June 12, 2015 Joshua Rosner 646/652-6207 jrosner@graham-fisher.com Twitter: @JoshRosner

Please refer to important disclosures at the end of this report.

“Deep MI”, “CSP”: The MBA’s New and Dangerous “Mission Creep” Between 2000 and the financial crisis the term “mission creep” was aptly and often used by large banks, mortgage lenders and the private mortgage insurance (PMI) industry to warn of the threat of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac creeping over the borders of their intended functions. The GSEs were created and chartered as secondary-market firms and intended to provide liquidity to the primary mortgage market, and transfer credit risk into the hands of investors. Mission creep was, in fact, a real threat not only to those primary market players but also to systemic stability. When the GSEs activities blurred the lines between primary market lenders and secondary market liquidity providers, as example through their automated underwriting systems, they transitioned away from being the backbone of a countercyclical insurance regime to ensure that liquidity to the primary mortgage origination market would continue in adverse economic periods. As the crisis descended on the economy and mortgage markets, the problems of the GSEs and the primary market players became highly correlated. While this should have been a lesson for policymakers and the mortgage industry, it has not yet been learned. Instead, over the past few years we have witnessed increasing efforts by primary market players to get a larger role and foothold in the secondary market. With the GSEs muzzled in conservatorship and prohibited from engaging in activities that could be argued to be lobbying, there are few voices to warn of the dangerous path we are on – of a new “mission creep” led by the primary market players, who seek to comingle functions across those two distinct markets. Unless there are independent and honest voices brought to bear on this matter, we will recreate the same dangerous and pro-cyclical system that failed. It is understood that Corker-Warner, Crapo-Johnson, Rep. Hensarling’s PATH Act and the recently introduced Title VII of Sen. Shelby’s reform bill (authored by Sen. Corker) would be generous gifts to the big banks and PMIs. Given the false assumption that private capital attracted in good times would remain available in bad times, these bills do little to provide necessary countercyclical buffers beyond a further backstop of the federal government’s safety net for these same institutions.

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With legislative efforts having stalled, the largest primary market players in concert with PMIs and rating agencies are now seeking to exert public, political and administrative pressure to force their way into the secondary market. This can be seen through their efforts, with the assistance of captured or naïve legislators,i to gain access to the secondary market Common Securitization Platform (CSP) that FHFA is forcing the GSEs to build. It can also be seen through their efforts to gain acceptance of “deep MI”ii as a means to reduce the fees charged by the GSEs for insuring mortgages originated by those largest lenders and to generate new revenue and income streams for the PMIs and rating agencies. The CSP While the purpose of this brief is to raise some red flags about unspoken risks of “deep MI”. Still, it is worth briefly highlighting three of the key concerns we have with the too-big-to-fail institutions’ purchased support for gaining access to the CSP.

1- The GSEs, as secondary market providers of liquidity for support of the primary market, were never intended to insure or guarantee all mortgages, even all of those mortgages that are conforming and conventional. They were intended to ensure liquidity, in the form of insurance, in instances where primary market lenders did not have sufficient access to, or where there was not sufficient access in, the primary market. If the GSEs properly priced the cost of the insurance they provided (g-fees) to the primary market then those largest primary market lenders who choose not to hold loans on balance-sheet and have direct access to capital markets, would be able to package and securitize mortgage-backed securities, as private label securities (PLS), at comparable rates to those they would find as a result of a GSE insurance wrap. In good times this would reduce the size and need of the GSEs (secondary market). As a result, only those smaller lenders who did not have direct access to the capital markets would require GSE insurance wraps. Through the GSEs these smaller firms would be able to compete, on a level playing field, with their larger peers. In adverse economic times, though, well-capitalized GSEs would be able to properly price the credit risk and cost of insurance so that any firm that did not have direct access to markets would be able to continue to support the allocation of capital to the mortgage market of the real economy.

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2- If the largest firms get direct access to the CSP, those smaller firms would likely lose their ability to compete with the larger firms as they would not generate the same volume of loans and would therefore suffer relatively higher execution costs. As a result, they would be increasingly likely to sell their volumes to the larger players. This would turn the smaller players into the same “third party originators” that failed during the crisis and create further concentration in the primary market.

3- If the largest firms were to gain access to the CSP it is likely that within a few short years they would use their lobbying power to suggest, without any real proof, that by being allowed to vertically integrate real estate sales into their allowable activities they could reduce the costs to homebuyers. Obviously, given the broad competition in real estate sales, compared to the heavily concentrated and oligopolistic nature of the mortgage origination industry, this argument is threadbare.

