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Our Guest today is Andrew Davidson and
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he's the head of Andrew Davidson company
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which is a a risk analytics company uh
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and they do consulting services around
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Residential Mortgages and mortgage back
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Securities yes thanks for joining us
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thank you um we want to talk about the
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state of play with fenny May and Freddy
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Mack which are the two huge government
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agencies uh that uh help to securitize
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mortgages um and uh pass them on into
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into the market so they provide
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liquidity for Residential Mortgages um
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and a huge percentage of US Residential
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Mortgages passed through those two
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entities at some point uh they blew up
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in 2008 along with a lot of mortgage
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related things um uh the government
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bailed them out as I understand it most
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of that bailout has been repaid or more
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than repaid uh but nevertheless it was
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almost $200 billion involved and of
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course there's a lot of interest in
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preventing that from happening again and
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so um while they were taken over the
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thought was always that well they were
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quazi owned uh or quazi run government
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entities before they had a government
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Charter but really they were run as a as
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private companies but when they blew up
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the government had to come in and take
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over uh and the idea has been that
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someday that would get reversed and
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there's been lots of plans put forth and
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none of them have seemed to have worked
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out um and we may be getting to a point
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there's a couple of new papers out by
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folks like Mark xandi who's with Moody's
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Analytics who you were just uh involved
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in a seminar with so you would you
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you'll be fresh on this topic and I
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understand you have a new paper coming
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out and I think what might be different
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about these papers is that there're
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starting to be a realization that maybe
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these entities can't be run as as
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private companies and maybe the
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government really needs to be involved
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and I'll let you take it from there sure
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so uh you know in 2008 when these
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entities were shut down secretary
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Paulson at the time said there should be
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a timeout and I think now the timeouts
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seems like the game instead of the
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timeout but uh you know he was sort of
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hoping that people could reexamine how
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these entities were run and say you know
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how do we make some adjustments um so we
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went through a process after that where
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different people had you know a wide
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range of proposals um on how to change
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Fanny and Freddy uh some to make them
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more private some to make them closer to
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the government um but so of none of
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these proposals really sort of could
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capture sort of a large percentage of
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Congress you know supporting them um in
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the meantime uh the regulator of Fanny
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and Freddy fhfa um has actually made a
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number of changes to these organizations
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and uh I think some people are starting
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to realize that the changes that have
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been occurring are maybe gsse reform and
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that this is sort of a path Way Forward
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is to look at what's happened already
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and say you know can we do something to
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continue to change the entities rather
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than throw them out and start all over
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because that was been that's been one of
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the suggestions like they're
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irretrievable we just have to start from
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the ground up yeah I think if you look
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at almost any of the proposals from 2008
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through last year they all started with
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either wind down the gsse or shut down
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the GS or eliminate the GSS and I think
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this sort of new round of proposals The
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xandi Proposal as well as my proposal
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say let's start with what we have and
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how do we take what we have now and turn
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it to what we want so there's some fresh
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thinking around this I think it's worth
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pointing out that gsse government
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sponsored entity which Fanny and Freddy
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are or
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were it's it is this quazi this is this
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hybrid thing so even back before 2008
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before the financial crisis although
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they were considered private companies
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most people thought yeah but if they get
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in trouble we all kind of know the
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government's going to bail them out
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other people would say no no no they're
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private they're you know the
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shareholders will take the hit but when
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push came to shove and and things were
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collapsing not just them but so much of
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the financial system um the government
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did come to the rescue so those who
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thought that would happen ended up being
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correct so it's not that much of a
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stretch to say now I mean is it really
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so different what you're talking about
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from the way things were run for
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probably decades so I think think think
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about is that the shareholders actually
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did lose you know almost all their money
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or all their money depending on how
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litigation comes out so the government
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did not rescue the shareholders but what
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the government did do is step in and
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protect the bond holders so those people
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who are investing in the mortgage back
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Securities in the secondary markets
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right or the debt of these instrum of
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these entities and I think almost
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everyone thought that the government
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would step in okay on that so um the
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rating agencies for a long time have
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said that you know due to government
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sponsorship we view the debt instruments
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of Fanny and Freddy to view the highest
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credit quality and based on the capital
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that those entities had there's no way
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that they would have thought that
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otherwise so so I think you have to sort
