PROJECTHousing Finance Reform Incubator

Michael D. Berman and Mark A. Willis: Multifamily GSE Reform: A Different Road
Body

May 16, 2016

While the recent proposal “A More Promising Road to GSE Reform” takes a fresh and well-conceived approach to restarting the conversation about government-sponsored enterprise (GSE) reform, the focus is on the single-family secondary market. Multifamily and its lending industry are different and should have a different reform approach that addresses the shortcomings of the GSE multifamily business model and meets the multifamily market needs for US renters. We propose a new organizational structure and legal ownership of these business units. (We do not intend to express any view as to the rights of the existing minority shareholders.)

The GSE multifamily business differs from the single-family business in five ways.

  1. Smaller market, larger loans. The $1.06 trillion debt market for multifamily loans is about one-tenth the size of the market for single-family loans, so its needs can be addressed with smaller institutions. This allows multifamily to avoid the pitfalls of too-big-to-fail and of satisfying the special needs for homogenous, liquid securities in the single-family space, as well as the impacts on capital flows and demands of any privatization. With larger loan sizes (average GSE loan size for multifamily is $10 million versus less than $250,000 for single-family), investors can underwrite each multifamily loan.

  2. No to-be-announced (TBA) market to enable rate locks. The GSEs do not facilitate a market for the forward commitment of interest rates for multifamily mortgages as they do for single-family homebuyers. Accordingly, the multifamily arena does not have the same capital flow and liquidity needs.

  3. Risk sharing is already a reality. The multifamily GSE business units for Fannie Mae and Freddie Mac have mature, time-tested risk-sharing models that were adopted voluntarily.

  4. Significant private competition exists. Competition in the multifamily finance industry from the private sector (e.g., banks, life companies, and commercial mortgage-backed securities [CMBS]) has revived since the Great Recession, but on the single-family side, the private-label residential mortgage-backed securities market has not recovered, and no equivalent private competition has emerged in the conforming loan space.

  5. More resilience in economic stress. Unlike the single-family arena, the GSEs’ multifamily lending criteria combined with its loss-sharing programs results in exposure to the GSEs at or below 70 percent loan-to-value (LTV). Accordingly, in stressed economic cycles where values may drop 30 percent, for example, there is little or no exposure to substantial losses. Higher LTVs in subsidized and rent-restricted rental apartments has exhibited little default rate volatility in times of economic stress because of the rent restrictions and undersupply of this housing type for low, very low, and extremely low income households.

Importance of Multifamily Housing and the GSEs' Roles

Multifamily housing is an important source of rental housing. The number of American households that live in rental housing has grown from 34 million in 2005 to 43 million in 2016, and the percentage of households that rent has reached a recent high of 37 percent. Renters are usually lower income, earning less than 50 percent of what homeowners earn ($32,466 versus $67,298 per year, according the US Census Bureau). Half of all renters, or 21.3 million households, pay over 30 percent of their income to rent, and half of those households, or 11.4 million households, are paying over 50 percent, according to the Harvard Joint Center for Housing Studies. Accordingly, an adequate supply of quality and affordable rental housing is important, including middle-income workforce housing, affordable housing for low, very low, and extremely low income renters (including subsidized housing), housing for seniors, and manufactured housing. Consistent and affordable multifamily financing helps provide this housing stock.

Countercyclical support. The implicit government guarantee of the securities issued by the GSEs allowed them to finance multifamily properties when other private financing sources vanished during the Great Recession.

Long-term financing. The GSEs supply the long-term financing that provides a consistent, dependable takeout for construction and rehabilitation loans, which are essential for our aging multifamily housing stock.

Standardization and liquidity. The GSEs have enhanced the multifamily housing market by providing a benchmark for standardization of the secondary market and liquidity to ensure a sufficient supply of competitively priced capital to maintain the affordability of such financing.

Today's GSE Multifamily Business

The GSEs’ multifamily and single-family businesses’ approach to risk sharing and loan level credit decisionmaking operate differently. Until the Federal Housing Finance Agency (FHFA) mandated the GSEs to sell and syndicate risk, the single-family businesses had no private capital other than private mortgage insurance on higher-leverage loans. In contrast, the multifamily business units had voluntarily decided to utilize risk-sharing lending mechanisms that put private capital in front of or in parri-passu position with the GSE guarantees: Fannie Mae’s program started in 1988, while Freddie Mac programmatically adopted risk sharing in 2009, although Freddie Mac has required that each individual loan be prereviewed and preapproved by its underwriting staff since 1993.