Although we have other concerns with the idea of granting primary market firms with direct access to the secondary market CSP, we will address those in a future note.

Deep MI Over the past year, we have witnessed the Mortgage Bankers Association’s (MBA’s) efforts to try to advance the notion of “deep MI”iii. These efforts have grown louderiv, more full of hyperbole and less considerate of the risks of “deep MI”. This is not traditional mortgage insurance, in which the GSEs require a borrower to buy – either directly or through a bulk policy – mortgage insurance on any portion of a mortgage that exceeds an 80% loan-to-value ratio, and when the borrower builds enough equity in their home, the mortgage insurance is cancelled – thus reducing the revenues to the PMI firms. This is a new product selected and paid for by lenders, and the numerous problems in its design would become new operating costs to the GSEs. Because the GSEs calculate the cost of an insurance wrap that a lender must pay to cover the risk the GSEs bear, both for the MI as counterparty and for the underlying loan, the g-fee reflects those costs. The Mortgage Bankers Association is now pushing the notion that by buying PMI directly and more deeply than the 80% LTV, they can justify – and should receive – a lower cost on the g-fees they pay the GSEs. While this sales pitch sounds sensible on its face, it ignores the risks incurred and appears little more than another effort of the “mortgage industrial complex” to creep into the secondary market and to assure new volumes of loans,

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insurance contracts and ratings assignments. Below we highlight a few of the concerns we have with this proposal.

1- The PMI industry has a horrendous track record of pricing risk, remaining adequately capitalized and paying claims. This has been proven during several mortgage cycles and resulted in large-scale failures in the industry during the 1930's, 1950's, and 1980’s and in this crisis. In fact, had the GSEs not been placed in Conservatorship, and provided forbearance to the MI’s, it is unlikely any of the legacy firms would have survived.

2- The PMI industry remains less well capitalized today than it even was in 2007. Today the industry has only about $8 billion in capital; in 2007 it had about $11 billion. Given that the GSEs have about $5 trillion of business on their books it is clear the PMI industry doesn’t even have sufficient capital to insure the top 20% of their books, let alone the capital to insure down to 50% or 60% of their books of business.

3- As state regulated insurance firms, whose holding companies and operating subsidiaries are often situated in different states. It is difficult, if not impossible even for state regulators to assess claims paying ability or ensure that claims are paid.

4- While capital standard requirements governing the ability of the GSEs to do business with a PMI have been strengthened, and are proper authorities of the GSEs and their regulator, it must be remembered that due to the failures of state insurance regulators, the GSEs were forced to provide forbearance to struggling MIs in this crisis. Five of the ten PMI firms that the GSEs did business with exceeded state 25:1 risk-to-capital ratios and three of those five either entered runoff, deferred payments to the GSEs or became unable to write new business.

5- Although the MBA would like policy-makers to see it as such, the reality is that “deeper MI” is not fully funded credit protection. When, as happened during the crisis, a PMI becomes insolvent or state insurance regulators prevent the MI from paying full or partial claims the GSEs will not have the benefit of credit protection.

6- Since the MIs’ business is almost exclusively tied, and highly correlated with the business of the GSEs it is likely that their claims paying ability would be most impaired at the time the GSEs would most need to rely on their claims paying abilities.

7- Since the lender, and not the GSEs would purchase the “deep MI” coverage, it would be difficult, or impossible for the GSEs to manage their exposures to any particular MI. This is nonsensical given that the GSEs would be the ultimate

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beneficiary of any MI policy and should therefore be able control their exposures to particular MIs.

8- As we witnessed in the crisis, the largest lenders were able to extract the lowest G-fees from the GSEs. It is reasonable to expect that, given their larger volumes of loans, the largest banks will almost certainly be able to negotiate cheaper premiums than smaller lenders. Leading to further concentration of the lending industry to the detriment of smaller lenders.

9- Deep MI appears to be little more than a scheme to ensure the PMI and credit rating firms remain relevant in a world in which there are more and better ways to transfer and to analyze risk. Increasing use of transfer securities, by the GSEs, has proven both efficient and effective. If, eventually, market access to credit risk transfers allows the GSEs to transfer risks that would otherwise be backed by PMI, that would become an existential threat to the PMIs business volumes.

10- Unlike regular PMI, for which the GSEs or their regulator defines the standards, deep-PMI is designed for the based on the economics of the structures of an asset-backed security. This is precisely the problem of financial engineering that proved difficult for the ratings industry to model and track and, more importantly, it would require levels of disclosures - to investors - that would not likely be forthcoming.