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of separate out the equity investors
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from the bond investors okay and U so
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one of the important things in gsse
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reform is to just be explicit about that
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rather than sort of have a wink
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relationship sort of a fudging going
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said um oh you know no we don't
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guarantee any of those assets you know
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it's in big bold letters on the front
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page of the Fanny May and Freddy Mac
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bonds these are not government
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guaranteed bonds but s you know
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privately saying oh sure you know we're
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not going to let those fail and the the
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rates were set in a way that reflected
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what would happen if they were
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guaranteed correct exactly right so the
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market said they're really yes they're
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really guaranteed and so rather than
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live in that world why not live in a
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world where you say yes the government
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will guarantee certain instruments
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created by these entities because we
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recognize that in order to have a giant
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real estate market and housing market
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like we do in the United States we like
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to have a 30-year fixed rate mortgage
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and a 30e fixed rate mortgage functions
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much better with a government guarantee
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than without one and so if you believe
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that then you say we need the guarantee
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and so let's start from the idea that we
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will have a guarantee and it will be
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explicit but we still have to figure out
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who the entities are that are going to
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create these loans which is kind of
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where your paper probably starts so tell
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us the title of your paper and where
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where people can find it and then tell
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us what's in it please so the paper I
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don't think it's up yet but it'll be on
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the uh Urban Institute website um it'll
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also be on our website my company Andrew
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Davidson and Company ad-
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zoo.com uh the paper is called uh I
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believe uh four steps forward and the
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four steps are to
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streamline share
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risk wrap and mutualize so by streamline
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says let's make these entities smaller
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than they are now by share risk it says
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that we don't actually have to put all
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of the capital for bearing credit risk
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into these two entities that they've
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actually started to sell off their
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credit risk through these what credit
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risk sharing trans transactions which
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are basically ways where Fanny and
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Freddy buy insurance from the market and
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then they're also buying some insurance
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from reinsurers and maybe some insurance
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from the mortgage insurance industry and
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so that program is now $30 billion or so
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of money that actually now stands in
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front of the taxpayers if there's credit
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losses on Fanny and Freddy mortgages uh
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so that program should be expanded
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uh the third step is w and that's what
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we were talking about before which is
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there needs to be an explicit government
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W and that W has to be structured in
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such a way that the government only is
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liable if there's catastrophic losses so
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you have to have very bad performance in
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both the housing market and unemployment
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before the government would need to pay
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something but the government will know
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that's when they've got to put the money
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in but that government is taxpayers
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taxpayer bailouts right right but the so
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you know I don't know if I'd consider it
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taxpayer bailouts so the the government
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would be running an insurance program
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it's going to be collecting premiums for
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that you know when the FDIC makes good
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on Deposit Insurance we don't call that
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a bailout um when they make good on
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saving a company maybe that should have
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failed maybe that's a bailout but you
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know it's an insurance program and
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they're paying the money you know that
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they've been earning premiums on so
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they're creating a reserve that will
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that will cover a certain percentage of
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front but you're saying beyond that if
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there's something
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catastrophic there's the reserve only
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goes up to a certain percentage correct
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so the reserve is only going to cover
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you know so much losses but you know and
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then the government can either recover
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or not recover that afterward but the
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point is to structure that so it's much
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further out on the probability curve you
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know than we stand now with this current
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implicit guarantee so most people are
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talking about Fanny and Freddy you know
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having either capital or reinsurance
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that covers you know four to 5% of
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losses right versus before they they
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only needed to hold 45 basis points or
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less than half a percent of coverage of
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losses so you know if they had 200
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billion do of capital more than they had
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before then there wouldn't have been
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this need for the bailout of the
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entities as they were before and that
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was definitely a bailout because I say
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there was no mechanism in place to say
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that they were buying some insurance
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right well let's be clear about that
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because that's that's really an
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interesting point so if what you're
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proposing had been in effect in 2008
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I think what you're saying is things
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would not have happened the way they
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happened that there would have been
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enough cushion enough of a shock
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absorption there to prevent at least
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Fanny and Freddy maybe you know not not
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talking about everyone else this
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probably you know the subprime market
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you know had its own problems and this
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wasn't going to help that but Fanny and
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Freddy would have had enough capital or
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enough reinsurance to cover the losses