The GSE multifamily risk-sharing mechanisms are as follows:

  • Freddie Mac uses the K Series Program to purchase multifamily loans, aggregates those loans into pools for securitization, and sells off the top 15 percent of loss to private bond investors, while providing the Freddie Mac guarantee wrap on the remaining 85 percent of the pool (equivalent to a AAA tranche).

  • Fannie Mae has a Delegated Underwriting and Servicing (DUS) Program, which employs counterparty risk mechanisms with its licensed lenders contracting to absorb either 33 percent loss sharing or 5 percent top loss plus additional loss sharing up to nearly 20 percent through the capital stack.

While both GSEs have established similar underwriting and eligibility criteria, the differences between these two risk-sharing programs are significant. The Fannie Mae DUS Program focuses on the motivation and discipline of the lenders who make each loan and retain risk for the life of each loan. Fannie Mae shares in the first dollar of that risk on most loans. In contrast, the Freddie Mac K Series Program requires that Freddie Mac prereview and preapprove each loan and is subject to the discipline of third parties who buy the riskiest tranches of each pool of loans. Freddie Mac takes no first-loss position post-securitization for the first 15 percent of losses. The implications for times of economic stress are also significant, as the pricing of the Freddie Mac K Series subordinate tranches is subject to pricing spikes, while Fannie Mae has some first-dollar loss exposure. Both GSE multifamily business units performed well during the Great Recession. The differences in these models and the innovative approach of each business unit have resulted in competition between the GSEs, providing a healthy diversity of mortgage products for the multifamily industry.

From 2003 to 2007, the GSEs became more aggressive to keep up with the competition but maintained sufficient underwriting discipline to avoid losses because of their approaches to risk sharing and underwriting. Freddie Mac’s multifamily loss experience from 1989 to 1993—when its underwriting system was weak—has not been repeated in the last 20 years. The combined GSE book of guarantee and portfolio multifamily business of $367 billion (a 34.6 percent share of total outstanding multifamily debt) has experienced cumulative losses of less than 0.8 percent of outstanding balances over the last 10 years. In contrast, other sources of multifamily finance experienced significant losses—particularly CMBS lenders and some banks—during the Great Recession as multifamily market vacancies increased and net operating incomes declined.

In addition, the GSEs played a countercyclical role in the Great Recession as they maintained a steady stream of mortgage purchases. As a result, the GSE market share increased from about 30 percent in 2004 to 2006 to over 80 percent in 2009. And as liquidity in the private capital markets increased from 2011 to 2014 through life companies, CMBS, and banks, the GSE market share gradually retreated to under 40 percent, partly because of a cap imposed by FHFA, the GSE regulator, in 2013. However, most experts believe that based on competition from banks, life insurance companies, and CMBS lenders, the GSE market share would have been under 40 percent in 2013 and 2014 even without the loan volume restrictions imposed by FHFA. The FHFA volume cap is now $70 billion, with caveats for affordable housing with a goal of less than a 40 percent market share.

Within each of the GSEs, the relationship between the single-family and multifamily business units is independent, with many parallel functions in each unit. This is especially evident in the key functions of loan production and acquisition, underwriting and credit, asset management, and increasingly in securitization. Various infrastructure-sharing functions (e.g., accounting, information technology, human resources, reporting, and legal) have become more independent over the past few years, with an increasing focus on securitization functionality independence. Over the past 10 years, the strong domestic and global markets for single-family GSE securities has helped the multifamily units sell their securities, especially in the international market. If they were spun out from their minority position within the GSEs, they would face new challenges, such as raising their own corporate debt and equity.

Flaws in the Current System

The current GSE model, however, could be improved in the following areas:

  • Increase competition in the multifamily mortgage market by

    • opening up the duopoly of Fannie Mae and Freddie Mac to competition by providing other entities access to the government guarantee; and

    • expanding the number and breadth of lenders that can access the government-guaranteed secondary mortgage market to include more community banks and lenders focused on secondary and tertiary housing markets, including those in rural areas (currently, only about 40 lenders are authorized to sell multifamily loans to the GSEs).