11- Failure of the trustee in an MBS deal can result in the cancellation of insurance.

12- Failure of a servicer to meet PMI guidelines may result in a reduction of coverage on already issued MBS.

13- Deep PMI creates incentives to originate higher average LTV loans. This increase in consumer leverage was proven, during the crisis, to have deleterious impacts to macro-economic stability.

14- Deep MI can reduce losses for lower loss severities but in cases of higher severity losses, the deep MI is only able to absorb a portion of the loss.

15- Deep MI is little more than another attempt, by the mortgage industrial complex, to arbitrage the GSEs, investors and consumers:

a. Where the borrower ultimately pays for standard MI, that borrower is relieved of their duty to pay when they accumulate enough equity to be relieved. While it is claimed that deep MI shifts the entire costs of the coverage onto the issuer, this would almost certainly come at increased costs to the borrower while passing the financial benefits of reduced G-fees on to mortgage

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bankers (and, due to increased business volumes, the rating agencies and PMIs);

b. Mortgage bankers would also benefit from the lower required subordination and reduced yields paid to MBS investors even though the rating enhancements are theoretical and modeled rather than based on long history of empirical experience;

c. The complexity required to properly calculate any justified reduction in G-fees would also likely be lobbied and politicized, to the benefit of the issuers, and would stretch the ability of a primary federal regulator - or the GSEs - to properly model that G-fee based on any historical experience; and

d. Without a clear and stated mechanism to address future downgrades of the ratings of a PMI company there would be no effective mechanism to require or enforce a 'topping up' of collateral pools to protect investors. Moreover, there is no historically tested experience in ensuring that investors are protected in these circumstances.

Once again, we would warn regulators and policy-makers those industry efforts to create new structures, rather than repairing existing and transparent structures, leads to a loss of economic productivity and risks creating the basis for the next crisis. i Letter from Senators Bob Corker, Mark Warner, Mike Crapo, Jon Tester, Dean Heller, Heidi Heitkamp, Pat Toomey, Mark Kirk to The Honorable Mel Watt Director Federal Housing Finance Agency, March 17, 2015, available at: http://www.corker.senate.gov/public/_cache/files/221a4274-f6fd-432d-b03b-949cc055498e/Senate%20CSP%20Letter%2003172015.pdf (See: “A CSP that is accessible and valuable to not only to Fannie Mae and Freddie Mac, the Government Sponsored Enterprises ("GSEs"), but also private sector participants in the secondary mortgage finance market, would facilitate positive transformation in the nation's housing finance system.”) Note: The only shareholder owned and governmentally chartered secondary-market firms are the GSEs and the home loan banks. This is clearly an attempt at mission creep by firms that are not chartered or regulated for secondary market activities. Allowing such firms access to the secondary market will only serve to increase systemic risk and reduce the effects of competition, in the primary markets, from smaller lenders. ii Letter from David H. Stevens, President and Chief Executive Officer of the Mortgage Bankers Association to the Federal Housing Finance

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Agency, September 5, 2014, available at: https://www.mba.org/Documents/mba.org/files/MBALtrtoFHFAonPMIERsProposal.pdf (See: “FHFA should adopt a program to allow for deeper MI coverage on high LTV loans, and coverage on loans with LTVs below 80%, accompanied by a reduction in G-fees. Importantly, this would require lowering the floor on loss factors to account for these lower risk loans”) iii “GSE Up-Front Risk-Sharing”, Mortgage Bankers Association, available at: https://www.mba.org/issues/residential-issues/gse-up-front-risk-sharing (See: “MBA strongly supports requiring the GSEs to test new approaches to risk-sharing that include the use of deeper up-front risk-sharing. MBA submitted comments on FHFA's Request for Input on Guarantee Fees and Request for Input on PMIERs and in both letters reiterated the need for, and benefits of, deeper up-front risk-sharing. MBA will continue to push for reductions in LLPAs through deeper risk-sharing. Congress should urge FHFA to implement a deeper risk-sharing pilot program.”) iv “More Competition Would Rally Mortgage Market”, Editorial by Michael Fratantoni, Chief Economist of the Mortgage Bankers Association, American Banker, June 10, 2015, available at: http://www.americanbanker.com/bankthink/more-competition-would-rally-mortgage-market-1074799-1.html?utm_campaign=abla%20daily%20briefing-jun%2011%202015&utm_medium=email&utm_source=newsletter&ET=americanbanker%3Ae4543084%3A474409a%3A&st=email (See: “Making risk-sharing options available to lenders at the point of sale, rather than on the back end, would allow additional private capital and competition to flow into the secondary market.”)

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