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so most people are talking about loss
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coverage probably about double the
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experience of the 200 uh 2008 time
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period so yeah and then so that's WRA
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and then the the fourth one is okay now
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we have these entities we have a
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functioning system but they're still in
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conservatorship how should we spin these
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back out into the market and uh so in my
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proposal I think they should be turned
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into mutual companies owned by The
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Originators and the mutuals should um
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own Fanny and Freddy they should put up
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some Capital based on how much they use
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those entities
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um and that those entities will um
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basically fill the same functions that
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Fanny and Freddy are doing now but they
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wouldn't become stockholder owned
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company they'd become Mutual owned
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companies the uh xandi Proposal with his
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co-authors is almost exactly the same as
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mine up to this point um except that
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instead of being a mutual they believe
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that it should become a government
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corporation I see so that the so it
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wouldn't be a government agency like uh
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FHA it would be more of a government
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corporation FDIC sort of an example of a
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government corporation um and then other
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people have said these should entities
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should become utilities or if you go to
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the back to the Johnson crepo law it
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would have said these entities should
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have become competitive guarantors so at
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this point we'd really be talking about
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differences in governance of this
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residual entity but I think any
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discussion along that line is a big step
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forward from saying let's shut them down
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and start all over again so what are
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the big benefits to all this from from
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your point of view you're you're you're
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pointing out of course that um there'll
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be more of a cushion if there was some
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kind of meltdown so that seems like a a
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public good right but also um this is
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going to preserve the 30-year mortgage
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which is um really so important to to
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Americans and uh they're they're they'd
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be very disappointed if somehow market
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conditions didn't allow that to continue
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so does this accomplish that yes the by
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um by creating the government WRA it's
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really the essential ingredient in order
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to continue the 30-year fixed rate loan
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there just really aren't investors who
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are willing to invest in that kind of
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interest rate risk and also take on
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credit risk and what the guarantee does
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it just splits those two risks apart um
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so you know certainly that's one
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important G um Advantage uh another
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important Advantage is that uh a lot of
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people are very concerned about
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maintaining access to credit uh in two
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different ways one is that every
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borrower who's a qualified borrower and
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can you know afford a loan over time
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should be given the opportunity to have
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a loan and by having sort of a national
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entity you can sort of have that
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National entity responsible for making
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sure there's people operating in every
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Market uh so preventing discrimination
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of some sort or another you know and you
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say oh this you know we don't serve this
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particular Market because it's too far
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out of the way or you know a national
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entity can either do it itself or
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encourage the banks who are its members
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to say you know someone who needs to
00:13:00
serve this market so is this addressing
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the idea of affordability is that the
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point yeah so it's so there's access and
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then there's affordability as well and
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affordability is handled in several
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different ways like right now Fanny and
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Freddy actually um don't price each loan
00:13:15
individually there's some averaging of
00:13:17
the risk and so by averaging the risk
00:13:20
the people with the Better Credit
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actually subsidized to some degree of
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people with worth worse credit so that
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helps with affordability uh the other
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thing that most of the proposals have is
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some of the money that the government
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earns from providing the wp goes into a
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fund that also directly supports
00:13:37
affordable lending I see U affordable in
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the sense of subsidized rat some sort of
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some sort of subsid kind of subsidy okay
00:13:46
okay um so you know another important
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part of uh these proposals is uh what
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happens to the profits that are made by
00:13:55
Fanny and Freddy right so Fanny and
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Freddy made a lot of profits when they
00:13:58
were private entities so one of the
00:14:00
advantages of being a mutual company is
00:14:03
that if they're making a lot of profits
00:14:05
those profits go back to the owners who
00:14:07
are also mortgage Originators and
00:14:08
they're competitive and so then that can
00:14:10
feed back into lowering prices or
00:14:13
lowering rates for borrowers so if you
00:14:15
move from sort of a competitive market
00:14:17
where you have stockholders outside of
00:14:19
the mortgage Market to the stockholders
00:14:22
inside the mortgage Market even if you
00:14:24
do end up with Monopoly profits they
00:14:27
recycle back into the system but most
00:14:30
Mutual is there a problem with
00:14:31
diversification there though if
00:14:32
everyone's sort of in the same family of
00:14:34
the mortgage World um versus in the past
00:14:37
maybe shareholders were just interested
00:14:39
in in in diversifying you know and chose
00:14:42
that as uh you know one of their
00:14:44
Investments so so so one of the things
00:14:47
that makes this work now is the
00:14:48
existence of these credit risk sharing
00:14:50
deals and so you know I think about 75%
00:14:53
of the risk that's created should be
00:14:55
moved outside of this system and so by
00:14:58
using different Bond structures or
00:15:00
reinsurance structures the credit risk
00:15:02
doesn't all sit inside Fanny and Freddy
00:15:04
so it doesn't actually have to sit those
00:15:06
Originators so they're going to get
00:15:08
other people to take that risk so the
00:15:10
diversification happens through the
00:15:12
capital markets um yeah I think
00:15:14
otherwise you would have this situation
00:15:16
where it's like you know 200 300 billion
00:15:18
dollars worth of capital sitting at one
00:15:20
or two entities and um you would need to
00:15:23
find a way of diversifying the
00:15:25
shareholders little too ancest the
00:15:27
industry couldn't take on that much risk
00:15:30
okay on the other hand you know we do
00:15:32
believe in skin in the game and so to me
00:15:35
part of having the members also part of
00:15:37
this Mutual is that they are responsible
00:15:40
jointly and severally for you know the
00:15:42
activities that they're creating what
00:15:45
else is it important to know about your
00:15:47
proposal um you know I you know I don't
00:15:50
know whether or not it would happen but
00:15:51
you know I think that there's a pretty
00:15:53
clear pathway to get there um like say
00:15:57
it doesn't require creating all new
00:15:59
entities um it just requires changing
00:16:01
the ownership structure of existing
00:16:03
entities and uh by doing that it sort of
00:16:06
takes us out of having a transition plan
00:16:08
that lasts you know 10 or 20 years which
00:16:11
you know you who knows what or longer
00:16:14
who knows what would happen over the
00:16:16
that time Horizon thanks for coming in
00:16:18
and shing with
00:16:27
us
00:16:30
[Music]
