New York | This week in The Institutional Risk Analyst, we feature a discussion with Ted Tozer, former President of Ginnie Mae (2010-2017) and veteran mortgage banker. He is a Senior Fellow with the Milken Institute.

The IRA: Thanks for talking the time to catch up Ted. First, let’s start by talking about what it was like to take over GNMA in 2010, which was a very tough year in the mortgage industry and for financials generally. Can you give us a sense for your priorities when you took that job a decade ago?

Tozer: I was somewhat prepared for the task because of running capital markets for National City Mortgage, which was a top ten originator at that time. We saw the shift from Fannie Mae and Freddie Mac product to FHA product that occurred after 2008 as the credit climate changed. I knew the shift to FHA was going to occur, but I also recognized the potential that GNMA had to serve as a backstop for the industry and the US economy. We needed to leverage and improve our technology and the effectiveness of our people to really make a difference for consumers, so I made customer service for our issuers and our investors the priority.

The IRA: That’s a radical concept for Washington, especially when aspiring politicians like to portray mortgage lenders as the enemy. How did you reorient the culture at GNMA to focus more on being customer centric?

Tozer: When I got to GNMA, we had good people, but they were like all government employees, focused on the job instead of the customer. We had to change from merely offering a product to being concerned about making the GNMA market attractive to lenders and investors. We needed to focus on service to all of our constituencies if GNMA was going to position itself to help the industry recover. GNMA provides the liquidity that makes the FHA, VA and USDA programs possible. We had to focus on improving the capital markets execution of GNMA. A lot of veterans at FHA saw their loan guarantee program as the only concern, but I made the argument that the combination with GNMA was powerful and really essential to our being able to serve the industry’s needs.

The IRA: How was the reception to that message?

Tozer: It was very positive. National City was the largest GNMA issuer in the US in 2007 and 2008, so I knew the GNMA staff well. We had worked together for years so that set me up to help the organization get through some tough years after the financial crisis. I really focused on conveying to my colleagues at GNMA, FHA and HUD how important we were to supporting the industry in those years. I also tried to educate people about the VA program and why that program was also crucially important. We had all of these veterans coming back from Afghanistan and Iraq that had an important benefit in the VA loan program, but many did not use it. Promoting the VA program was another way to support the mortgage industry and the US economy.

The IRA: People forget that in 2010 many investors, especially offshore sovereigns like the Bank of Japan and Norinchukin Bank, had backed away from the GSE debt market, leaving GNMA as the only mortgage asset class they would buy. The market for smaller, low-FICO loans had essentially disappeared when the banks and even GSEs backed away. Did you and your colleagues at GNMA feel like you were catching the falling knife in the housing sector in those dark years before residential assets truly recovered in 2012 and thereafter?

Tozer: There was certainly a sense of mission, but fortunately both the FHA and GNMA were well-positioned to play a counter-cyclical role in the housing sector. We were in a unique situation because GNMA had gotten so small during the 2000s. Most of the GNMA servicing was being done by Bank of America (BAC), Wells Fargo (WFC), JPMorganChase (JPM), and U.S. Bancorp (USB), strong financial institutions that minimized Ginnie Mae’s counterparty risk. This left us free to focus on the future and what we needed to accomplish to better support the industry. Unlike the GSEs, which as issuers of MBS with pre-crisis loans had to deal with the problems of legacy subprime mortgages, our servicing was being done by large banks. But we also put out the welcome mat to attract new non-bank issuers into the GNMA market. Had we merely focused on working with the large banks as before, would have dramatically slowed the housing recovery.

The IRA: After BAC closed the Countrywide acquisition, they shut down their correspondent channel. Cost BAC shareholders billions in lost revenue. But good timing on your part to pivot back to the non-banks as the commercial banks were leaving the FHA market. We always laugh when researchers fret about the rise of the non-banks, when in fact it was the return of the non-banks going back to the S&Ls of the 1980s. In this cycle, much of that distressed FHA loan product was eventually transferred from BAC, JPM et al. to high touch non-bank servicers and at the insistence of prudential regulators and state AGs.

