Mr. James E. Millstein
@1:20:50 ". . . The system that Senator's Corker and Warner designed is one that requires a good deal of first loss capital. We here can speculate on how much it is, when it will come, and how much appetite there is. But at the end of the day, your legislation is depending upon the investment decisions of tens of thousands of investment managers, and you can't command them to show up on queue. They are going to have to see the new system design, and see it operate a little-bit, before they are going to start coming in droves.
Today, with all due respect to my colleague Mr. Zandi, there is $8B of capital in the private mortgage insurance business. Yes, Mr. Burkowitz has shown up with an offer that says he will put $17B in, but there is a long way between that offer and a closing; a lot of other things have to happen. But the most important lesson, I think, in terms of this benchmark vs. timeline is: you are trying to design a system that will induce people to put capital into new mortgage insurers and into new first loss securities that don't exist today, in a system for a guarantor with a guarantee that doesn't exist today, for a market of new securities that doesn't exist today -- it's going to take time.
You're depending on tens of thousands of individual investment managers to play with you -- to shake your hand, and say, 'yes, I will help you build this market.' They may come, on a five year timetable, but if they don't, when you flip your switch, your system is going to shut mortgage availability down -- nothing any of you want to do[sic]. So, that's the risk, to me, of having a very hard timeline built into this. And that's the risk, to me, of taking the assets under your control, today, that you could recapitalize -- today -- to make sure that this system functions. The risk of just saying, 'in order to preserve the possibility that magic will be able to raise $125B of capital to play my first loss role, I am going to trash the assets that are currently doing this for me in this market.' That to me is crazy! Crazy!"
"I have spent the entirety of my thirty year professional career—as a lawyer, banker and public servant—in the corporate restructuring business. I have restructured companies as diverse as American Airlines, WorldCom and Charter Communications in the United States, Cadillac Fairview in Canada, United Pan European Communications, EuroDisney and Marconi in Europe, and Daewoo Corporation in Korea. During the recent financial crisis, I served as the Chief Restructuring Officer of the US Department of the Treasury. In that role, my primary responsibilities were managing, restructuring and designing the exit from the Department’s substantial investments in AIG and Ally Financial.
I am here today because embedded in the task of reforming our nation’s housing finance system is a restructuring of the two largest players in that system: Freddie Mac and Fannie Mae. These companies now operate in conservatorship under the control and direction of the Federal Housing Finance Agency. Because they are central to mortgage credit formation in the United States today, “winding them down” as some members of Congress and the Administration suggest is certain to have significant and adverse consequences for mortgage credit availability and for the nascent housing and economic recovery. Rather than wind down, I urge you to consider a restructuring alternative that addresses the fundamental causes of the companies’ insolvency, eliminates the private gain/public loss nature of their current government sponsorship, generates a significant profit to Treasury for supporting their solvency, and, most importantly, ensures a smooth transition to a new housing finance system that better protects taxpayers against future losses while providing for the continuing availability of credit to the credit-worthy.
There appears to be a growing consensus in the policy community around the basic architecture of that new housing finance system. A federal guarantee on qualified mortgage products is required to ensure the widespread availability of a thirty-year fixed-rate product, and to sustain the deep and liquid mortgage securities funding markets that have developed over the past thirty years to complement balance sheet lending from the US banking system. The guarantee should be explicit and structured as reinsurance, available to reimburse investor losses only after a layer of private “first-loss” insurance provided by well-capitalized mortgage insurers or subordinated capital provided through structured product markets has been exhausted. The reinsurance should be priced at arm’s length by an independent agency required to use its reinsurance fees to build a reserve fund to protect taxpayers against future loss should that reinsurance ever be called. Finally, in contrast to the system prevailing before 2008, the government reinsurer also needs to be a strong regulator with authority over all issuers, guarantors and servicers with whom it interacts in the new system. In this regard, I commend Senators Corker and Warner and the coalition of other members of this panel behind S. 1217 for putting out a bill with all of these elements in it.
However, the transition to this new system contemplated by S.1217 is fraught with difficulty and needs serious re-thinking to mitigate three significant risks that any credible transition plan must address. First, our fragile economic recovery cannot afford the risk of a significant disruption in mortgage credit. Borrowing rates will need to rise in the new system to reflect the cost of the first-loss capital and new reserves required to protect taxpayers on their guarantee. At the same time we need to protect against a significant contraction in the availability of housing credit that would push us back into recession. Second, the government must end its ongoing backstop of Fannie Mae and Freddie Mac in conservatorship in a way that minimizes the likelihood that Treasury will need to cover future losses on their $5.5 trillion of liabilities. While the substantial guarantee fees and net interest margin which the companies are currently earning and paying over to Treasury may look like an asset to be seized by taxpayers as the quid pro quo for their bailout, it could easily turn out to be a substantial liability if there were another significant housing downturn. Managing that liability in a responsible way to avoid future taxpayer losses is a critical challenge of the transition. Third, there must be a credible path toward the development of the substantial layer of private “first loss” capital on which the functioning of the new system will depend. If you build the new Government reinsurer but the required layer of first-loss capital doesn’t come in the size or at the pace of your contemplated wind down of Fannie and Freddie, the whole system will shut down before it has a chance to start. The idea that “if you build it, they will come”, may work in the movies, but you are playing with the nation’s housing finance system. Hope is not a credible strategy.
You have to make a fundamental choice in meeting these challenges in the transition: Restructure Fannie and Freddie and use their assets and operations to create a well-capitalized set of private market players who can ensure that the new system functions as contemplated, or wind them down on the bet that if you build the new reinsurance system, new private players with the sizeable capital required to make the new system function will come. My concern with both S.1217 and the Protecting American Taxpayers and Homeowners Act introduced in the House of Representatives is that each is based on the bet that to-be-named new players with capital yet to be raised will show up right on queue as the two institutions at the center of the current system are mechanically wound down. As I hope to demonstrate in the following testimony, we don’t have to gamble with the future of the housing market. There is a better alternative."
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