Form, Function and Purpose of the Proposed Texas Mortgage Guaranty Corporation -By Rick Baron

I have met with officials from the Texas Department of Savings and Mortgage Lending, the Texas Department of Housing and Community Affairs, and the Texas Mortgage Bankers Association and they all believe this concept has merit and deserves serious consideration. I hope you will consider it and support it as well.

Description of Purpose – This is a proposal for the State of Texas to sponsor the creation of a 501(c)(3) Non-Profit Corporation (NPC) for the purpose of purchasing, securitizing and selling mortgage loans that meet its criteria to institutional investors in the Mortgage-Backed Securities (MBS) secondary market. Mortgage loans secured only by Texas properties will be purchased from state-wide mortgage lenders. It will be founded on the principle that the two most important parties in the flow of mortgage money are the borrower and the investor.

With tax exempt status and no need to distribute profits to shareholders and investors, the NPC substantially reduces and possibly eliminates the moral hazard of private profits and social losses in the mortgage securitization arena. The vast majority of its net operating revenues will be banked into an ever-growing Guaranty Reserve Fund (GRF), with a smaller percentage consistently added to operating capital to gradually reduce the need for financing of its operations. Also, at least 1% of its annual net operating revenue will be dedicated to public financial educations efforts to teach citizens how to become qualified, prime-class mortgage borrowers and home owners.

Since the Federal Government has announced the wind down of Fannie Mae and Freddie Mac over the next 5 to 7 years, and because they will be reducing maximum loan amounts, increasing down payment requirements, and raising fees between now and then, it only makes sense that we should create a securitization firm that protects the state from the additional harm this will cause to Texas real estate markets. Doing so will also have a positive impact on property tax and sales tax revenues, stabilize and support our real estate markets, support and strengthen our regional economy, and normalize our mortgage lending environment.

Description of Loan Products – Initially, loan products will mirror current Fannie Mae and Freddie Mac Agency products and securities with a few key differences outlined later in this document. Products allowed will be prime class fixed and adjustable rate terms ranging from 10 to 30 years in duration. Adjustable Rate Mortgages offered will be 3/1, 5/1 and 7/1 ARMs with 2/2/6 caps on 3/1 ARMs and 5/2/5 caps on 5/1 and 7/1 ARMs and indexed to 1 Year Treasury Securities. Loans will be secured by 1 to 4 family residential properties only. No loans will allow for negative amortization, pre-payment penalties, or interest only features. Multi-Family securitizations may be phased in at a later time if deemed appropriate.

Loan-to-Value ratios (LTV’s) and Combined Loan-to-Value ratios (CLTV’s) will be as follows:

Conforming SFR Owner-Occupied:

95% LTV to $417,000

90% CLTV to $417,000

90% LTV/CLTV to $417,000 on all ARMs

Second/Vacation Homes – 90% LTV

2-4 Unit Owner-Occupied and Investor loan limits will match current Fannie Mae limits

Investor (Non-owner occupied) – 80% LTV 1-2 Unit – 75% LTV 3-4 Unit

Jumbo Conforming SFR Owner Occupied:

90% LTV/CLTV to $625,500

All cash-out/equity loans will be limited to 80% LTV/CLTV

Eventually, a self-insuring, 3% down First Time Home Buyers program will be introduced to compete with FHA, and possibly a zero down VA-type program as well for Military Veterans.

All loans with LTV’s above 80% will require Private Mortgage Insurance (PMI) to assist in restoring investor losses in the event of default. Loan level price adjustments and risk-based pricing will also be used within reason. The above terms will remain the same as Fannie and Freddie wind down.

The Jumbo Conforming terms will possibly require Congressional approval since they are not currently allowed in Texas. However, the lack of available Jumbo financing has decimated Texas property values in the $500k to $1 million price range causing tremendous losses in property tax revenues. In Travis County alone, assessed values in this range fell by over $1.7 billion between 2009 and 2010 (source: TCAD). We desperately need affordable and available financing in this range.