Tozer: A lot of the correspondent people at Bank of America came to GNMA. And non-banks strengthened the agency and helped us build a business with new issuers like Quicken, Penny Mac (PMT), Freedom and Caliber. There were also some significant new high touch distressed servicers like Mr. Cooper (COOP), Ocwen (OCN) and Carrington, who processed huge volumes of troubled loans and made many thousands of FHA loan modifications. Carrington was a great example because they were set up to clean up the private label mortgage market, so they had the people and systems to handle distressed FHA loans very effectively.

The IRA: What was the biggest challenge during your time at GNMA?

Tozer: Throughout Washington, whether you are talking about HUD or Capitol Hill or other agencies outside the mortgage complex, there is little real awareness about how mortgage finance works in practical terms and GNMA specifically.

The IRA: One of the more amusing things about housing reform is to see how few people understand that GNMA is a guarantor only, with bank and non-bank issuers handling the bond issuance and servicing, while the GSEs are issuers themselves, guarantors and the owners of servicing. How do we bridge the enormous chasm of understanding?

Tozer: At the start of my tenure, very few people at Treasury or the other parts of government knew what GNMA did or what we accomplished by enabling the FHA and other programs. When I explained it to people at the White House, they were actually shocked. I am not being critical here, but housing finance is a specialized niche. There were a lot of very smart financial people and politicians I met over the years who did not understand GNMA’s role and our potential to drive recovery in the housing market. And this is the same challenge with housing finance reform, because so few people understand the complexity and nuances of housing finance.

The IRA: Even with the growth in FHA lending and RMBS issuance at $2.1 trillion, today GNMA is less than 20% of the total residential housing market. The large banks are the top of the food chain with $2.5 trillion of mostly large, prime, non-FHA loans, the GSEs currently occupy the big middle of $5.5 trillion or so, and the non-agency private loan market makes up the rest. So when we read the Trump Administration proposal to downsize the FHA, we wonder if they understand that there is no other practical market for small, lower FICO loans?

Tozer: Reading the Administration proposal, the first thing that jumps out at me is the huge growth in GNMA were it to provide the credit wrap for the existing GSE securities as part of the re-privatization of Fannie Mae and Freddie Mac. Under the proposal, GNMA would become a monster guarantor for three quarters of the mortgage bond market. Operationally Ginnie Mae could support the growth because of the hundreds of millions of dollars Ginnie Mae spent to modernize its infrastructure. FHA has actually been a very successful program in a sense that they capped market share by limiting the size of the loans, but they took such a broad swath of the market that the credit loss performance was fine. By undercutting private issuers and taking a broad cross section of the credit spectrum in smaller loans, you did not need risk-based pricing. The good loans balanced out the bad in terms of risk. When the subprime issuers that underpriced the credit risk arrived from Wall Street, however, that threw off the entire system through FHA being adversely selected. But the basic FHA model actually worked quite well.

The IRA: During the period before 2007, the large banks were pushing the GSEs out of the way to acquire residential collateral for private label securitization deals. Investors clamored for more deals. How did that surge of demand affect FHA and GNMA?

Tozer: The Wall Street banks cherry picked the better loans out of the market and left the FHA with the poorest quality subprime product. Now that we have restored the balance in the FHA and other programs, however, we don’t really need risk-based pricing to do a good job for our issuers and investors, and thereby protect the taxpayer. If we coordinate the demarcation between GSE execution and FHA, the program is quite stable and could return to the type of operating performance we saw before 2008. In the early 2000s, the FHA was so well capitalized that it actually waived premiums for some low-income borrowers. I’d like to get back to that situation.

The IRA: So will banks come back to the FHA market? Prudential regulators have told banks to avoid smaller loans due to reputational risk.

