Why we need GSEs: The Multifamily Finance Market and Affordable Housing
By Saul McDonald
NAREIM Fellow, University of Wisconsin-Madison MBA’15
Twice a year, NAREIM invites graduate students from the top real estate programs across the country to attend our Executive Officers’ Meetings as Fellows. After attending the September EO Meeting, Saul McDonald, a 2nd year MBA student at the University of Wisconsin-Madison’s, James A. Graaskamp Center for Real Estate found he had something to contribute to the GSE debate. His article considers the importance of Fannie Mae and Freddie Mac maintaining their mandate to support affordable housing.
Fannie Mae & Freddie Mac (Government Sponsored Entities or GSEs) are needed within the multifamily capital markets. GSEs provide the liquidity and stability to capital markets which support affordable housing. I will present my thesis by first giving the reader a brief history of the GSEs, then dispel some ubiquitous misconceptions of the GSEs followed by facts that support why the GSEs are relevant. Lastly, I will wrap up the article by giving insight into potential GSE reform and discuss its potential effect on affordable rental housing.
Clarification of Terminology
Before moving forward I must clarify what I mean when I use the term affordable housing. For the purposes of this paper I will define affordable housing as determined by the Federal Housing Finance Agency (FHFA), which sets the housing goals for the GSEs. Affordable housing under the GSE’s housing goals are defined as follows: 1) Units affordable to low-income families (income no greater than 80 percent of area median income) 2) Units affordable to very low-income families (income no greater than 50 percent of area median income).
Birth of GSEs
The GSEs were birthed out of the Great Depression as a response to the national housing crisis. Fundamental issues within the nation’s housing finance market was magnified during the great depression and by 1933, “the government estimated that 20% to 25% of the nation’s home mortgage debt was in default.”[i] To remedy this issue a component of President Roosevelt’s New Deal Policy was the National Housing Act was passed in 1934. The Housing Act was created to provide stability, liquidity, and affordability to the nation’s mortgage market. Subsequent amendments to the National Housing Act created the GSEs who in addition to the single family housing mortgage market, also provided support to the multifamily mortgage market from their initial beginnings. Because of the dire impetus to the creation of the GSEs, what we have are entities whose main purpose is to support affordable housing. This fact can be seen in the GSE’s ability to exceed their housing goals and I truly believe that the GSEs have not strayed away from their purpose, especially within multifamily, and will provide evidence to support this claim later in the article.
I recently had a job interview with a prominent Life Company. Because of my background as a GSE underwriter I was asked the question if I thought the GSEs were relevant. I must add that this question was preface by a story of how frustrated the lender was at losing deals, Class A – Core Market, to the GSEs because of their lower pricing. That question, which is valid, could be rephrased as follows, “What value are the GSEs adding by financing an asset that 10 other capital sources would love to finance?”. I answered that question by saying that the GSEs are relevant because the majority of what they finance, approximately 90 percent, is the Class B/C assets which are affordable and lie outside of your risk spectrum. The problem that most other sources of capital have with the GSEs stems from assessing them from a very narrow point of view that only takes into consideration how their business is affected by the GSEs without reflecting on the benefits they provide to the greater society. A holistic view of the GSEs reveals that the 10 percent of Class-A assets they finance pales in comparison to the 90 percent of affordable housing loans they purchase. See Exhibit-A[ii] which shows a breakdown of amount affordable units Freddie Mac supports by purchasing acquisition loans.
Another misconception that people have with the GSEs is that they use their government guarantee to misprice risk. This claim is difficult to argue because how do we know that lenders without a government guarantee are correctly pricing risk? As the previous recession taught us free markets make mistakes as well. Therefore, to my knowledge, the only metric to analyze if risk is mispriced within the debt markets is frequency of default. Here’s where the argument that the GSEs misprice risk breaks down. Looking at the major competitors (banks and CMBS lenders), they historically have higher mortgage delinquency rates. See Exhibit-B[i] below, which compares the mortgage delinquency rates of multifamily capital sources. Therefore, from the standpoint of default delinquency, if the GSEs are mispricing risk, their still getting it right more often than other sources of capital. As you will see from Exhibit-B the only capital source that delinquency rates as low as the GSEs are life companies (ACLI), which invest solely in safer Class-A properties.
The last misconception I would like to dispel stems from the GSE’s implied government guarantee, which leads people to believe that the American Tax Payer has to front the cost of GSE multifamily mortgage defaults. This is completely untrue because the GSEs have mechanisms in place to ensure that private capital absorbs any losses from events of default. At Fannie Mae their delegated loan originators are required to participate in loss-sharing with Fannie. The loss-sharing participation can be structured as follows,
“This can range from the lender bearing a first loss share to no loss. A typical arrangement is one where the lender bears one-third of losses, with Fannie Mae responsible for the remaining two-thirds. In addition, the lender may be required to bear the entire loss, upon default, if Fannie Mae determines there was a breach of lender representations or warranties.”[i]
Freddie Mac on the other hand has a securitization platform know as K-deal in which multifamily loans are purchased by Freddie Mac then are pooled and placed into two type of bond securities called guaranteed senior bonds and unguaranteed bonds known as subordinate and mezzanine bonds. Default risk is handled as follows,
“Should credit losses materialize, those losses are initially borne by the private investors who have purchased the subordinate bond. That is called a “first-loss position” or a “B-piece” and in our K-Deals it typically represents the first 7.5 percent of the mortgage pool. In the unlikely event that losses were to exceed this level, losses would then be absorbed by yet a second layer, the mezzanine bonds, which represent another five to 10 percent of the mortgage pool.”[ii]
Therefore, under Freddie’s K-deal platform at least 17.5% of a mortgage pool would have to default before guaranteed senior bonds are affected. “Furthermore, Freddie Mac has not realized any credit losses on our K-Deal guarantees as of June 30, 2014.”[iii]
Why we need the GSEs
An efficient, smoothly functioning finance system is needed to insure the viability of the apartment building market and the multifamily industry. In normal times, multiple sources provide fresh credit to the multifamily market and industry. During this period of extreme distress, however, only federal sources are active in the multifamily finance market.[iv]
– Harvard Joint Center for Housing Studies, circa 2009
To ensure that multifamily housing, especially affordable housing, is adequately supported we need liquidity even when the credit markets are not operating properly. It is the liquidity that the GSEs provide during the troubled economic times that provides stability to the multifamily capital markets and subsequently affordable housing. However, we forget this fact when the credit markets are running smoothly. The Harvard Joint Center for Housing Studies iterated this need in 2009 during the height of the Great Recession.