  • Increase access to the GSEs’ long-term fixed-rate credit products by

    • offering special programs for smaller loans through more lenders that serve the owners of properties with 5 to 50 units (their current average loan is about $10 million);

    • offering special programs for loans to rehabilitate the older properties that make up a large share of the stock of multifamily properties; and

    • offering programs through more lenders tailored to needs of affordable housing for low, very low, and extremely low income renters; while the GSEs’ books of business include a significant portion of workforce housing, the GSEs should focus on financing housing that serves not just those with incomes at or below 120 percent of the area median income (AMI) but also those with incomes at or below 80 percent of AMI and those with incomes at or below 60 percent of AMI, with consideration toward limiting loans on luxury rental housing (i.e., properties with average rents affordable at over, say, 200 to 250 percent of AMI).

Design Features of a Reformed Multifamily Finance System

Private capital should be at the core of the system and in a first-loss position, as is the case with Fannie Mae and Freddie Mac’s multifamily risk-sharing business models. Any new system for multifamily housing finance should include the following 13 design features, many of which were included in the bipartisan Johnson-Crapo Bill:

  1. Separate the multifamily and single-family businesses. The new system should create new regulated bond guarantors, two of which would be created by spinning out and grandfathering Fannie Mae’s and Freddie Mac’s multifamily business units.

    • Each new spinout guarantor could be owned by the private sector (through a public offering of its stock) or in a mutual structure, provided that no lender to the multifamily sector controls more than 10 to 15 percent of these entities to avoid vertical integration.

    • FHFA would regulate the guarantors and treat the guarantors in many respects as utilities.

    • FHFA should license up to three additional guarantors and license at least one in addition to the two GSE spinouts to ensure competition but not oversaturate the market. All guarantors must be required to oversee their multifamily servicers and special servicers of defaulted loans and oversee counterparties in credit risk-sharing transactions. (The vertical integration restriction from above would apply to investors in the new guarantors.)

    • Each guarantor, as a mono-line business, should have a minimum capitalization of 2 to 4 percent of outstanding multifamily loan guarantees plus defaulted loans that have been foreclosed plus any portfolio loans. At 2 percent, this is over two-and-a-half times the cumulative losses experienced by the GSE multifamily business units in the last 10 years, including the Great Recession.

  2. Minimum loan standards. Eligibility of loans for the guarantee should be limited and prescribed by FHFA and the government insurer (see paragraph 3 below) to limit the guarantors’ and taxpayers’ credit-risk exposure. Such loan-eligibility standards should require full documentation, the use of in-place cash flows (or other adequate security for rehabilitation loans), a maximum LTV, and a minimum of debt service coverage ratio. Examples of FHFA criteria could include an LTV limit of, say, 75 to 80 percent, with interest-only features prohibited on all loans over 65 percent LTV, and a debt service coverage ratio limit of, say, 125 percent, except for affordable housing loans for properties with tenants with incomes under 60 percent AMI where there are local, state, or federal restrictions or subsidies that mitigate the additional credit risk.

  3. Government insurance for catastrophic loss. The government should provide an explicit guarantee to insure investors in multifamily mortgage-backed securities against any loss of principal and interest for these guarantor-issued securities. This would ensure the liquidity of these mortgage-backed securities and maximize the potential for mortgage financing to be available to property owners throughout the economic cycle, particularly in times of moderate and severe economic stress. There would be no government guarantee of the debt or equity invested in each guarantor. A possible entity to provide the catastrophic insurance is the Government National Mortgage Association (GNMA), which confirms appropriate counterparty risk for issuing its securities and the servicing of loans collateralizing these securities backed by Federal Housing Administration and US Department of Veterans Affairs mortgages. (GNMA would need to adjust its processes to account for the lack of government insurance on these mortgages.) In this role, GNMA would approve any guarantors licensed by FHFA and would have its own counterparty oversight.

  4. Third parties hold top loss. Third parties should hold a percentage of the top-loss risk of all securities issued by the guarantors at levels set by FHFA. For standard loans of up to 75 percent LTV, that top loss could be mandated by FHFA at 15 percent. The percentage may be adjusted for various loan types depending on the risk characteristics of each type (e.g., a lesser top-loss sharing would be permitted for loans that don’t exceed 55 percent LTV). The Fannie Mae DUS Program should be grandfathered but might need to meet a higher capital requirement or require a sale of a portion of its top-loss exposure to account for its sharing of the top-loss risk. (The quality track record of losses of the DUS Program should be used in determining treatment of the top loss for capitalization purposes.)

