Now that mortgage giants Fannie Mae and Freddie Mac have put huge accounting scandals behind them, they’re retraining their sights on their lending businesses, working to increase flexibility, introduce new products, and win back their position as market leaders.
Several lenders believe that the government-sponsored enterprises (GSEs), which together hold roughly $1.4 trillion in debt, are beginning to innovate and get creative to win back market share. “They’ll continue to become more aggressive in order to compete more effectively,” said Paul Weissman, a senior vice president and director at Credit Suisse/Column Capital.
Still, while the GSEs drive the affordable housing market, their competitiveness is declining toward the market-rate end of the multifamily spectrum, where conduit lenders offering commercial mortgage-backed securities and collateralized debt obligations have become increasingly important players, lenders said.
So even as the rejuvenated firms are re-engaging the market, they are doing so at a time when competition is at an all-time high. The GSEs developed the multifamily market in the late ’80s and early ’90s, “but it’s a frothily competitive debt market these days, and Fannie and Freddie don’t drive that market like they used to; they are simply a player in the market,” said Steve Wendel, managing director and co-head of Deutsche Bank Berkshire Mortgage (DBBM). “On the less affordable half of the properties, the conduits are all over it, and Freddie and Fannie are just in there with everyone else.”
And that’s not the only challenge the agencies are facing. The scandals hastened reform efforts in Congress, and the GSEs are now bracing for a wrangle over legislation introduced in March by Rep. Barney Frank (D-Mass.), chair of the House Financial Services Committee. That bill inhabits the middle ground between Republican hopes for a stronger regulatory structure and Democratic hopes for an affordable housing fund for the GSEs.
“Part of the bill improves and toughens the regulatory structure. If we just tried to set up an affordable housing fund without changing the regulatory structure, you would not see the Bush administration signing on,” Frank said. “There will be a new regulator within Treasury, and it would be a buffed-up type OFHEO (Office of Federal Housing Enterprise Oversight).”
As the legislation moves through Congress, the clouds of turmoil are finally starting to part for the GSEs, giving way to the dawning of a new era. After a long period of uncertainty, fundamental questions—Who will lead the organizations? How will the accounting scandals be punished? What regulatory structure will be in place?—are beginning to get answered.
And as the uncertainty dissipates, many industry observers see the re-made GSEs aggressively re-engaging the market, emerging from their suspended animation with a market-driven appetite, hungry to get back in the game.
Many lenders say 2006 is when the GSEs started to become more market-driven and aggressive. That momentum is building in 2007.
“They were saddled with what they could and couldn’t do over the last couple of years,” said Vincent Toye, managing director for Wachovia’s Real Estate Capital Markets group. “As they get their houses in order, I think they’ll have more latitude to get creative and innovative on their products.”
Weissman of Credit Suisse/Column has seen the GSEs offer more flexibility on debt-service coverage ratios, as well as the occasional extensions of amortization past the 30-year benchmark, “which was for a very long time kind of a sacred thing to them,” he said. “We have a couple of 1.15x/35-type deals that are under application right now.”
Due to the timeline of each GSE’s accounting scandal (for more detail, see sidebar on page 30), Fannie Mae is at a disadvantage when compared to Freddie Mac. “Freddie got a two-year head start,” which has allowed it to become more aggressive and evolve more quickly over the last two years, said Donald King, a director of production at Credit Suisse/Column.
In King’s view, Freddie Mac does a very good job of looking at deals and assessing the business risk. “They’re not always worried about if it fits into a specific box, but [are] looking at any deal on its individual merits,” King said.
“Over the course of 2006, they became more flexible in going down to a 1.20x and even a 1.15x debt service coverage. Freddie Mac has been ahead of Fannie in that regard,” he said.
As Fannie struggled to get its financials current under the hawkish eyes of auditors over the last few years, there wasn’t much money, time, or effort left over to concentrate on product innovation and market strategy. “The staff is basically 100 percent distracted; there’s very little appetite for new program development,” said Chris Tawa, a senior vice president at MMA Financial, Inc., a subsidiary of MuniMae.
But lenders expect Fannie Mae to eventually get back to its market leadership position. “You’re almost starting to see some of the load being lifted and some focus on trying to be the innovator instead of the follower,” said King.
And some lenders say that move to the front of the pack has already begun. Fannie Mae participated in financing $34.3 billion in multifamily business last year, compared with $28.8 billion for Freddie Mac. Both GSEs boosted their production for seniors housing, with Freddie Mac nearly doubling that volume to $1.5 billion in 2006, and Fannie Mae increasing its financing of seniors deals by 29 percent, to $2.2 billion.
