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Johnson Crapo GSE Discussion Draft:
A Few Suggestions for Improvement
Its been nearly six years since Fannie Mae and
Freddie Mac (the GSEs) entered conservatorship.
During the past few years, a consensus has been
slowly developing on the goals of GSE reform:
preserve the liquidity of the mortgage market while
protecting the taxpayer by putting private capital in
a first loss position, retain wide availability of long-
term fixed rate mortgages, provide access for
lenders of all sizes, and support affordable housing.
Senators Tim Johnson (D-SD) and Mike Crapo (R-
ID) have offered a new discussion draft of S.1217,
which strives to achieve these goals.
The Johnson Crapo discussion draft owes a heavy
intellectual debt to Senators Bob Corker (R-TN) and
Mark Warner (D-VA), who initially introduced S.1217
in 2013. Senators Johnson and Crapo used Corker
Warner as a base, then conducted an intense series of
hearings and meetings with market participants and
other interested parties reflecting all perspectives.
The outcome is a bipartisan bill, which is hard to
achieve in todays hyper-partisan context. While there
is more work to be done, the newest draft reflects an
important step forward. Initial reactions to the draft
have been guardedly positive, which for a
controversial topic is a feat in itself.
While we too are generally supportive of this 442-
page bill, there are two major areas in which we
would like to see changes during the mark-up
process: the structure of the private capital in the
first loss position and the structure of the affordable
housing provisions, in particular the incentive fee.
In both cases, the system as proposed has
intellectual appeal, but is apt to have unintended
and undesirable consequences.
The Dual System for Private
Both versions of S.1217, Corker Warner and
Johnson Crapo, provide for a catastrophic
government guarantee to support the liquidity of
certain mortgage-backed securities (MBS). In both,
the government guarantee can be accessed through
either of two channels: (1) by well-capitalized credit
insurers (guarantors) and (2) by entities who pool
mortgages into securities (aggregators) through
individual capital markets structures. By
establishing two channels, the bills sponsors hoped
to increase competition, allowing borrowers to
benefit from lower mortgage rates.
Perfectly regulated so that they operate on a level
playing field, the two models might indeed provide
important market discipline. However, our concern
is that the dual system, which adds markedly to the
bills complexity, could invite regulatory arbitrage
and result in the very instability and taxpayer risk
the bill is meant to overcome. The Pragmatic Plan
for Housing Finance Reform, authored by Ellen
Seidman, Phill Swagel, Sarah Rosen Wartell, and
Mark Zandi, and released last June, called for only
the guarantor execution for exactly these reasons.
More precisely, we have three sets of concerns: the
volatility of the capital markets execution, the
difficulty in maintaining a level playing field, and the
maintenance of liquidity in the To Be Announced
(TBA) market. Lets look at each in turn.
Volatility of Capital Markets
The capital markets execution can be accomplished
through a variety of structures, but the predominant
format will likely be a senior/subordinated
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structure, in which investment-grade senior bonds
are supported by higher-risk capital in the first loss
position, the subordinated tranches of the MBS.
When faced with changes in the financial landscape,
prices can change very quickly on the subordinated
tranches. Intellectually, this should not be an
issuewhen prices for the subordinated tranches
become too high, the execution vehicle of choice will
move from a capital markets execution to a
guarantor execution. We saw this in 2008, when the
private label securities markets dried up completely
and the market shifted almost entirely to
government-chartered guarantor channels.
In 2008, the GSEs, as well as the programs of the
Federal Housing Administration (FHA) and the
Department of Veterans Affairs (VA), were in place
to pick up the slack and keep the housing market
from collapsing completely. Our concern in a post-
GSE world is: If the capital markets execution
becomes the dominant model for a period and then
disappears, will there be guarantors who have
sufficient capital on hand to quickly step in and
provide the lost market capacityor will credit costs
skyrocket on scarce supply? If it is the latter, there
will be a large increase in volatility in mortgage
rates paid by borrowers, and likely also significant
constriction (at least during a transition) in the
availability of mortgage credit.