  5. Protect taxpayers from losses. A guarantee fee should be charged for the explicit government backstop to create a reserve fund that will protect taxpayers from losses. This fund should be a reserve of 1 percent of the outstanding covered securities to be built up over, say, 7 to 10 years. A portion of the guarantee fee should defray the operating expenses of running an insurance program and managing the fund. This reserve of 1 percent, in combination with the 2 percent minimum equity capital for the guarantors, would create a buffer more than three-and-a-half times the cumulative losses over the last 10 years. Accordingly, the taxpayer is protected by (1) strict loan eligibility criteria (including minimum borrower equity requirements), (2) the guarantors’ 15 percent top-loss risk-sharing requirements, (3) the guarantors’ 2 percent minimum equity capital (with their history of less than 0.8 percent cumulative losses over the past 10 years), and (4) this additional reserve of 1 percent. This should protect the taxpayer in times of severe economic stress, when multifamily values drop by 30 percent or more.

  6. Broader access for lenders. Mandate that the guarantors provide access to lenders of all sizes in a competitive landscape, including small community banks and credit unions. FHFA should eliminate the duopoly of the GSEs by licensing up to three guarantors in addition to the two GSE spinouts (if market conditions allow).

  7. Underserved markets. FHFA should impose duty-to-serve mandates (subject to revision every three years) for the guarantors to provide access to underserved communities, such as rural and inner-city markets, affordable housing, housing for seniors, and manufactured housing.

    • Each year, the covered securities issued by each multifamily guarantor for the rolling previous 24 months (rolling book) must meet the following tests: 60 percent of the rental units financed must be affordable to tenants whose incomes are at 80 percent of AMI (60 at 80 test), and 10 to 15 percentage points of this cohort should be affordable to tenants at or below 60 percent of AMI. These affordability tests should be based on the rent roll (or pro-forma for new construction) at the time of loan commitment using US Department of Housing and Urban Development standards for units with different numbers of bedrooms.

    • Guarantors should be restricted to 10 percent of their rolling book for higher-end rental properties (where average rents are over 120 percent of AMI) and should be further restricted to 5 percent of their rolling book of guarantees for luxury rental property loans (where average rents are affordable at or above say 200 percent of AMI).

  8. Affordable housing fund. Provide funding of 10 basis points on each loan in a guaranteed security for the National Housing Trust Fund and the Capital Magnet Fund created by the 2008 Housing and Economic Recovery Act legislation to assist low and extremely low income households with rental housing.

  9. Funding for a limited mortgage portfolio. The guarantors should retain only a very limited mortgage portfolio to aggregate loans for securitization, implement FHFA-approved pilot loan programs and other risk-sharing transactions, finance rent-restricted housing subject to a regulatory agreement, and buy back defaulted loans. Guarantors should seek warehouse lines and other forms of credit and equity to fund these portfolios, their aggregation functions, and their ability to buy back defaulted loans for loan modifications. The old business of creating arbitrage profits by holding loans in portfolio and issuing cheap corporate debt should be prohibited.

  10. Size and activity limits. FHFA should maintain its current goal of a 40 percent market share limit for the guarantors in the aggregate, except during times of economic stress. The guarantors should be mono-line entities; there should be no guarantor activities other than those required to issue the securities and to carry out their responsibilities under the terms of the securities (e.g., dealing with defaults and the underlying collateral).

  11. Flexibility in times of economic stress. Under “unusual and exigent circumstances of economic stress,” FHFA, with approval from the Federal Reserve, can reduce the capital standards for guarantors and the top-loss risk-sharing requirements, help insure warehouse lines and other sources of liquidity for daily operations, and modify rolling book and market share restrictions.

  12. Resolution authority. For failing guarantors, the resolution authority of FHFA should be based on standards and processes in the same manner as the Federal Deposit Insurance Corporation with respect to institutions which are “critically undercapitalized.” FHFA would take over failing guarantors and continue operations and could wipe out the old shareholders of the failed guarantor and recapitalize these failed companies when the economic stress dissipates and liquidity returns to the markets.

  13. Transition. When the two GSE multifamily business units are spun out, their books of business can be held in the new entities and capitalized by the new shareholders. Alternatively, each legacy book can be retained in the old GSE with an asset-management contract to each spun-out entity to reduce the necessary capital raised in the spinouts while maintaining consistent asset-management oversight.

