Q&A with Jim Lockhart [Mortgage Banking]

The former director of the Federal Housing Finance Agency talks about lawsuits against private-label issuers, finding a new CEO for Freddie and recent changes to the Home Affordable Refinance Program.

James B. Lockhart III, vice chairman of WL Ross & Co. LLC, New York, served as director of the Federal Housing Finance Agency (FHFA) at the time the federal government decided to place Fannie Mae and Freddie Mac in conservatorship in September 2008. His tenure as FHFA director spanned the two years leading up to the conservatorship decision. * Prior to FHFA, Lockhart headed the predecessor agency, the Office of Federal Housing Enterprise Oversight (OFHEO), whose duties were assumed by FHFA after legislation was passed in 2008 to give federal authorities the power to place Fannie and Freddie into conservatorship and fund any shortfalls. Lockhart had urged Congress since his arrival at OFHEO to pass reforms that would improve the safety and soundness of the government-sponsored enterprises (GSEs) and strengthen regulatory oversight of the two. * From 2002 to 2006, Lockhart was deputy commissioner and chief operating officer of the Social Security Administration, where he promoted the Bush administration's Social Security reforms. He succeeded in getting the Supplemental Security Income (SSI) program, the nation's largest cash-assistance welfare program, removed from the high-risk list of the U.S. Government Accountability Office (GAO). * Lockhart also served as executive director of the Pension Benefit Guaranty Corporation (PBGC) under President George H.W. Bush. When he headed the PBGC, it faced major airline and steel company bankruptcies. * In 1997 Lockhart co-founded Greenwich, Connecticut-based NetRisk Inc., a risk-management software and consulting firm. He also earlier served as senior vice president of finance at National Reinsurance Corporation and managing director at Smith Barney's Investment Banking group.

Lockhart holds a master of business administration degree from Harvard University and a bachelor's degree from Yale University. An honors graduate of the Navy Supply Corps School, he served as supply officer on the nuclear-powered ballistic-missile submarine USS George Washington Carver, whose home port was in Holy Loch, Scotland.

Mortgage Banking caught up with Lockhart at WL Ross in New York recently to ask him about developments affecting the FHFA and Fannie Mae and Freddie Mac, as well as the state of the mortgage industry.

Q: As you know, the FHFA is suing 18 big banks, claiming they misled Fannie Mae and Freddie Mac on the risk involved in mortgages in private-label mortgage-backed securities iMBSj. What do you think of the decision by FHFA to file this lawsuit?

A: Obviously, Fannie and Freddie were the biggest buyers of those securities and the Federal Home Loan Banks, for that matter, were the third-biggest buyers. Certainly a lot of those securities were extremely poorly underwritten to begin with and some of the packaging was very sloppy. I don't know enough about the case to know the merits. Certainly, it sounds like in the case of some securities, the disclosure was not adequate.

On the other hand, people have argued that Fannie and Freddie were pretty sophisticated buyers. So, my view is that I don't know enough about the underlying securities to know whether or not there was fraud and whether or not Fannie and Freddie were duped.

Q: Should FHFA have played a stronger role in advocating against the holding of private-label MBS by the GSEs, given it was entirely a discretionary matter and by loading up on them, they were increasing systemic risk should one of them fail?

A: Well, actually right after I became director of OFHEO, we froze their portfolios so that they couldn't increase their exposure to any more private-label securities. Even before I arrived, words were had with both [Fannie and Freddie] about their increasing rapidly their investment in the private-label securities.

One of the key issues is that the Department of Housing and Urban Development [HUD] was giving credit for the underlying mortgages in those securities toward meeting affordable-housing goals. Freddie Mac used [the purchase of private-label securities] quite aggressively to meet [its] affordable-housing goals, and neither of them would have come close to meeting their goals without those private-label securities.

And, as you know, it was HUD that set the affordablehousing goals. In a way, to meet those goals they felt that they had to buy the securities and I think they felt that buying a triple-? security was safer than buying the mortgage itself. As it turned out, that's right. Buying the underlying mortgages would have been a disaster, but even then, the securities were not that great.

Q: Shouldn't Fannie and Freddie have known better than perhaps anyone about the risk of the mortgages in the private sector, since they have extensive loan performance and loan characteristic data and they were offering some of the same mortgage products?

A: Certainly Fannie and Freddie were extremely knowledgeable about mortgages and certainly they had the data tapes for these mortgages because they went into them to figure out if they were affordable mortgages. They had to know where the mortgage was, what the income was of the individual. So, they did have data there.