The Level Playing Field
While the bill ostensibly requires that equivalent
private capital stand in front of the government in
either execution, in practice it will be virtually
impossible to establish and maintain a level playing
field. This is the case both because the two models
require completely different regulatory regimes and
because the quality of the guarantors capital will
likely be higher.
Under the capital markets execution, the Federal
Mortgage Insurance Corporation (FMIC) will have
to evaluate thousands of separate securities
issuances each year, each backed by hundreds of
individual mortgages, to determine the correct
amount of capital needed to protect the
government, based on number, size, and
characteristics of each of the mortgages and the
pool as a whole. In particular, under section
302(a)(1)(A), less diversified pools of mortgages
will require significantly more capital than more
diversified pools to provide equivalent support to
the government.
The FMIC will essentially have to operate as a rating
agency, making sure the quantity and quality of
capital in the security truly protects the
government. And once a security comes to market,
the capital behind that security in a capital markets
execution is set: if the FMIC underestimated the
capital needed or market conditions change to make
that amount insufficient, the government has no
ability to require additional capital.
In contrast, the regulatory challenge with respect to
guarantors is the far more manageable and
traditional one of understanding whether each of a
limited number of monoline diversified insurers,
probably 5 to 10, is sufficiently capitalized. And
perhaps as important, the government would be
required to regularly stress-test the capital of the
larger guarantors and could require them to raise
additional capital.
The quality of the guarantors capital is also
considerably higher than that backing individual
securities. The government would pay off on a
security with a direct guarantee if mortgage defaults
caused all the private capital to be paid out to
investors. Thats the limit of the governments
cushion. In contrast, the government would pay out
on securities backed by a guarantor only if the
guarantor itself were insolvent, meaning that in
effect the government is backed by all the capital
backing all the securities the guarantor has insured.
Not only is the guarantee deeper, providing
diversification across years, but in a guarantor
execution, the stress tests enable the government to
require that more capital be raised at the first sign
of trouble.
On an intellectual level, one can argue that one can
take account of the difference in the quality of the
capital by allowing the guarantor to hold less
capital, to hold some of the capital in the form of
future expected premiums, or to pay a lower fee to
the government for catastrophic insurance. In
practice, we believe it will be impossible to create a
level playing field.
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And if the playing field is not level, it is apt to
encourage riskier loans to execute through the
capital markets. Sound familiar? This scenario is
eerily similar to the MBS markets of 2004 to 2007.
Preservation of the TBA Market
Finally, were concerned that most securities issued
through the capital markets execution will not be
able to be traded in the To Be Announced (TBA)
market because of the variety of structures that will
be represented. The homogeneity of the TBA
market is what makes it possible for consumers to
lock in a mortgage interest rate after the loan is
approved and before it is closed. Perhaps more
important, it is also what makes the market liquid
enough that MBS can be used as investments by
fiduciaries and many others.
There are two forms that a capital market execution
can take: a senior/subordinate structure or a credit-
linked note. We believe credit-linked notes may be
TBA eligible, although credit-linked notes and other
fully funded synthetic structures have never been
issued for a term of 30 years. That is, most of the
synthetic structures to transfer mortgage credit risk
to date have 10-year final maturities. A 30-year
structure would be necessary to fully transfer the
risk. The senior/subordinate structure presents
more difficulty with respect to TBA eligibility. In
particular, a security that represents the cash flow
of the entire security is not the same as a security
that represents the most senior 90 percent of the
cash flows.
An additional issue is that a very substantial
amount of loan-level information must be disclosed
in order to sell either the subordinated bonds or
credit-linked notes. The amount of information
disclosure required would be significantly higher
than what is contained in current Fannie and
Freddie loan-level disclosures. Would this
information raise privacy concerns that potentially
compromise the homogeneity of the TBA market?
In a nonhomogeneous market, the cheapest-to-
deliver security would dominate the pricing,
securities with more desirable characteristics would
sell as customized products, and the market would
become increasingly fragmented.