Conclusion

This proposal preserves the successful features of the GSEs’ multifamily business units while reforming the system to mitigate some of the system’s flaws. This proposed system ends the conservatorship and reduces the government role by returning the multifamily secondary market’s functionality to the private sector with proper regulatory oversight, the ability to operate throughout the economic cycle, and a focus on affordable and workforce housing. The system protects the taxpayer with restrictions on activities to secondary-market guarantees of eligible loans with sound underwriting characteristics, loss sharing and risk allocation to the private-sector participants, adequate capital for guarantor entities, and a catastrophic backstop loan-loss reserve. We look forward to a further dialogue to move quickly to a final resolution of the current conservatorship.


Michael Berman established Michael Berman Consulting LLC in 2014 to provide advisory services to best-in-class enterprises in the real estate finance industry. Drawing from his extensive experience in the industry, Berman provides strategic and tactical advice in business and policy. From 2012 to 2014, Berman served in the Obama administration as senior adviser of housing finance for Shaun Donovan, secretary of the US Department of Housing and Urban Development. Berman also served on the senior administration housing policy team focused on developing policies for reforming the government role in housing finance for both single-family and multifamily lending. Until September 2012, Berman was president and chief executive officer of CWCapital (CW). Mr. Berman served as chairman of the Mortgage Bankers Association (MBA) from 2010 to 2011. He also chaired MBA task force committees on the future of the GSEs. He served on the board of directors of the Real Estate Roundtable (2011–12) and the executive committee of the board of the National Multifamily Housing Council (1995–2012). In 2014, he was appointed a senior industry fellow at the Harvard Joint Center for Housing Studies. In 2012, Berman received the Burton C. Wood Legislative Service Award from the MBA for his work on the future of the government’s role in housing finance. In 2013, he was designated one of the “30 Most Influential People in Real Estate” by Commercial Property Executive. Mr. Berman earned a BA from Harvard University and a JD from the University of Pennsylvania Law School.

Mark A. Willis is the senior policy fellow at New York University’s Furman Center for Real Estate and Urban Policy.  Before joining Furman, Willis was a visiting scholar at the Ford Foundation following  a  19-year career developing and overseeing JPMorgan Chase's programs and products to help strengthen low- and moderate- income communities. Before joining Chase, Willis held various positions with the City of New York in housing, economic development, and tax policy and was an urban economist at the Federal Reserve Bank of New York. He serves on the boards of several banking and community-oriented organizations. He is a frequent participant on panels at academic, industry, and government conferences and convenings, and his recent publications have focused on affordable housing, national housing finance reform, and the Community Reinvestment Act.  Willis also teaches housing and community development policy at New York University’s Wagner School. He has a JD from Harvard Law School and a PhD in urban economics and industrial organization from Yale University.

Image
A photo of Laurie Goodman. Dark hair, glasses, bright smile.
Image
Tim Howard
Image
A photo of Jim Millstein. White hair, slight smile, suit and tie.
Image
A photo of Alex Pollock. Slight smile, suit and tie.
Image
A photo of Mark Zandi. Slight smile, suit, brown hair.
Image
A photo of James Carr. Severe smile, suit, dark hair.
Image
A photo of Andrew Davidson. Slgiht smile, greying hair, glasses.
Image
A photo of Mark Calabria. Slight smile, suit, dark hair, glasses.
Image
A photo of Patricia Mosser. Dark hair, glasses, bright smile.
Image
A photo of Marc Morial. Big smile, suit, dark hair.
Image
A photo of Laurie Goodman. Dark hair, glasses, bright smile.
Image
A photo of three individuals. All three are smiling, have suits, ties, and dark hair.
Image
A photo of two individuals. Both are smiling, have suits, ties, and glasses.
Image
A photo of two individuals. Both are smiling, have suits, ties, and glasses.
Image
A photo of two individuals. Both are smiling, have suits, and ties.
Image
A photo of Jim Millstein outside. Dark hair, big smile, suit and tie, glasses.
Image
A photo of Pinto. White hair, glasses, slight smile, suit.
Image
A photo of Taylor. White hair, suit.
Image
Mike Calhoun and Sarah Wolff
Image
Rodrigo Lopez and Debra Still
Image
Janet Murguía
Image
Jim Parrott
Image
row of houses rendering
Research Areas Housing finance
Policy Centers Housing Finance Policy Center