Over that time, Fannie Mae has gotten much more flexible on terms and pricing, several lenders said. “2006 saw Fannie Mae step back into a much more aggressive posture after having been relatively conservative compared to the market in 2004 and 2005, both in terms of pricing and underwriting,” said Michael Berman, president of CWCapital, LLC. “There was a time when it was very difficult to do a Fannie Mae loan under 1.25x debt-service coverage, and that was a big disadvantage.”
Fannie Mae’s increased flexibility means that its Delegated Underwriting & Servicing (DUS) guide, which sets standards for what kinds of loans Fannie Mae-affiliated lenders can make, has gradually become more fluid.
“Each deal is so independent now that the guide is really just that, a guide; each one of our deals is now almost individually structured,” said Phil Melton, a director of affordable housing for Collateral Real Estate Capital. “You’re going to see a real focus on stretching for the right deals.” Fannie Mae is also openly soliciting requests from its DUS lenders, “to basically provide them with a blanket list of pre-approved waivers that we want as a lender,” Melton said.
New products and process
According to Phil Weber, senior vice president of Fannie Mae’s multifamily division, the company’s pipeline is rich for 2007. Following on the heels of last year’s single-asset substitution product, the company expects to roll out a new acquisition-rehab mezzanine product aimed at the affordable arena in the first half of 2007.
“We think it’s a very exciting new product that will serve a need especially in the preservation space, where there’s a lot of product that is 30-plus years old that needs modest rehab,” said Weber. “We’re trying to be innovative and bring flexible features to our DUS lenders.” The company is also aiming to improve its early rate-lock program with an eye on quicker cycle times.
Fannie has reorganized the administration of its DUS network, creating internal “deal teams” that are dedicated to a specific lender and made up of a customer service manager, credit officer, and pricing officer. With the new structure, the agency hopes to decrease deal cycle time.
The single-asset substitution product, introduced toward the end of 2006, is an example of the company’s increased competitiveness. “I think it’s a great marketing tool; it’s a differentiator for Fannie Mae,” said Jeff Day, managing director and co-head of DBBM. “It points to the bigger picture, which is that Fannie Mae is trying to do some hard thinking to figure out how to differentiate and create new products.”
The product, rolled out in November, gives a borrower looking for a mortgage exit strategy the ability to replace the original mortgaged property while keeping the existing loan in place. Previously, asset substitution was only available for a pool of loans of more than $50 million, but this product is aimed at the average borrower and a single property.
Freddie Mac’s reorganization of its multifamily division is focused on increasing production by streamlining divisions of labor and separating production and sales functions from underwriting functions. In the past, a single contact was responsible for processing, data quality, underwriting and selling the loan, managing the customer relationship, and product development.
The GSE is also making enhancements to its early rate-lock program, and expects to roll out a new acquisition-rehabilitation product in the first half of 2007. “We’re going to do acquisition-rehab business in a bigger way,” said Mike May, senior vice president of Freddie Mac’s multifamily sourcing division. “With the right sponsors in the right market with the right story, we’re going to be aggressive and win that business.”
Visions of reform
Meanwhile, Congress is playing tug-of-war with the GSEs’ business plans, leaving open the question of just how powerful the agencies’ revamped regulator will be and how it will affect the GSEs’ competitiveness. One thing is likely: When the dust settles on these reform efforts, the nation’s two largest mortgage financers will be regulated with more stringent oversight than they have ever faced, and grow at a pace that has as much to do with their regulator as Wall Street.
OFHEO, which regulates Fannie Mae and Freddie Mac, has been slammed for failing to exercise adequate oversight during the period when the GSEs were misstating their earnings. Over the past year, however, OFHEO has become more powerful under the leadership of James Lockhart, a man with a deep understanding of the financial markets. Lockhart has served as deputy commissioner of Social Security, as well as executive director of the Pension Benefit Guaranty Corp. He also happens to be close friends with President Bush; they attended the same prep school and were fraternity brothers at Yale.
Lockhart would like to see the GSEs’ regulatory structure mirror the way the banking industry is regulated. In a best-case scenario, the GSEs’ new regulator “would have independence,” said Lockhart. “It would, like bank regulators, be able to look at minimum capital and risk-based capital, would be able to look at the full set of risks an organization takes and make sure they don’t grow out of control.”
In the new scheme, Congress would give the regulator instructions as to what the portfolios should be invested in, and the new regulator would size up the risk and issue proposed changes with an open-comment period. “From that process, there would be not necessarily a cap, but some constraints on growth and maybe some resizing,” Lockhart said.
A major issue yet to be resolved is how much of a capital cushion the GSEs need to hedge against risk. The minimum capital and risk-based capital requirements outlined in the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 are inflexible, said Lockhart. “The present model is outmoded. There has been a lot of advancement in the risk management area since then.” In Lockhart’s view, the perfect regulator would have the ability to put the GSEs into receivership and make sure that any problems don’t spread to other financial institutions.
