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Friday, August 31, 2007

About GSE Portfolio Caps

by Tanta on 8/31/2007 08:26:00 AM

This issue of the GSE portfolio caps has been tossed around a lot lately. In the spirit of improving the quality of the discussions, I offer a simple version of what the deal is here. If you're new to UberNerdity, a primer on GSE MBS is here.

The GSEs can "provide liquidity" to the secondary mortgage market in two ways: they can buy loans outright for their own investment portfolios, which means they keep those loans, funded with their own money (raised through debt issues, generally), and earn the interest income from them, taking the credit risk as any investor does. Or, they can buy loans to pool for MBS issues. When they do that, outside investors buy the MBS, fund the loans, and earn the interest income. Because the GSEs guarantee their securities, they charge a guarantee fee to the lenders who sell them the loans, and they have the guarantee obligation left on their books while the MBS is outstanding. Occasionally, the loans that end up in the portfolio are the ones the GSEs bought out of those MBS pools in honor of their guarantee obligation.

Also, the GSEs buy two general types of loans: what we might call "inventory" and "flow." You will usually see the inventory stuff described as "bulk" purchases. That means the GSEs are buying loans, usually in a big chunk (a "bulk" deal), that the lenders already originated, using some guidelines that may not be exactly the same as what the GSEs require in their standard MBS programs. So these deals involve negotiation of pricing. But since the loans have already been originated, you negotiate over the exact pile of loans you have, not over some guidelines that might generate some unknown pile of loans in the future.

The flow business is the forward business. This is a matter of the GSEs publishing guidelines and putting out prices that allow lenders to originate new loans into a forward commitment. Clearly, for the GSEs and the lenders, this stuff is harder to price. You might see reference to "TBA" deals. That means the actual composition of a pool of loans is "to be announced." This is true "rep and warranty" business: the price is established based on the representation that the pool of loans that we end up with will follow all the published guidelines. (The "warranty" means you pay back some or all of that price if your representations were not true.)

As a general rule, the GSEs buy bulk for their portfolios and flow for their MBS programs. There isn't really a law about this, it's just the way they do business most efficiently. If you want to think about it in terms of their "liquidity" functions, they use their portfolios to liquify lender inventory, and their MBS business to liquify lender current production. Small banks and most non-bank mortgage companies don't have the capital to build up "inventory," so all of their business is flow. It's usually the big banks who accumulate "inventory," and either sell it in bulk to the GSEs or securitize it privately or sell it to some insurance company or hold it in their own portfolio, as the market and the bank's investment needs may warrant. Of course, for years now those "inventory" trades generally didn't go to the GSEs, they went into this private security market. A great deal of that ended badly.

It does not have to be that way, and in fact we saw Freddie announcing a few weeks ago that they were shifting some portfolio dollars from bulk to forward on Alt-A purchases. They were more concerned about the liquidity crunch at the level of current production than at the level of inventory. This required them to limit the forward Alt-A purchases to only those lenders from whom they have purchased bulk Alt-A deals in the past, because that offers some kind of reference for a forward commitment. It was a matter of saying, if you originate stuff that is sufficiently like the stuff you have sold us in the past, we will buy it on a forward basis at a predetermined price level. Without some kind of reference point like that, you've got a pig in a poke, and nobody rational can price such a thing in advance.

The portfolio caps for the GSEs are in place in an attempt to control their risk-taking by limiting the dollar amount of loans they can own outright. The caps do not limit what they can buy for their MBS programs: they can buy as much of that as they can 1) find investors for and 2) afford to guarantee.

The assumption has been, in many quarters, that if the GSEs are to provide substantial liquidity to the subprime or near-prime (say, refis of subprime loans that don't quite meet standard guidelines, often because the LTV is so high) markets, they would do so by portfolio purchases. These loans are not uniform and prime-quality like the usual stuff in the MBS program.

And, after all, the problem appears to be a lack of investor appetite for the stuff. If the GSEs bought it for their MBS programs, they would be able to sell the resulting securities only because they were offering that guarantee on those MBS that you don't get in the private issue market. At some level this means the GSEs would have to "price" the risk on loans that the private market has essentially said it cannot or will not price. Most of us are assuming that the GSEs would have to put a pretty steep G-fee on this stuff in order to pull that off. That, in turn, increases the interest rate on the loan, and you do get into that problem of how the new loan can be more affordable to the borrower than the old loan was at a certain point.

The options for the GSEs, then, are to buy for portfolio or buy for MBS. In terms of portfolio purchases, they have some room left to increase holdings up to their caps (they are both under their caps right now), but that's not, most people think, enough in dollar terms to really make headway with the liquidity problem. So one solution is to raise the caps so they can buy more. Another is for them to sell off some of what they have in portfolio to "make room" for these subprime or near-prime purchases.

We just looked yesterday at Freddie's Q02 report, which showed that its portfolio holdings are about 80% prime MBS and 20% "other" (subprime, Alt-A, and other higher-risk loans). As the idea is not to add more subprime or Alt-A paper to the market, you couldn't have them sell off the hinky stuff, so you'd be asking them to sell off some of the 80%.

I'm not sure I follow the logic, necessarily, of leaving the portfolio caps in place to control risk, and then forcing the agencies to rebalance these portfolios so that a higher percentage of their holdings is in the highest-risk classes. Personally, I think the only way this makes much sense is to limit such purchases to that "bulk" or "inventory" part of the business, precisely because it can be more accurately priced. And, of course, because that means originators can share some of the pain here: by "more accurately priced" I mean the GSEs can insist on a reasonable discount. They can free up dollars on lender balance sheets by taking the loans, but they don't have to do so at a profit to the lenders. We're talking liquidity injections here, not transferring bad pricing decisions from private lenders to the GSEs. You will, however, note that this means targeting the big banks and mortgage companies for "relief," not the little community banks and credit unions and so on who don't do bulk deals.

That leaves the flow or current production problem to be solved by the MBS programs, not the portfolios. This is what the GSEs mean when they talk about putting together new mortgage products for these distressed refis, for instance. These new products put a set of standard guidelines or underwriting practices on the table that lenders can originate to in current production. The struggle for everyone will be to put a price on it that makes investors, the GSEs, the lenders, and the borrowers come out ahead.

I will suggest that anyone who thinks the GSEs can do this for free is deluded. In order to fix the mess we're in, someone is going to be subsidizing something somewhere. That does not necessarily mean a direct taxpayer cash subsidy, at least not in immediate terms. But it may mean forcing the GSEs to underprice their risk, and if they do too much of that, the taxpayers will own the problem.

I don't have an answer for that, but I do suggest that those who are really freaked out over the raising of the portfolio cap issue think it through: that isn't necessarily worse than "rebalancing" the portfolios or having the GSEs issue securities at "below market" G-fees. Remember that "rebalancing" the portfolios would require the GSEs to sell off their good stuff into a market that isn't offering top dollar for anything, good, bad, or indifferent.