Currently there is a strong appetite for multifamily on part of lenders (all types, GSEs, Life Companies, Pension Funds, Banks, Debt Funds, foreign investors, particularly from Canada and China). Lenders are comfortable with current and future multi-family demographics and fundamentals. These fundamentals include rent growth, job growth, reduction of homeownership, the baby boomer generation renting in urban hubs, a release in pent up demand from recent graduates finding work and moving out of home and favorable risk adjusted returns. The current conditions within the multifamily credit market is similar to prerecession conditions, flushed with capital. It is during the times of healthy capital markets that the relevance of the GSEs come into question.
The answer to the question of the GSE’s relevance can be found at the height of the recession in 2009. By 2009 the majority of conduit (CMBS) lenders went of business, banks stopped lending or went out of business entirely, and life companies also pulled back; however, life companies only finance Class-A properties so they do not provide support to the Class B/C properties that is of concern in this paper. Within this illiquid capital market the GSEs acted as a safety net and provided liquidity. This can be seen in the GSEs shift of market share from 27% in 2005 to 85% in 2009, Exhibit-C[i] outlines this market shift. The GSE’s market share rises during times of troubled capital markets and falls during normally functioning markets, which can also be seen in Exhibit-C. Although the GSE’s market share is currently on the decline, we should not solely look at a snap shot in time but the entire cycle of the multifamily credit markets to remind ourselves of the importance of the GSEs.
Future of the GSEs
Although most real estate professionals are confident that the GSEs will be reformed in some manner, they are spilt the timing of reformation. This is because there are many political hurdles to overcome before change/reform can be enacted. First and foremost, there is no consensus in Congress. This fact is unlikely to change until after the 2014 Midterm elections, and perhaps meaningful change will probably not occur until after 2016’s Presidential election. This is because partisan politics within Congress have created an environment that favors rhetoric over action and have shined a spotlight firmly on hot-button issues such as the Affordable Care Act. That being said, below I have outlined on what reform would look like under the Johnson-Crapo Bill.
- “Federal Mortgage Insurance Corporation (FMIC) would replace Fannie and Freddie as the guarantor and regulator of a new system. The FMIC, patterned after the Federal Deposit Insurance Corporation, would be explicitly backed by the full faith and credit of the United States.”[i] The GSEs will “spin off” into private entities which will be governed by the FMIC. Fannie & Freddie will then have the capability to originate loans that have government guarantees backed by the FMIC.
- The FMIC will also designate which private entities will have ability to issue mortgages that have government guarantees. In order to qualify for the government guarantee lenders must take a 10 percent first loss position.
- All loans originated with government guarantees will have 10 basis points priced into the rate which will act as a market based incentive to support affordable housing. Furthermore, in order for a lender to be able to originate loans with a government guarantee, 60 percent of the units they finance must be affordable to families between 60-80 percent of AMI. Within the changes to the treatment to affordable housing is the repealing of the GSE housing goals.
In regards to multifamily, the proposed changes to the GSEs are only a change in structure; the system they regulate will not change much after reform. The roles of the GSEs will be overtaken by the FMIC, and the GSEs will be repositioned to function similarly to the private lender entities from which they currently purchase mortgages. I believe this is a testament to how well the GSEs have functioned within the multifamily capital markets.
There is one change that I’m not too keen on and that’s the repeal of the housing goals. Although, lenders will be required that 60 percent of what they finance is affordable units and a market based pricing incentive will be put into place, I firmly believe that if it’s not broke don’t fix it. As you can see from Exhibit-D[i] that the GSEs have been very successful at meeting their housing goals. Furthermore, under a conceptual stress test I ask the following question: In 2009, would the 60 percent affordable unit requirement and market based incentive been strong enough to rescue the multifamily capital markets? I’m not sure it would have been. In 2009, the GSEs stepped up because supporting affordable multifamily housing was first priority for both companies, which I believe is stronger than having affordable housings goals being a byproduct of business operations.
What I really want the reader to take away from this article is that when assessing the relevance of the GSEs (multifamily solely) your analysis must be holistic and extend the length of a real estate market cycle. When you conduct your analysis in such a way you will discover that the GSEs not only help to support affordable housing, but also provide stability and liquidity to the multifamily housing markets. I’m not claiming that the GSEs are perfect, I’m however saying that the benefits they contribute to society is greater than what people initially perceive.
[ii] http://www.freddiemac.com/multifamily/pdf/mf_securitization_investor-presentation.pdf← NAREIM Dialogues now Available for iPhone Curious about Real Estate Crowdfunding, but too Nervous to Invest? →