Underwriting Philosophy – Technology has been a tremendous benefit to the mortgage industry. However, circa 2000-2001, a sea change occurred that caused the industry to lose its way. It was decided that software underwriting programs would make the final loan decision on all loans sold to Fannie Mae and Freddie Mac. This change removed human accountability for risk-assessment from the system and relegated human underwriters to the role of “validators” of the information required by the software. Sub-Prime and Alt-A lenders quickly followed suit, and before long the risk of default was all but disregarded. This shifted all of the risk of default and loss to the borrower and the investor while all of the “middle-men” benefitted immensely.

Software is a useful underwriting tool, but it can only assess numerical parameters set by its programmers. In the first 7 years of the past decade the parameters were clearly set too broadly and today the parameters are too narrow and inflexible. Software simply cannot properly assess a borrower’s risk of default as well as a human underwriter can, nor can it be held accountable for its results. Therefore, this institution will require that human underwriters have final loan decision responsibility for all loans, along with the authority to override software findings either pro or con with proper justification and documentation.

Borrower income, assets, credit history, debt-to-income ratios, and property appraisals will be required, documented and assessed on every loan by certified human underwriters. For the previous six decades before the last one, this method of underwriting worked extremely well and resulted in an historical default rate of less than 1%. Underwriting software will continue to be used but only as an underwriting aide.

This institution will be staffed with human underwriters with no less than 15 years of underwriting experience. Underwriters for state-wide lending institutions will be encouraged to call staff underwriters to discuss scenarios and gain assistance with loan decisions.

Underwriting Accountability – All loans will be tracked and monitored. Loans that default within the first 12 months will be flagged and analyzed for fraud, improper underwriting, and unforeseen circumstances. Where improper underwriting is determined, policies will be in place to put underwriters on probation and/or require decertification if certain default benchmarks are exceeded. Underwriters are much more prudent when they know their job is on the line.

100% Risk Retention – The FDIC recently released its joint recommendation with six other agencies requiring non-Qualified Residential Mortgage securitizers to retain 5% of the risk of loss on the MBS it sells. This institution will endeavor to retain 100% of the risk of loss on its securities, exceeding FDIC requirement by 95%. The NPC will retain specific authority to foreclose on defaulted properties on behalf of the investor. With PMI covering losses above 80% LTV, the vast majority of properties can be liquidated quickly at roughly 85% of their value, allowing the NPC to pay off the entire loan and recoup the costs of foreclosure. Once a property is foreclosed upon, the GRF will be used to bring delinquent payments current and will continue to make monthly payments to the investor until the property is liquidated and the loan is paid in full. Any deficiencies resulting from the liquidation of the property will be covered by the GRF as well. Any excess funds resulting from liquidation will be put back in the GRF.

100% Transparency – By law, a Non-Profit Corporation is required to be transparent in its operations in order to maintain its tax-exempt status. However, this institution will go much further on behalf of investors. It will provide an investor portal where interested investors can view real-time information on the level of its Guaranty Reserve Fund as well as delinquency and default rates, pre-payment speeds, and any other information deemed important to an investor’s decision whether to invest in this firm’s securities. This information will be easier to obtain and maintain if the sister non-profit servicer recommended below is also created.

Geographic Concentration of Risk- Although Texas is currently one of the healthiest real estate markets in the nation and has a large and diverse economy, geographic concentration of risk is still an issue for investors. However, mechanisms will be in place to help mitigate this risk such as increased down payment requirements in particular zip codes or MLS areas when bubbles are detected, and LTV increases to 90% for qualified investors to stimulate sales in areas that are depressed.

Securities and Securitization Volume – Securities offered will be of the simple “pass-through” variety and hopefully traded in the TBA and Specified Pool markets. Texas funds over $35 billion per year in mortgage loans (source: TMBA) and generates an average of $40 billion per year in residential real estate sales (source: Texas MLS). It is anticipated that this company will be able to securitize and sell between $10 billion and $30 billion per year in MBS.

The goal of this institution is to create securities of high enough quality and safety to compete effectively with U.S. Treasury Securities.

The Guaranty Reserve Fund – Assuming 1% gross revenues from delivery and guaranty fees and $12 billion per year in securitizations, this company should easily be able to set aside $100 million per year into its Guaranty Reserve Fund to protect investors from losses. Once the fund reaches appropriate levels as determined by actuaries, excess revenues can be used to increase operating capital and reduce the need for financing. Excess reserves will also be used to support affordable housing/financing goals such as down payment assistance programs and possibly interest rate subsidies.