Tozer When the DOJ and FHA took the pound of flesh from banks large and small after the 2008 financial crisis, they ensured that banks would exit FHA lending and not return. The big public banks don’t want the reputational risk and the smaller banks don’t want to put capital at risk with the DOJ. You can’t force people to make FHA loans. If you have a limited number of people that want to make FHA loans, then the program will be offered on a limited basis. This capacity issue should become apparent in the next economic cycle. The punitive aspect of the DOJ and FHA approach, where they went back years to penalize technical deficiencies in loans, defects that will not affect the loan’s performance, burned the bridge with the depositories. This has important effects because it essentially makes the FHA a procyclical program. That scares me. When we had the large bank issuers, they could lean into a receding market as a countercyclical resource and help to support lending during a recession as in 2010 onward. But not anymore.

The IRA: The smaller non-banks in the GNMA market clearly face a funding challenge in a moderate to severe loss cycle. Yet in retrospect, the FHA and GNMA were fortunate that the non-banks came into the government market, cleaned up the subprime mess and then replaced the banks in the role of GNMA issuers. Clearly a depository is a superior model for the GNMA market because of the large escrow balances. But speaking of non-bank issuers, what would you say about the White House proposal prohibiting refinance of FHA loans? We discussed same in National Mortgage News ("Trump's housing plan attacks the FHA mortgage market").

Tozer: Many borrowers in the FHA market would not be able to refinance out of the FHA market because of needing to get private mortgage insurance on the GSE loan. I do agree that a GSE loan should not be refinance by the FHA, because that suggests that the FHA is again going to be getting the problem loans. I don’t see the issue of an FHA refinance into another FHA loan. FHA already owns the risk, so lowering the payment for a borrower is good for the FHA and the consumer both.

The IRA: Precisely. Most of the product being written in 2019 is rate product, not cash out loans as in 2018. Responsible FHA and VA lenders will lower the cost to the borrower and keep the loan amount stable. Speaking about risk-based pricing, if we take Fannie and Freddie out of conservatorship without a legislative fix that provides for GNMA guaranteeing the existing securities, what happens? Do Washington folks understand that the GSEs are issuers, and also need to fund bond payments and have the liquidity to fund advances?

Tozer: Fannie and Freddie are like CapitalOne (COF) before they bought Chevy Chase and MBNA before they got bought by Bank of America. These monoline non-bank credit card issuers had a very tough time funding their businesses without access to government guaranteed debt (bank deposits). None of them were really able to make it because of the cost of financing. I think the cost of financing for Fannie and Freddie will become prohibitive to them if their debt is no longer guaranteed by the Treasury.

The IRA: The discussions about GSE reform make us recall the warnings from Dave Stephens when he was head of the Mortgage Bankers Association. He said that when Mel Watt left the Federal Housing Finance Administration, things would change. And they certainly have. Mark Calabria seems to think that private capital is enough to support the GSEs, but most of our colleagues inside the enterprises suggest otherwise. Even a change in funding costs of as little as 20% to reflect the difference between GNMA at zero risk weight and Fannie/Freddie at 20% for Basel III would be intolerable. Warren Kornfeld of Moody’s wrote that: “Reducing Freddie and Fannie’s footprint would be credit negative for GSEs,” but increased funding costs are even more problematic. What would happen to FHA flows if the GSEs were really privatized without a federal guarantee for the bonds or the issuers? Say the GSEs ended up as “A” credits c/o Moody’s.

Tozer: Well, first off, the UMBS would become next to impossible to administer. The GSE MBS would become the obligations of the issuers that were no longer obligations guaranteed by the United States. MBS investors would have limits on how much exposure they would have to each GSE. The GSEs would be joint and severally liable for the other GSE MBS that were included in their mega or giant pools. For example, the only reason they are allowing other issuers to sell production into mega pools is that there is a government guarantee. If they are guaranteeing the other agencies securities, then they have the counterparty risk as well. I don’t think that people in Washington understand all of the moving parts involved with the GSEs operationally. You miss one moving part and the whole operation falls apart. You can tinker on the edges, but you cannot make wholesale changes without destabilizing the conventional market. That is why unless Congress acts to guarantee the securities issued by the GSEs, I do not see how they will be able to leave conservatorship.

The IRA: Thanks Ted. See you in Dallas next year at Americatalyst 2020.