Jim Parrott, former economic adviser to President Obama, left the White House earlier this year to join the Urban Institute as a senior fellow, and to start Falling Creek Advisors, which provides financial institutions with strategic advice on housing finance issues. In the White House, Parrott served as a senior advisor with the National Economic Council (NEC). Prior to joining the NEC, Parrott was counsel to the secretary of the US Department of Housing and Urban Development (HUD).
Among Parrott’s publications for the Urban Institute is a paper, “Opening the Credit Box,” co-authored with Mark Zandi of Moody’s Analytics. It makes the argument that the country’s long-term economic health may hinge on easing mortgage-lending standards in ways that extend loans to more creditworthy borrowers. The Score connected with Parrott recently in Washington, D.C., and he graciously agreed to answer some questions about the paper, and to share his perspective on other pressing issues. [Note that our conversation took place shortly before U.S. Senate Banking Committee leaders released their proposed legislation to overhaul the mortgage finance market on March 16.]
1) Why have lenders been reluctant to expand access to mortgage credit, and do you see the credit box opening over the next year?
There are several factors that have been holding back access to credit in recent years. First, there is a general reticence by larger institutions to take on credit risk after coming through a credit-driven crisis. It is just harder these days for the mortgage banker to go to their bank’s chief risk officer (CRO) for more flexibility to take on risk, given that the CRO is likely still working through the damage that the last expansion of credit risk did to their institution.
Second, there are significant costs associated with servicing non-performing loans. Not only is it roughly ten times more expensive to service a non-performing loan than one in which the borrower continues to pay on time, but lenders today face increasing reputational and legal risk in servicing pools containing significant numbers of distressed borrowers. This leaves them wary of expanding their credit box where doing so will eventually leave them with larger numbers of borrowers who need more help hanging on to their homes.
And third (on what could be a much longer list), there is a great deal of uncertainty over the rules in GSE [Government-sponsored enterprise, i.e., Fannie Mae and Freddie Mac] and FHA lending. In particular, it is unclear when and why Fannie, Freddie or the Federal Housing Administration (FHA) will force a lender to take the credit risk back on a loan they have guaranteed or insured for mistakes in underwriting the loan. FHA lenders also have the added risk that the Department of Justice will file a claim for triple damages under the False Claims Act for such mistakes. The uncertainty of what constitutes a mistake makes it difficult for lenders to control this considerable risk through better quality control, so they control it instead by tightening the credit box through which they lend. For more on this, it’s worth taking a look at the paper Mark Zandi and I published back in September, “Opening the Credit Box”.
All of that said, I’m cautiously optimistic that we’ll see the credit box open in the months ahead, if only gradually. The larger institutions are already showing increasing comfort with taking on more risk as the market continues to improve. And while the significant cost of servicing distressed borrowers is not likely to decrease anytime soon, policymakers can make headway in addressing the third driver I mention, put-back uncertainty. FHA has already spent months working with lenders to understand why they are applying credit overlays, and seem to be a few months away from attempting to address the problem. For more on this effort take a look at this piece. And while a similar effort by the GSEs back in late 2012 fell short of expectations, I would expect- or I should say hope- that Director [Mel] Watt will push the GSEs to take another run at addressing the problems there.
2) In what areas do you expect Mel Watt, Director of the Federal Housing Finance Agency, to have the greatest impact?
Director Watt is by nature much more cautious than most appreciate. Unlike his more ardent critics and perhaps some of his most ardent supporters, I don’t see him moving aggressively or controversially in the early months, but taking his time to understand the different perspectives involved on the major issues he faces and seeing where there are areas for consensus on a path forward.
As for the topics he is most likely to focus on, I hope he chooses two areas: the first is expanding access to sustainable credit, which I’ve just explained a bit, and the second is what I think of as near-term GSE reform. There is an important opportunity for FHFA to put the GSEs into a more stable position while in conservatorship and, at the same time, better prepare them for transition to whatever future system Congress ultimately decides on. They can do this by focusing on two areas:
First, they can increase the number and scale of Fannie and Freddie’s risk-syndication pilots. Whatever one’s view of long-term reform, we all agree that it will involve much more private capital ahead of any government risk. So it is critical that we develop a better sense of how to bring in private capital ahead of the government risk. The pilots are designed to do precisely that, but they will only be informative as we increase the scale and range of the pilots involved. Only with multiple iterations of multiple structures can we compare back-end risk syndication through the capital markets and front-end risk sharing through mortgage insurers, for instance. Determining which of these structures works best, and how, is going to be essential to the direction long term reform ultimately takes, so better to begin learning now.
