Without Fannie and Freddie, Mortgage Securitization Must Return

Although bond investors might not be thrilled about the government's decision to withdraw a significant amount of its mortgage market support and slowly wind down Fannie Mae and Freddie Mac, Wall Street should see it as an opportunity. This means that now it must be more involved in the mortgage funding process more than ever before. A more privatized mortgage market should signal the return of mortgage securitization and a new covered bond market, unless regulation gets in the way.

There's actually an interesting dynamic at play when it comes to mortgage securitization. For those who are still unfamiliar with the process, that's when a bank gets a big pool of mortgages, slices it up into bonds to sell to investors. As borrowers make mortgage payments, that money flows to the bondholders based on the deal's structure. Unfortunately, during the housing bubble, mistakes were made and many mortgage-backed securities (MBS) became toxic. Assuming that banks, rating agencies, and investors do a better job in the future, the market may rise again eventually.

It hasn't yet, however. Although commercial MBS have begun to resurface, there's little need for residential MBS to return: the U.S. government has continued to own or guarantee more than 90% of the new mortgages created after they nationalized Fannie and Freddie. But as the government slowly backs away, residential mortgage securitization should return.

Unfortunately, the government has got in its own way in allowing the residential MBS market to return. In the Dodd-Frank financial regulation bill passed last summer, a number of new rules were created for securitization. One such rule requires banks to retain 5% of new MBS deals created. This essentially makes securitization more expensive, which in turns will make mortgage financing more expensive.

Another way in which the market will likely respond to the challenge of providing more mortgage market funding will be through the development of a covered bond market. These would actually function a lot like Fannie Mae agency debt. In that case, the firm held a large portfolio of mortgages and issued a bunch of debt that was paid for by their mortgage portfolio, but not directly by like securitization. So it's like unsecured debt, but is indirectly secured by a mortgage portfolio. Instead of Fannie or Freddie, a bank can do the same thing through a covered bond.

Not only would this allow banks to obtain funding for a huge portfolio of mortgages held on their balance sheets, but it could also mean lots of issuance fees for Wall Street. There would almost certainly be a large demand for covered bonds when agency debt disappears. Since 2009, Fannie Mae has issued about $2.5 trillion in short- and long-term agency debt.

But again, the government needs to pave the way to make this possible. Currently, the needed legislation isn't in place to create a robust covered bond market in the U.S. Such provisions almost made it into the Dodd-Frank bill, but were kicked out at the last moment when the Senate decided to address covered bonds when they weren't rushing to pass a huge package of regulatory restraints.

If the government really does take a giant step away from the mortgage financing system, then it needs to ensure that federal statues and regulations don't inhibit the private sector from stepping up to take on that responsibility. Under the current framework, it would be very difficult to see how securitization alone, particularly with the new constraints it has on it from Dodd-Frank, can accomplish this task. But if those rules are made more practical and covered bond legislation is introduced, then the disturbance to the mortgage market will be as minimal as possible. If changes aren't made, however, it's hard to see how adequate mortgage funding would be available.