Fed Chair Bernanke Sets Out Three Scenarios for Reforming the Securitization of Mortgages

Noting that no mortgage securitization is occurring today in the absence of a government guarantee, Federal Reserve Board Chairman Ben Bernanke set forth three alternative ways to reform securitization so that mortgage-backed securities can regain the confidence of investors: privatize Fannie Mae and Freddie Mac, tie them closer to the federal government, or introduce covered bonds. And securitization must be reformed, he said, since the ability of financial intermediaries to sell the mortgages they originate into the broader capital market by means of the securitization process serves two important purposes: First, it provides originators much wider sources of funding than they could obtain through conventional sources, such as retail deposits; and second, it substantially reduces the originator's exposure to interest rate, credit, prepayment, and other risks associated with holding mortgages to maturity, thereby reducing the overall costs of providing mortgage credit.

Privatization of Fannie Mae and Freddie Mac would solve several problems associated with the current GSE model, he said. For example, it would eliminate the conflict between private shareholders and public policy and likely diminish systemic risks as well. Other benefits are that private entities presumably would be more innovative and efficient than a government agency, and could operate with less interference from political interests. However, he questioned whether the GSE model is viable without at least implicit government support.

A greater concern with fully privatized GSEs is whether mortgage securitization would continue under highly stressed financial conditions. It may be advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil. One possible approach is to create a government bond insurer, analogous to the FDIC. This new agency would offer, for a premium, government-backed insurance for any form of bond financing used to provide funding to mortgage markets. For example, debt and mortgage-backed securities issued by the privatized GSEs and mortgage-backed bonds issued by banks would be eligible for the guarantee.

A securitization device widely used in other countries is the covered bond, which is a debt obligation issued by financial institutions and secured by a pool of high-quality mortgages or other assets Covered bonds are the primary source of mortgage funding for European banks. These instruments are subject to extensive statutory and supervisory regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuing bank.

Legislation typically specifies the types of collateral permitted in the cover pool, defines a minimum over-collateralization level, provides certainty of principal and interest payments to investors in the case of insolvency, and requires disclosures to regulators or investors or both. In addition, the government generally provides strong assurances to investors by having bank supervisors ensure that the cover pool assets that back the bonds are of high quality and that the cover pool is well managed.

Covered bonds also help to resolve some of the difficulties associated with the originate-to-distribute model. The on-balance-sheet nature of covered bonds means that the issuing banks are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed, he noted, thereby ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. Also, the structure used for such bonds tends to be fairly simple and transparent.

Currently, the US does not have the extensive statutory and supervisory regulation designed to protect the interests of covered bond investors that exists in European countries. To this end, the recent introduction of the FDIC policy statement on covered bonds and the Treasury covered bond framework were constructive steps. Finally, the cost disadvantage of covered bonds relative to securitization through Fannie and Freddie is increased by the greater capital requirements associated with covered bond issuance.

A third approach, besides privatization and covered bonds, would be to tie Fannie and Freddie even more closely to the government. In doing so, the choice must be made whether to continue to allow an element of private ownership in these organizations. A public utility model offers one possibility for incorporating private ownership.

In such a model, the GSE remains a corporation with shareholders but is overseen by a public board. Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders. If private shareholders are excluded, several possibilities worth exploring remain. One approach would be to structure a quasi-public corporation without shareholders that would engage in the provision of mortgage insurance generally.