January 27, 2015 Watt Admits Moving the Dials Can't Move the Housing Market ______

What's Happening: Testifying before the House Financial Services Committee for the first time since he left the panel himself as a member of Congress, Federal Housing Finance Agency (FHFA) Director Mel Watt faced aggressive questioning from members of both parties for four hours today on a wide variety of topics related to the sustainability of the housing finance system in the wake of the financial crisis and housing market crash.

Why It Matters: The highlight of his appearance was his admission that the recent reduction in loan-to-value ratios for purchasing mortgages will be only a small part of the overall government sponsored enterprise (GSE) business. The next most important exchange was regarding a decision on guarantor fees (g-fees), which Watt has not yet made. The director attempted repeatedly to demonstrate how he is fairly weighing the pros and cons of any moves in this regard. During one line of questioning from Democrats, he mentioned that principal reduction remains under consideration, but clearly intimated that it would be very limited, likely only to areas that are heavily in distress such as Detroit. Media reports have focused on this as the biggest takeaway from today's hearing, but we believe that this is an incorrect characterization of the verbal exchange and Watt's priorities.

What's Next: Watt stated that a decision on g-fees will likely come this quarter (late March or early April) and FHFA is actively reviewing an unprecedented number of comments on the federal home loan bank eligibility rule which could have an impact on real estate investment trusts (REITs). Director Watt will likely remain under pressure from both sides of the aisle on all of the issues mentioned above and we expect him to be a frequent guest of both the House Financial Services and Senate Banking Committees. The Democrats will press Watt to direct FHFA to further expand access to credit and increase affordable housing availability for low- and middle-income households, especially first-time homebuyers and minorities, while conservatives will vehemently oppose any action perceived to increase risk to taxpayers as long as Fannie Mae and Freddie Mac remain under conservatorship.

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Opening Statements

Chairman Jeb Hensarling (R-TX) criticized moves by FHFA to delay an increase in guarantor fees, reduce downpayment requirements for GSE mortgage purchases to as little as three percent, and lift the suspension on contributions to the Federal Housing Trust Fund and Capital Magnet Fund as putting taxpayers at risk. Ranking Member Maxine Waters (D-CA) lauded Watt’s efforts as appropriately balancing risk and increasing access to credit.

Director Watt used his opening statement to draw attention to the recently released 2015 scorecard outlining its priorities for Fannie Mae and Freddie Mac, as well as their joint-venture, Common Securitization Solutions. The scorecard expands upon goals established by the Strategic Plan for the Conservatorship of the GSEs. He highlighted the three primary goals of maintenance of credit availability and foreclosure prevention, reduction of taxpayer risk, and the creation of a common securitization platform. Watt noted that proposals on g-fees, the single security, mortgage insurers, and affordable housing goals remain under active consideration at this time. Although not mentioned today, we also expect that FHFA will issue counterparty risk standards for non-bank mortgage servicers in the coming months.

Reduced Downpayment Requirements

Hensarling expressed fears that Watt had reversed decisions of former FHFA Acting Director Edward DeMarco, undermining the sustainability of housing finance. He pressed Watt on what he believes is inherently greater risk of lower downpayment requirements, to which Watt responded with a list of compensating factors that could equalize risk across loans of varying loan-to-value ratios. Factors such as loan counseling, higher FICO credit scores, and private mortgage insurance reduce the likelihood of default even for loans with lower initial equity, Watt testified. Hensarling contends that this is not the case and that FHFA and FHA are in competition to become the “nation’s largest subprime lender,” to which Watt objected. Watt admitted later in the hearing that the number of borrowers impacted by this lower downpayment threshold is a relatively small portion of the GSEs' portfolios and that it will only expand access to credit on the margin.

Contributions to Housing Trust Funds

Watt repeatedly explained that he believes he is acting in compliance with statutory requirements to begin contributions to the affordable housing trust funds, which he addressed in his written testimony by including a lengthy citation of the relevant law. Watt stated that the contributions would not contribute to the financial instability of the enterprises and that the contributions are held until the end of 2015 at which time

they are transferred to the respective funds at Treasury Department and Department of Housing and Urban Development (HUD). Watt emphasized that he agreed with the decision of Acting Director DeMarco that the conditions at that time warranted a suspension of the contributions and FHFA has now determined that the criteria for suspension as defined by the statute are no longer met.

Rep. Sean Duffy (R-WI) repeatedly challenged Watt for what Duffy believes to be a circumvention of the statute in his decision to commit funds to the housing trust funds.Watt argued that, because the enterprises remain under conservatorship and all profits are swept by Treasury, capitalization is not a relevant factor to consider. The statute states that Watt can not dedicate money to the trust funds if such action would undermine the capitalization of the GSEs, but because the decision has no impact on their capitalization while under conservatorship, Watt believes that this action is consistent with the statute. In effect, the preferred stock purchase agreement has rendered these provisions immaterial. Duffy strenuously objected to this interpretation and has requested legal interpretations from the agency. Watt further stated he intends to continue the ban on lobbying by the GSEs in a letter response to members of the panel.