Some would argue that this heterogeneity is
irrelevant to investors, who are concerned only
about the government guarantee. That argument is
incorrect: a government wrap is a necessary but
insufficient condition for a homogeneous market.
These disclosures will allow investors to better
determine prepayment speeds, which is very
important in determining the total return on the
securities. There are provisions in the legislation,
such as section 302(b)(1)(D), that are intended to
keep this from occurring, but the standards are
unclear for when liquidity is being compromised
too much.
We understand the appeal of capital market
transactions as a pricing discipline on monoline
guarantors. The same virtue can be achieved by
encouraging or requiring the guarantors to offload a
portion of their own risk to private investors in
most normal market conditions. This will create
transparency and additional risk mitigation,
without creating a system that could literally
disappear during times of market stress when we
most need stability and liquidity in the market. It
also allows for a broader range of market
participants to invest in this market (debt investors,
for example), ultimately lowering insurance costs
and benefiting borrowers.
In short, we urge the senators to move toward the
simplicity of a well-capitalized guarantor model with
sufficient private capital ahead of the taxpayer. In
addition to concerns about the volatility of home
prices, the level playing field, and the preservation of
the TBA market, it will be impossible for a regulator
to provide direct oversight for the thousands of
capital markets transactions in a given year.
Affordable Housing Provisions
There are no explicit affordable housing goals under
Johnson Crapo. In fact, section 408 of the bill
would repeal the housing goals that currently apply
to Fannie Mae and Freddie Mac. Rather, Johnson
Crapo establishes a series of strategies relating to
affordable housing and the broad availability of
mortgage credit, including (1) recognition in
section 201(b)(5) as a purpose of the FMIC; (2) the
establishment of the Office of Consumer and
Market Access in section 208, with authority to
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monitor the market and aggregators and
guarantors level of success at meeting specified
market needs; and (3) the creation of the affordable
housing fee and allocations in section 501, and of
the Market Access Fund in section 504.
The affordable housing fee is set at 10 basis points
(bps) on all MBS that receive a government
guarantee from the FMIC. It would not apply to
Ginnie Mae securities, nor to the private label
market. The 10 bps fee, once built up over the life of
MBS issuances, will result in a much larger pool
than would have been created through the 4.2 bps
fee on annual GSE purchases that was mandated in
2008 under the Housing and Economic Recovery
Act, but was never collected because the GSEs went
into conservatorship. The funds would be
distributed as follows: 75 percent to the National
Housing Trust Fund, 15 percent to the Capital
Magnet Fund, and 10 percent to the Market Access
Fund. Perhaps the bills most innovative feature is
the incentive structure for this fee under section
501(b)(2). Loosely derived from a proposal of the
National Community Reinvestment Coalition, the
incentive structure would provide for variation in
the fee based on how well an aggregator or a bond
guarantor does in providing support for
underserved consumers and markets.
Structure of the Incentive Fee
Most simply, aggregators and guarantors will be
judged on three criteria: their performance relative
to (1) their approved peers, (2) primary market
originations in underserved areas and (3) the
degree to which each market segment used to judge
performance is underserved. Aggregators and
guarantors with the highest rankings would pay a
lower fee on all of their guaranteed MBS. To make
sure the affordable housing funds receive adequate
financing year after year, the average of all fees
must be 10 bps (section 501(b)(2)(A)). In addition,
the highest fee paid cannot exceed twice the lowest
(section 501(b)(2)(B)). If the minimum and
maximum fee were set in a symmetric manner, the
lowest fee would be 6.667 bps, and the highest
13.333 bps. Other nonsymmetric configurations are
also possible: the lowest fee could be 8 bps and the
highest 16 bps, for example. Section (b)(3) allows an
aggregator or guarantor to opt out of being ranked
on its service to underserved markets by agreeing to
pay the highest fee charged to any other entity.