Lockhart also envisions the regulator as having the ability to litigate independently, rather than going through the Justice Department, as well as the power to sign off on new products. “The third major area is combining the mission, the new product authority which is now at HUD (the Department of Housing and Urban Development), with our safety and soundness powers,” Lockhart said. “We’re really the only regulator to have that separated.”
Should Rep. Frank’s bill (H.R. 1427) pass in anything close to its current form, Lockhart will get much of what he’s wishing for. The legislation would create a new regulator, the Federal Housing Finance Agency, to replace OFHEO, and give it strong regulatory powers that include the ability to set capital requirements for each GSE, the power to force the companies to sell assets if necessary, and the ability to put the GSEs into receivership if they become undercapitalized. The agency would also have jurisdiction over the introduction of new products.
The Treasury Department has already weighed in with its support of the legislation. Important aspects of GSE reform include “ensuring that the new housing GSE regulatory agency has independent funding outside of the appropriations process, independent litigating authority and other related powers, and the full set of regulatory and enforcement tools,” said Treasury Under Secretary Robert K. Steel in mid-March testimony before the House Financial Services Committee. “H.R. 1427 largely accomplishes these goals.”
Death by a thousand restrictions
For the GSEs, it’s a delicate balancing act between government regulation and competitiveness. The consequences of a portfolio resizing would be significant: Should critics like Federal Reserve Chairman Ben Bernanke (see sidebar, page 30) and Lockhart have their way, a sizable portion of the GSEs’ mortgage and mortgage-backed securities holdings would have to be sold, ultimately making the GSEs less competitive.
The top executives from both Fannie Mae and Freddie Mac have conceded that a tougher regulator is needed, but they fear that the regulatory pendulum will swing too far.
“The loudest voices in the debate have been those demanding not only to tighten oversight of the GSEs—which we agree with—but to diminish our tools and shrink the box within which the GSEs can operate,” Richard Syron, Freddie Mac’s chairman and CEO, told the National Association of Home Builders’ annual convention in February.
“And if the extremists in this debate get what they want, the results will bleed the GSEs dry—death by a thousand restrictions,” he said.
The systemic risk concerns are somewhat unfounded, Syron maintained. The congressional aim in designing the GSEs was to benefit America’s homeowners and renters without direct federal aid. If you impede the GSEs’ ability to turn a profit, he argued, you only shift the onus of a possible bailout back onto the taxpayer.
“One source of opposition to our retained portfolio is that they can be profitable. But that’s an indispensable part of the GSE model: There need to be profits,” Syron said. Should the GSEs suffer a catastrophe, “the first line of defense is not the taxpayer, it’s roughly $100 billion in private shareholder capital. But shareholders demand an adequate return on their investment, and if that return falls too low, the model simply will not work.”
Syron cited demographic projections that indicate about 15 million new households will be created in the United States in the next decade, 10 million of which will be minorities. “Why change the basic business model of the GSEs when we will be more needed than ever to help sustain the world’s most liquid and successful housing finance system?” Syron asked the conference.
Similarly, Fannie Mae CEO Daniel Mudd indicated that the risk posed by the GSEs’ portfolios is vastly overstated. “We hold over $40 billion in core capital, which is $19.3 billion more than our risk-based capital requirement, $13 billion more than our minimum capital requirement, and $4.3 billion more than our OFHEO-directed 30 percent required excess,” Mudd told a financial services conference at the end of January.
“We want legislation—there is no doubletalk from Fannie on the topic,” Mudd said. “Our simple test is that the [regulatory] regime be based on bank-like regulatory processes, and that we would be able to run the business when all is said and done.”
In the wake of the accounting scandals, OFHEO imposed a 30 percent temporary surcharge on the GSEs’ required minimum capital levels. This forced the GSEs to raise new capital and reduce their portfolios. Wendel of DBBM believes that such restrictions have slowed down the GSEs’ growth rates. As long as those restrictions exist, “it would be difficult for them to dominate the whole multifamily market; I think they’ve recognized that, so they’re choosing to dominate the mission-rich part of the market,” said Wendel.
In a debt financing market flooded with capital, growing or just maintaining market share could be a challenge, regardless of the consequences of reform legislation. “We’re going to maintain relevance in the market, so as the market races down there, we’re going to go with it, but we’re not going to be the leaders in racing to the bottom,” said Freddie Mac’s May. “We want to pick our spots.”
And Fannie Mae too has more than maintained relevance, even at a time characterized by accounting corrections that have hampered the company’s growth. “Fannie Mae did do $34 billion in multifamily last year, and at the same time, completed their restatement, paid their fine, worked on policies and procedures,” said Howard Smith, executive vice president and chief operating officer at GreenPark Financial.
“That’s a pretty remarkable story,” Smith said. “They are very relevant to the market—even in a wounded state.”