Draining the Swamp: Credit Scores and Housing Finance Reform


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News that Senator Bob Corker (R-TN) is retiring from the Senate was not welcome news for advocates of reform in the government-controlled world of housing finance.  “A big loss,” said John Thune (R-SD). “He’s always been a guy who’s really about trying to find solutions, common ground, and getting results.”

Corker was indeed somebody who would work with his colleagues across the isle, but he was also willing to work period on difficult and contentious issues like housing, something few members are willing to do.  His departure leaves a considerable vacuum in terms of the capacity of Congress to engage on the issue of housing finance, much less pass legislation.

As the mortgage finance industry heads into the last quarter of 2017, we are still running about 30% down in terms of lending volumes compared to last year, the result of the post election pop in yields for US Treasury bonds that killed the declining refinance market.  No amount of innovation, quantitative easing from the Federal Open Market Committee, or new, more accommodating credit scores can make up for this sharp decline in production of mortgage loans. 

Meanwhile in Washington, the prospects for ending the decade-long conservatorship of Fannie Mae and Freddie Mac are dim at best.  In his statement to Congress, Melvin L. Watt, Director of the Federal Housing Finance Authority, said “ that these conservatorships are not sustainable and they need to end as soon as Congress can chart the way forward on housing finance reform.”  But nobody on Capitol Hill seems to consider the status quo a problem when it comes to Fannie Mae and Freddie Mac.

Watt seems headed for a potential confrontation with the Trump Administration and Congress over the issue of maintaining minimum capital for the GSEs, but ultimately he must blink.  In his remarks, the former congressman from North Carolina seemingly made clear that he is preparing to modify the “sweep” of profits from both enterprises to the Treasury to prevent one or both from becoming technically insolvent, an eventuality that would require support from the Treasury. Watt stated:

 “Like any business, the Enterprises need some kind of buffer to shield against short-term operating losses.  In fact, it is especially irresponsible for the Enterprises not to have such a limited buffer because a loss in any quarter would result in an additional draw of taxpayer support and reduce the fixed dollar commitment the Treasury Department has made to support the Enterprises.  We reasonably foresee that this could erode investor confidence.  This could stifle liquidity in the mortgage-backed securities market and could increase the cost of mortgage credit for borrowers.”

While by law the Treasury’s ability to support the GSEs with new capital is limited, bond market investors and the credit rating community accords “AAA” ratings to Fannie and Freddie because of the fact of the conservatorship and the presumption of unlimited credit support from the United States.  Whether such confidence is reasonable given the current posture of Congress and the Executive Branch when it comes to the GSEs and federal debt more generally is another matter entirely. 

Watt is aware of this market reality and what a repeat of the 2008 bond market debacle would mean to the mortgage market and US taxpayers.  Yet despite his tough talk, it is not safe to assume that Watt will direct the GSEs to start accumulating capital because ultimately he reports up to Treasury.  He said in blunt terms:

“FHFA has explicit statutory obligations to ensure that each Enterprise ‘operates in a safe and sound manner’ and fosters ‘liquid, efficient, competitive, and resilient national housing finance markets.’  To ensure that we meet these obligations, we cannot risk the loss of investor confidence.  It would, therefore, be a serious misconception for members of this Committee, or for anyone else, to consider any actions FHFA may take as conservator to avoid additional draws of taxpayer support either as interference with the prerogatives of Congress, as an effort to influence the outcome of housing finance reform, or as a step toward recap and release.  FHFA’s actions would be taken solely to avoid a draw during conservatorship.”

Watt may seem willing to make changes in the way that the GSEs compensate taxpayers for the continued sovereign credit support given to both enterprises, yet he is unlikely to act — especially when you recall he said the same thing last year. 

Watt to his credit continues to be skeptical of calls for FHFA to allow alternative credit scores when underwriting loans covered by insurance in the GSE market. “FHFA has received overwhelming feedback from the industry that it would be a serious mistake to change credit scoring models before the Enterprises implement the Single Security in mid-2019,” Watt told Congress, reflecting the view of many mortgage market participants.

The incumbent consumer credit bureaus – Experian, TransUnion and Equifax – have been pushing a weaker credit score as an alternative to the incumbent credit scoring monopoly held by Fair Issaac’s FICO model.  Huge amounts of money have been spent to promote the alternative scores, so far with little in the way of commercial success. Indeed, most media organizations are cowed into silence by the vast amounts of money flowing through Washington c/o Equifax and the other members of the credit score triopoly.

“We have looked deeply at these issues, and this process has raised additional concerns,” Watt noted in a barely disguised rebuke for the consumer data triopoly.  “For example, how would we ensure that competing credit scores lead to improvements in accuracy and not to a race to the bottom with competitors competing for more and more customers?  Also, could the organizational and ownership structure of companies in the credit score market impact competition?”

There are certainly legitimate concerns about competition in the consumer credit market, yet the more important issue is how a change would impact the primary and secondary markets for mortgage credit.  The bond market in particular is very opposed to any change in how default risk probabilities are measured, including both investors and the credit rating agencies that serve institutional investors.

The fact is, the bond markets like having one benchmark for measuring default risk, a fact that seems to elude advocates of “competition” in credit scoring.  Having multiple benchmarks is not about competition but rather intellectual chaos.  And as the old saying goes, be careful what you wish for, you may get it. 

Fact is, were FHFA to allow for the use of multiple credit scores in underwriting loans that back Fannie Mae and Freddie Mac securities, investors and credit rating agencies would be compelled to “score” the different models. Based on what we know today about the respective credit score products, the alternative score being pushed by the three incumbent consumer credit repositories would almost certainly trade at a discount to the FICO score used in most default models.

Watt’s comments make clear that he understands that “competition” in credit scores is really about opening the credit box to higher risk borrowers.  But thanks to the benevolence of central bankers, such worries are very distant from the minds of people who live and work in Washington. 

For the past decade, the FOMC has wrapped such concerns as market liquidity and default risk with a comforting blanket of cheap money.  When banks and the GSEs come to grips with the hidden default risk currently embedded inside trillions of dollars worth of new mortgage production, the conversation about housing finance reform may take on a bit more urgency and seriousness.  But sadly, Senator Corker will have left the building.

First Appear on:http://www.zerohedge.com/


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Draining the Swamp: Credit Scores and Housing Finance Reform

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