We assume variation in the fee has two goals: to
ensure there is sufficient quality housing
available and to provide consumers at least a
portion of the benefit of the reduced fee. As
discussed in the previous section, Johnson Crapo
provides for MBS to receive a government
guarantee either directly (capital markets
execution) or through a bond guarantor. In addition
to the problems noted above, the dual structure
makes it hard for guarantors to cross-subsidize
higher-risk loans with lower-risk ones, for fear of
losing lower-risk loans to the capital markets
execution. Thus, without any subsidy, the rate a
borrower would be charged on a higher-risk loan
may be quite high, constraining both the quantity
and attractiveness of these instruments.
The incentive fee may help overcome both these
problems. Because any fee break applies to an
aggregators or guarantors entire book of business
generated over the year, a small fee differential,
most of which is passed on to underserved
borrowers, may well be sufficient to (1) incent
lenders to want to expand their credit box,
increasing the volume of such loans; and
(2) provide enough of the break to the borrowers to
keep the price of the loan attractive. For example,
let us assume that 10 percent of the market is
considered underserved. Assume further that half
the aggregators/guarantors have no underserved
business at all, and pay 13.33 bps; the other half do
20 percent of their business in underserved markets
and pay 6.67 bps. The aggregators/guarantors with
a 20 percent underserved share could pass through
this 6.67 bps of savings on their whole book of
business to the 20 percent underserved share,
allowing for a 33.35 bps additional incentive to
those borrowers. We assume competition among
the guarantors/aggregators will cause most of the
incentives to be passed through to the borrowers.
Although the incentive fee structure is an exciting
feature in principle, we recommend additional
changes to reduce complication and potential
unintended adverse consequences.
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Concerns about the Incentive Fee Structure
First, in a dual system, it is not clear how one would
rank guarantors against aggregators. Guarantors
and aggregators are apt to have very different
business models: guarantors are likely to be quite
diversified, whereas many aggregators are apt to be
quite specialized. Will guarantors be ranked only
against guarantors and aggregators against
aggregators? If combined, will the entire benefit go
disproportionately to a few entities? The
distribution of these fees is critical, as this is one of
the few channels for providing a rate subsidy to the
underserved population. And, as noted above, the
dual structure limits the potential for cross-subsidy
within a bond guarantors book.
Second, section 210(a)(2) directs the FMIC to
establish up to eight categories under which
aggregators and guarantors will be judged and
specifically suggests six that may be applied:
(1) traditionally underserved areas, including urban
and rural areas, (2) manufactured housing,
(3) small-balance loans, (4) low- and moderate-
income creditworthy borrowers, (5) preservation of
existing housing stock created by federal and state
laws, and (6) affordable rental housing. These items
include both specific populations and specific
product types, and both single family and
multifamily issues, adding confusion about the
intent of the incentive.
Each of the eight categories must be compared on
three criteriarelative to each other, relative to the
market, and relative to the needfurther adding
complexity to the calculations. Moreover, the
plethora of categories and measurements dampens
the incentives provided by the subsidy; with more
borrowers considered underserved, the value of
the subsidy to each is lower. And, as shown in the
box below, the subsidy can decline very quickly as
the portion of the population considered
underserved increases.
Third, because the fee must average 10 bps, and
guarantors and aggregators are judged relative to
each other and to the market, the fee that each
participant pays will be determined on an annual
basis, with rebates paid to those who do particularly
well (section 501(b)(2)(E)(iv)). Because aggregators
and guarantors will not know how much, if any,
subsidy they will receive until after the reporting
year is over, they will be unwilling to use the fee to
subsidize underserved markets or borrowers. The
result is the subsidy is likely to be retained by the
guarantor or aggregator rather than being passed
through to the borrower. In fact, originators may be
able to capture some of the subsidy by holding in
portfolio mortgages the FMIC has determined will
qualify as underserved, and selling them at year end
to the guarantor/aggregator who is willing to pay
the most to achieve a break on the affordability fee.