The GRF will be self-funding from securitization operations and will grow stronger every year. Neither state nor federal taxpayer funds will be used or risked to protect investors.

Start-up and Operating Capital – To achieve the necessary economies of scale, it is estimated the NPC will need to raise $100 million in order to borrow up to $1 billion to finance initial securitization operations. Funds will be raised from industry participants such as Realtors, builders, mortgage professionals, financial institutions (community banks, credit unions, state banks, etc.), and possibly the State of Texas. I am currently researching commercial financing options and costs.

Legislation – State sponsorship is sought only to reassure investors this institution will be responsibly managed and regulated and to assist with start-up. Texas already has world-class licensing and regulatory infrastructures in place, so proper regulation and oversight is guaranteed. Additionally, carefully crafted legislation will be required (through Joint Resolution) to ensure lawmakers are prevented from accessing the GRF or requiring the NPC to lower its credit or lending standards. Industry participants need to clearly understand that the State of Texas will explicitly NOT guarantee this entity’s securities against losses. The NPC will provide an agency guarantee only.

501(c)(3) Tax Exemption Qualifications – Non-Profit Corporations function just like for-profit corporations, but can receive tax-exempt status if they meet at least one of the federal and state qualifications for a non-profit corporation. This company meets at least two of the federal and at least four of the state requirements for non-profit classification.

Federal – This NPC meets the charitable/benevolent requirement by providing affordable and available mortgage financing for all Texans and assisting with home ownership initiatives. It meets the educational requirement by providing free financial education programs to citizens with an emphasis on achieving prime borrower status and encouraging wealth building through real estate ownership. Every citizen should be taught what it takes to acquire a home and own it free and clear by retirement as part of their quest to achieve economic independence and enjoy the American Dream.

State – This NPC meets the charitable/benevolent and educational requirements, but it also fulfills two others. Since Texas has no state income tax and is primarily dependent on property and sales tax revenues for its operations, it supports a civic mission by supporting real estate values with affordable financing which enhances property tax revenues. It also fulfills the professional requirement by providing responsible lending guidelines and parameters for Texas mortgage lending institutions. Additionally, it provides a secondary market conduit for community banks and credit unions which will help avoid systemic risk issues when interest rates rise.

This NPC can and should pay its executives market rates for salaries and wages to ensure it will attract and retain talented, experienced industry professionals. Politicians need not apply.

Non-Profit Loan Servicing Corporation – In light of the recent news regarding questionable servicing practices among mortgage loan servicers, it would also make sense to have the state create a sister non-profit servicing company to service the loans securitized. This would enhance the ability to track information regarding delinquencies and pre-payment speeds for investors. Using its net operating reserves, it could become a valuable resource for individuals who find themselves in need of temporary mortgage help and counseling. If a homeowner suffers an unforeseen circumstance such as a job loss, a medical emergency, a death in the family, a divorce, or any of life’s happenings that cause temporary financial hardships, having a servicer in a position to make one, two or three payments on behalf of the borrower (while adding them to the back-end of the loan) would be a godsend to many and would additionally mitigate the risk of default.

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I believe this business model has the potential to be superior to Fannie Mae, Freddie Mac, or any other government or private market alternative. This business model helps diversify the industry away from Fannie, Freddie, and the federal government; it minimizes taxpayer risk, it mitigates risk from profiteers and well-meaning politicians, it protects and strengthens the bond between borrower and investor, it’s 100% transparent, and it grows stronger over time. This is not an attempt to reinvent the wheel; it is an attempt to recreate what used to work well with safeguards in place to prevent what went wrong from happening again. If it proves successful it can be duplicated by other states or other regions nationwide (e.g. in each of the 12 Federal Reserve Districts).

The Texas Legislature is only in session every other year for four and a half months at a time. They are currently in session now, and there are only a few weeks left to have this proposal considered during this session. I plan to present this proposal to select Texas lawmakers soon if I am able to gain access to them.

Comments or questions may be posted at https://goodcapitalism.wordpress.com , emailed to rick@rickbaron.com , or discussed directly with Rick Baron at 512-422-1949. Thank you in advance for your input. -rb