Second, the FHFA can begin to sync up the operations of Fannie and Freddie so that the two begin to function more and more as a single infrastructure for the mortgage market. This is a more efficient way for the enterprises to work while in conservatorship and it will put us in a better position to transition to whatever future system congress decides upon, because that system will inevitably involve a single core operational infrastructure rather than the multiple competing ones we have today (see both Johnson-Crapo and the PATH Act). The common securitization platform is an important first step, but the FHFA can also begin the move towards a single security, a single set of pooling and servicing agreements and even a single framework for master servicing agreements.
But that’s just my wish list. As I said, Director Watt is cautious by nature and, consistent with that, he views his mandate narrowly. So whether he moves on either of these fronts will depend on whether he comes to view access and/or near-term GSE reform as central to his job as a conservator. I am optimistic that he gets there on access, and hopeful that he does on near-term GSE reform.
3) Speaking of reform, now that we have movement the Senate Banking Committee, how do you see the legislative effort on housing finance reform shaping up over the summer?
If Senate Banking can get a bill out of their committee, then things are going to get interesting this summer. If they get it passed with strong bipartisan support in April, which is when Chairman [South Dakota Democrat Tim] Johnson and Ranking Member [Idaho Republican Mike] Crapo are trying to bring it for a vote, then there will be a good deal of pressure for Majority Leader [Nevada Democrat Harry] Reid to bring the bill before the full Senate for a vote. With strong support from the leaders on this topic from both sides of the aisle and the Administration, whatever makes it out of the Banking Committee is likely to have a very good chance of passing out of the Senate.
If that happens, then it would set up a fascinating dynamic with the House. Chairman [of the U.S. House Banking Committee, Texas Republican Jeb] Hensarling has passed a GSE reform bill out of the House Financial Services Committee that reflects the antagonism many House Republicans have for any government support of the market beyond the targeted support provided by FHA, VA and USDA. So they will naturally be suspicious of whatever more moderate bill ultimately comes out of the Senate. However, they are bound to realize that the political momentum on this issue is not in their favor. If we don’t pass something in this congress, it will become increasingly hard to muster the political fortitude to push reform as dramatic as that currently envisioned by the Banking Committee. So if the Senate does manage to pass something, the House will face a choice: either negotiate over the structure by which the Senate proposes to provide broad if remote government support for the market (not over whether there is such support at all as they do now), or allow the current nationalization of the housing finance system to go on indefinitely and run the very real risk that it becomes the new norm.
4) Changing topics a bit, how do you see the QM rule affecting lending in coming months?
I think early on we’ll see the biggest impact on middle class borrowers with anything less than perfect credit. Larger lenders will lend to wealthy non-QM borrowers because they want them as clients for other products. And they’ll lend to those with perfect credit scores because they don’t mind the minimal credit risk on their balance sheet. But those non-QM borrowers who don’t fall into either bucket will not be able to find a loan over the near term.
Hopefully this will change as you see a secondary market develop for these loans, allowing lenders (large and small) to make the loans without holding them in their portfolios. Unfortunately, we’re likely a ways off from that yet, given the frictions that are holding back the return of the PLS [private label securities] market.
5) Since you’ve raised the issue, how do we get private capital flowing back into a robust private label securities market?
This is a good question to ask, not only because it’s important, but also because folks have not been thinking about the issue very clearly in recent years. Most focus on getting the government out of the way, either by pricing them out of the market or lowering the maximum loan-size they can support. The assumption here is that it’s the government’s competitive advantage that is keeping private capital out.
The problem is that there are also other barriers to the re-emergence of a strong private label securities market. After being burned so badly in the downturn, investors don’t trust issuers, the ratings agencies or those that are underwriting the collateral on their investments. In essence, they don’t trust those on whom they depend to understand the credit risk on their investments. Until they do, they won’t step back into the market aggressively and we won’t see a robust PLS market.
So if you pull the government out of the market before you restore that trust throughout the system, you’ll create a credit wasteland beyond the border of government support, not bring private capital back. Fortunately you’re seeing policymakers beginning to think about this the right way. See, for instance, Treasury senior advisor Mike Stegman’s speech in New York a few weeks back.