A conceptual alternative to this pay and rebate
system is for the FMIC to establish a loan-level fee
schedule in advance that is designed to ensure that
(1) the 10 bps overall target is hit, (2) guarantors
and aggregators have an incentive to extend loans
to underserved populations, and (3) the incentive is
passed on to borrowers. Each guarantor or
aggregator would pay a fee computed by applying
the schedule to their total book of business. For
example, if the underserved population was
10 percent of the total, the FMIC could charge
aggregators and guarantors 15 bps for each
adequately served borrower and subsidize
aggregators and guarantors 35 bps for each
underserved loan. Under this pricing structure, if a
guarantor had a 20 percent underserved share, it
would pay 5 bps (15 bps on the adequately served
80 percent less the 35 bps subsidy on the
underserved 20 percent). A guarantor with a
0 percent underserved share would pay 15 bps.
This simple example illustrates that, even in a world
with certainty, the requirement that the highest fee
paid by a guarantor or aggregator be no more than
twice the minimum fee paid makes it difficult to
construct a schedule in which the FMIC is
guaranteed to hit the 10 bps average, while allowing
a subsidy of any size for the underserved
population. In our example, we have one guarantor
paying 5 bps and another paying 15 bps, a three
times, rather than twice, differential. And clearly we
dont live in a world with certainty. That makes it
impossible to calibrate a loan-level fee schedule in
advance that would hit the 10 bps target, ensure a
price break to the underserved, incent guarantors
and aggregators to make these loans, and follow the
rule that the highest fee paid be no more than twice
the minimum.
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How Would a Fee Schedule Work in Practice?
The FMIC would need to provide two critical parameters to set the fee schedule: (1) the highest fee a
guarantor/aggregator would be assessed on an adequately served borrower, and (2) the target percent of
underserved borrowers. In the example above, we assumed the highest fee a guarantor/aggregator would be
assessed on an adequately served borrower is 15 bps, and the target percent of underserved borrowers is 10 percent,
giving a 35 bps loan-level subsidy on underserved loans. If the underserved share was 20 percent, and adequately
served loans were charged 15 bps, then underserved loans would receive a 10 bps subsidy. The table below shows
the subsidies for various underserved shares, assuming a 15 bps maximum charge for adequately served borrowers.
Table 1: Designing an Incentive Fee Schedule
Underserved Population 10% 20% 30% 40%
Adequately Served Population 90% 80% 70% 60%
Maximum Fee for Adequately Served (bps) 15 15 15 15
Average Fee Collected on Adequately Served (bps) 13.5 12 10.5 9
Excess Available to Subsidize Underserved (bps) 3.5 2 0.5 -1
Actual Subsidy to Underserved (Excess Divided by Underserved Share)(bps) 35 10 1.667 -2.5

A few points are obvious from this simple example:
The larger the underserved population, the smaller the subsidy that can be provided. The subsidy goes
down quickly, as more underserved loans qualify for the subsidy and fewer adequately serviced loans pay
the extra fee. So if 40 percent of the loans were underserved, the underserved loans would have to be
charged 2.5 bps and the adequately served loans would be charged 15 bps to yield a 10 bps average fee.
The maximum fee charged to an adequately served borrower cannot be too high, because this fee is only
applicable to FMIC loans with a government guarantee. If the fee on adequately served loans is too high,
and it is passed through, adequately served borrowers will move toward non-FMIC execution, limiting the
room for cross-subsidization.
The requirement that the lowest-ranked guarantor/aggregator pay no more than twice the highest-ranked makes
the problem even more difficult. It is hard to imagine a situation in which the market share differential between
well-diversified guarantors is more than 10 percent. However, less diversified and more specialized aggregators
could well produce more differentiation. It would be conceptually possible to put a cap and floor on the incentive
fees, but then it is less clear that any portion of the fees will be passed through to borrowers.
Uncertainty as to the underserved share could make any fee schedule incorrect in retrospect, resulting in more or
less than the 10 bps average being collected. One could alter the schedule ex post, make it up the following year,
accept a shortfall or excess, or do a combination of these strategies. The exact mechanisms require considerable
thought and discussion with market participants. We think that certainty is important in ensuring that part of
the subsidy is passed through to borrowers, arguing for a make-up in subsequent years.
