserve that will
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that will cover a certain percentage of front but you're saying beyond that if
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there's something catastrophic there's the reserve only goes up to a certain percentage correct
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so the reserve is only going to cover you know so much losses but you know and then the government can either recover
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or not recover that afterward but the point is to structure that so it's much
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further out on the probability curve you know than we stand now with this current
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implicit guarantee so most people are talking about Fanny and Freddy you know having either capital or reinsurance
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that covers you know four to 5% of losses right versus before they they only needed to hold 45 basis points or
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less than half a percent of coverage of losses so you know if they had 200 billion do of capital more than they had
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before then there wouldn't have been this need for the bailout of the entities as they were before and that
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was definitely a bailout because I say there was no mechanism in place to say that they were buying some insurance
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right well let's be clear about that because that's that's really an
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interesting point so if what you're proposing had been in effect in 2008 I think what you're saying is things
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would not have happened the way they happened that there would have been enough cushion enough of a shock
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absorption there to prevent at least Fanny and Freddy maybe you know not not talking about everyone else this
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probably you know the subprime market you know had its own problems and this wasn't going to help that but Fanny and
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Freddy would have had enough capital or enough reinsurance to cover the losses so most people are talking about loss
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coverage probably about double the experience of the 200 uh 2008 time period so yeah and then so that's WRA
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and then the the fourth one is okay now we have these entities we have a functioning system but they're still in
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conservatorship how should we spin these back out into the market and uh so in my
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proposal I think they should be turned into mutual companies owned by The Originators and the mutuals should um
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own Fanny and Freddy they should put up some Capital based on how much they use those entities
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um and that those entities will um basically fill the same functions that Fanny and Freddy are doing now but they
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wouldn't become stockholder owned company they'd become Mutual owned companies the uh xandi Proposal with his
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co-authors is almost exactly the same as mine up to this point um except that instead of being a mutual they believe
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that it should become a government corporation I see so that the so it wouldn't be a government agency like uh
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FHA it would be more of a government corporation FDIC sort of an example of a government corporation um and then other
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people have said these should entities should become utilities or if you go to the back to the Johnson crepo law it
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would have said these entities should have become competitive guarantors so at this point we'd really be talking about
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differences in governance of this residual entity but I think any discussion along that line is a big step
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forward from saying let's shut them down and start all over again so what are
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the big benefits to all this from from your point of view you're you're you're
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pointing out of course that um there'll be more of a cushion if there was some
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kind of meltdown so that seems like a a public good right but also um this is going to preserve the 30-year mortgage
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which is um really so important to to Americans and uh they're they're they'd
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be very disappointed if somehow market conditions didn't allow that to continue
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so does this accomplish that yes the by um by creating the government WRA it's
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really the essential ingredient in order to continue the 30-year fixed rate loan
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there just really aren't investors who are willing to invest in that kind of
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interest rate risk and also take on credit risk and what the guarantee does it just splits those two risks apart um
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so you know certainly that's one important G um Advantage uh another important Advantage is that uh a lot of
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people are very concerned about maintaining access to credit uh in two different ways one is that every
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borrower who's a qualified borrower and can you know afford a loan over time
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should be given the opportunity to have a loan and by having sort of a national entity you can sort of have that
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National entity responsible for making sure there's people operating in every
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Market uh so preventing discrimination of some sort or another you know and you say oh this you know we don't serve this
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particular Market because it's too far out of the way or you know a national
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entity can either do it itself or encourage the banks who are its members to say you know someone who needs to
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serve this market so is this addressing the idea of affordability is that the point yeah so it's so there's access and
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then there's affordability as well and affordability is handled in several different ways like right now Fanny and
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Freddy actually um don't price each loan individually there's some averaging of
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the risk and so by averaging the risk the people with the Better Credit actually subsidized to some degree of
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people with worth worse credit so that helps with affordability uh the other thing that most of the proposals have is
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some of the money that the government earns from providing the wp goes into a fund that also directly supports
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affordable lending I see U affordable in the sense of subsidized rat some sort of
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some sort of subsid kind of subsidy okay okay um so you know another important part of uh these proposals is uh what
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happens to the profits that are made by Fanny and Freddy right so Fanny and Freddy made a lot of profits when they
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were private entities so one of the advantages of being a mutual company is that if they're making a lot of profits
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those profits go back to the owners who are also mortgage Originators and they're competitive and so then that can
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feed back into lowering prices or lowering rates for borrowers so if you move from sort of a competitive market
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where you have stockholders outside of the mortgage Market to the stockholders inside the mortgage Market even if you
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do end up with Monopoly profits they recycle back into the system but most Mutual is there a problem with
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diversification there though if everyone's sort of in the same family of the mortgage World um versus in the past
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maybe shareholders were just interested in in in diversifying you know and chose
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that as uh you know one of their Investments so so so one of the things that makes this work now is the
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existence of these credit risk sharing deals and so you know I think about 75% of the risk that's created should be
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moved outside of this system and so by using different Bond structures or reinsurance structures the credit risk
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doesn't all sit inside Fanny and Freddy so it doesn't actually have to sit those
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Originators so they're going to get other people to take that risk so the diversification happens through the
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capital markets um yeah I think otherwise you would have this situation where it's like you know 200 300 billion
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dollars worth of capital sitting at one or two entities and um you would need to
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find a way of diversifying the shareholders little too ancest the industry couldn't take on that much risk
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okay on the other hand you know we do believe in skin in the game and so to me part of having the members also part of
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this Mutual is that they are responsible jointly and severally for you know the activities that they're creating what
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else is it important to know about your proposal um you know I you know I don't
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know whether or not it would happen but you know I think that there's a pretty
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clear pathway to get there um like say it doesn't require creating all new entities um it just requires changing
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the ownership structure of existing entities and uh by doing that it sort of takes us out of having a transition plan
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that lasts you know 10 or 20 years which you know you who knows what or longer who knows what would happen over the
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that time Horizon thanks for coming in and shing with us [Music]