Common Securitization Platform (CSP)

Rep. Scott Garrett (R-NJ) questioned the level of industry participation in the development of the common securitization platform (CSP) being undertaken as a joint-venture between Fannie Mae and Freddie Mac. Garrett intimated that this was an attempt to maintain the dominance of the GSEs in the market and manipulate reforms to prevent the reentry of private capital into the market. Watt dismissed these claims, citing regular consultations with industry representatives while also noting that the process is intended to minimize risk by building a platform to support the market as it currently exists while making it adaptable to the future market yet to be defined by Congress through eventual GSE reform legislation.

Pending G-Fee Decision

Rep. Carolyn Maloney (D-NY) said that markets were indicating a possible decrease in g-fees rather than an increase, to which Watt responded that no decision had yet been made on what adjustments, if any, would be made to g-fees. Watt said that FHFA intends to finalize a decision by the end of this quarter, with the possibility that it slips into Q2. He noted that any risk-based pricing would impact states like New York with greater consumer protections which delay foreclosure proceedings. Maloney and representatives of other states with strong consumer protections lobbied Watt against risk-based pricing that would result in higher g-fees for those states, instead advocating a more equitable approach.

Rep. Randy Neugebauer (R-TX) noted the lack of market forces for the determination of risk pricing for the enterprises. Watt explained that a detailed rationale will be provided upon the release of a decision on g-fees. Watt insisted again that FHFA is not competing with FHA, but merely fulfilling its mandate to promote market liquidity.

Watt emphasized that the allocation of the housing trust funds lies with HUD for the National Housing Trust Fund and Treasury for the Capital Magnet Fund, in response to a question from Rep. Nydia Velázquez (D-NY). He also reminded the panel that the contributions are set aside beginning in January 2015 and if the statutory criteria for continuing contributions are met at the end of the year, that is, barring a change in circumstances, the contributions are made available for 2016.

Federal Home Loan Bank Eligibility Proposal

Rep. Frank Lucas (R-OK) expressed concern over the efforts to “change how the system works” by regulation rather than legislation, with respect to the Federal Home Loan Bank system. Watt restated that FHFA remains an independent institution that does not execute the priorities of the Obama administration, but is governed by statute. Watt reassured Lucas that the review is consistent with existing requirements for that system. He further noted that the agency received over 1,300 comments on the proposal, with perhaps 90 percent disapproving of the proposed rule. Watt stated that the statute will be applied as to minimize potential negative impacts noted by members of the committee and commenters. Later, Watt stated that preliminary analysis indicated that despite having approximately 7,500 members, only 50-100 would be adversely affected by the ruling.

Possibility for Principle Reduction

Rep. David Scott (D-GA) pressed Watt on the issue of principle reduction. Watt explained that FHFA continues to examine the issue and is looking to identify situations in which it is both helpful to borrowers and does not reduce the net present value of the loan for the GSEs. If and when that balance can be struck, Watt said, a decision will be made. Watt further noted successes of pilot initiatives such as the Neighborhood Stabilization Program, where nearly vacant neighborhoods were reducing values of occupied homes and principle reduction made sense. Contrary to some other analyses of Watt’s remarks, we do not believe this is inconsistent with his previous statements that FHFA supports principle reduction in theory but has yet to begin the process of expanding the policy outside of the pilot stage at this time.

Prospects for GSE Reform

Capitalization issues, brought up by Rep. Blaine Luetkemeyer (R-MO), prompted Watt to explain that the preferred stock purchase agreement with Treasury sweeps all profits to taxpayers, including any potential winnings of two pending lawsuits. If further losses were to occur, Watt conceded that Treasury and, by extension, the American taxpayer would be forced to cover them. Watt further conceded that it will be difficult for private capital to compete with the GSEs until Congress undertakes legislative reforms to housing finance.

Watt responded to questions from Rep. Rubén Hinojosa (D-TX) about the administration’s priorities for GSE reform, restating several times that it remains a legislative decision to be made by Congress and he will not express an opinion on the merits of any proposal, as it is outside the scope of the statutory mission of his agency.Watt did, however, point to aggressive risk transferring to the private sector as evidence of efforts by FHFA to increase private credit participation in the market, noting that the risk transfers have increased four-fold under his tenure.

Watt responded to questions about the urgency of GSE reform with the notion that “nothing is worse than uncertainty” and the longer that the issue drags on the more uncertainty will undermine the market function. Watt also noted the difficulty in retaining employees at the enterprises due to uncertainty about the direction of potential reforms.

Consumer Advocacy

Rep. Gwen Moore (WI-D) broached the topic of improved mortgage servicing for consumers with Watt. He explained that servicing evolved through the crisis from simply collecting money to a much more difficult process of dealing with homeowners in default, from which the current industry developed. Lenders historically performed much of their own servicing in-house, but now specialized firms are often called upon to perform complex mortgage servicing. Watt pointed to a new study from the Urban Institute that showed dramatic increases in costs of servicing due to increased responsibilities of servicers, exerting significant stress on the industry.

Members also grilled Watt on the legacy FICO credit scoring model currently used to determine credit worthiness, which advocates contend is outdated and fails to include relevant indicators of ability to repay loans. Watt responded that alternative credit scoring models are being evaluated, with attention being paid to the feasibility of implementation such that a switch can be made in a reliable way that does not create angst in the credit markets.