It is likely that a higher percentage of the adequately served borrowers will prepay, compared with the
underserved population, eating away at the fee for a particular vintage (origination year) of loans. We
suggest setting the fee schedule based on the dollar volume of purchase loans only (not refinance loans) that
are made to underserved borrowers as a percentage of the total dollar volume of purchase loans. Thus, in a
heavy refinance year, the total proceeds to the fund would be more than 10 bps, as adequately served
borrowers, who are likely to be more prepayment responsive, will be a larger percent of the total. This
excess will make up for a below-10 bps average in high purchase years. If more adequately served borrowers
move outside the system, adjustments in the fee structure will be necessary.
A high differential may enable guarantors to retain some of the incentive while still passing on a meaningful
subsidy to borrowers, and may thus incent guarantors to increase the supply of loans to underserved
borrowers. This is unlikely with smaller differentials.
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Here are some suggestions for improvement of the
incentive fee:
1. For the reasons discussed in the first part of this
paper, we are not enthusiastic about the dual
system for private capital. The presence of the
capital markets execution makes it impossible
(absent an incentive subsidy) for guarantors to
do any cross-subsidization on their book of
business. This is yet another reason to eliminate
capital markets execution as an alternative.
2. Reducing the number of categories to two
underserved communities and underserved
populationswould make it more likely that the
subsidy will actually increase the supply of
loans for underserved markets and that the
rewards of the variable fee would be targeted
to these borrowers.
3. Rather than having the institutions compete
with each other, the FMIC should be required to
set a fee schedule that would apply for the year,
and could be adjusted in subsequent years. This
would increase the likelihood that the incentive
is passed on to consumers and reduce the
likelihood that originators will hold these loans
hoping for a bidding war near the end of the
year that would increase the price of specific
assets. In addition, the fee schedule should be
based on the percentage of purchase loans
expected for underserved borrowers, and any
excess over the 10 bps average collected in high
refinance years should be retained to cover
shortfalls in high purchase mortgage years.
4. The opt-out provision should be removed. If a
guarantor does no underserved business, it
should be evaluated as such and the
information reported, to improve transparency
in the market.
5. We suggest that the requirement that the
relationship between the highest fee and the
lowest fee be expressed as a bps differential and
that it be stated as a goal for guarantors only,
not as a requirement. It would not be applicable
to aggregators. We also suggest that the
maximum for the highest fee be increased to
three, rather than two, times the lowest.
A market-based incentive fee to support affordable
housing is intellectually appealing. However, as
proposed, it is not likely to produce either more
lending or lower prices to borrowers. A few simple
changes, including a predetermined fee schedule
that guarantors and aggregators would apply to
their book of business, will make it more likely the
fee will be more effective.
Both the dual system for private capital and the
incentive fee structure are intellectually appealing.
However, both are, in practice, impossible to
calibrate, leading to unintended consequences. As a
result, we suggest a simpler approach: private
capital should be provided exclusively by
guarantors, and the affordable housing incentive
structure should be replaced with an explicit loan-
level fee structure, to create greater certainty on the
part of market participants as to the economic
benefit of meeting the needs of underserved
borrowers and markets.

Copyright April 2014. The Urban Institute. All rights reserved. Permission is granted for reproduction of this file, with attribution to the
Urban Institute.
The Urban Institute is a nonprofit, nonpartisan policy research and educational organization that examines the social, economic, and
governance problems facing the nation. The views expressed are those of the authors and should not be attributed to the Urban Institute, its
trustees, or its funders.
The Housing Finance Policy Centers (HFPC) mission is to produce analyses and ideas that promote sound public policy, efficient markets,
and access to economic opportunity in the area of housing finance.
We would like to thank The Citi Foundation and The John D. and Catherine T. MacArthur Foundation for providing generous support at the
leadership level to launch the Housing Finance Policy Center. Additional support was provided by the Ford Foundation and the Open Society