Now, one defense would be - and I'm not trying to defend them - no one saw how big a hit housing prices were going to take and if they had modeled that kind of fall, ja] 30 percent fall in housing prices, I think a lot people would not have bought any of these securities. 1 think the other thing is the way they were tranched - they were taking less risk than the lower tranches were. I think certainly it can be said that overall that they had as much knowledge about mortgages as anybody did out there, although probably historically they had not done a lot in the subprime space. Maybe 15 [percent or] 10 percent of their portfolio was subprime.

Q: Does FHFA s lawsuit delay the recovery of the private-label market and, in that sense, seem counterproductive to the goal of conservatorship for the GSEs and the goal of winding down Fannie and Freddie?

A: The private-label mortgage-backed securities market is going to have to be reborn. It's not going to be based on the kind of securities that were issued in the past. And what will cause the rebirth or the restart is a new, clean set of rules. The American Securitization Forum's Project RESTART is seeking to do that. And then you are going to have to slowly but surely price mortgages so they can be sold in the private sector rather than to Fannie and Freddie. The lawsuit, Í don't think, will hurt the recovery in the market. We actually are a manager of a PPIP [Public-Private Investment Program] fund, which invests in formerly triple-? private-label MBS. It's a joint investment with [Atlantabased] Invesco [Ltd.]. I think we have perhaps the best performance, if you look at the most recent quarterly report. In my sense, that market - at least on the higher-quality end - is reflecting reality at the moment. So, I don't think FHFA's lawsuit will impact that market significantly.

Q: Does FHFA's lawsuit threaten the economic recovery, as Vice President of Equity Research Dick Bove of Rochdale Securities has suggested?

A: The lawsuit?

Q: Yes. If FHFA wins the lawsuit, the thinking is that this will be a huge hit potentially to these banks and the banks could not play a role in lending to help the recovery or rebuild their capital base.

A: Well, I think you can certainly argue if |FHFA) wins, it will have a negative impact on banks, yes. These lawsuits take so long that hopefully we will be recovered by then. On the other hand, one can make an argument that certainly for the future it may help make sure there is better discipline amongst the underwriters.

Q: What do you think of the new changes to the Home Affordable Refinance Program [HARP] that removed the 225 percent loan-to-value [LTV] cap on 30-year fixed-rate refinancings? Is the goal to get people to refi to a shorter term? If people refi to 15 years under this program, it could certainly help households more quickly bring their mortgage balances down to the current market value of their home.

A: I'm certainly a believer in HARP, because J was one of the co-creators. I was one who put in the 125 percent loan-to-value limit. First, we put in a 105 percent limit and then we raised it to 125. I think it was a step in the right direction. I certainly have been calling for the liberalization of the 125 |LTV]. Also, the reps [representations] and warranties are a key issue. It's important that now the originators of these loans don't have to rep and warranty them because Freddie and Fannie already have the risk. The other thing is lowering the fees - I think that will be important. I think it's definitely a step in the right direction. I saw a figure that there is something like 8 million underwater mortgages that are current. And if we can encourage these people to stay current by reducing their fees and reducing their monthly payments, I think it's a great idea.

Q: In time, even if home prices never go back up very much, households can pay down the balance to the value of the home or less.

A: Yes. And the problem will be what they can afford. Some people are just barely surviving now, although they are current and they might not be able to take a shorter mortgage potentially with a higher payment. It will depend on individual circumstances.

Q: Freddie Mac Chief Executive Officer iCEO] Ed Haldeman announced he is going to be stepping down once Freddie can recruit a replacement CEO. How difficult will it be to recruit someone in the interim while Freddie is still in limbo in its conservatorship state? Where would you look for a replacement? What key skills are needed? And who do think will be weighing in on the choice?

A: First of all, Í think Ed has done a very good job. I did appoint him after [former Freddie Mac CEO] David Moffett left [in 2009]. It's a tough job. There's no doubt about it. Obviously you have to have a lot of financial skills, [andj knowing the housing market and mortgages is very helpful. Being a very good manager is important also, given the spotlight on Fannie and Freddie and the morale issues there. (It's important that the new CEO bej someone who can be respected by the troops, be a leader and help point to the future. It will be tough because the future is so uncertain for Freddie. The other thing that's probably important is to have a public-service gene so that Congress knows that you are there to help the American economy and help the housing market.

Q: Both Fannie and Freddie, as well as the FHFA, oppose principal reduction in their modifications, while in the private sector some lenders have done principal reductions with portfolio loans. Do you believe the policy of no principal reduction at the GSEs is correct and, if so, why?

A: I must admit that in 2007 1 was talking with Fannie and Freddie about doing principal reductions. I certainly approached the idea in 2008 with [Fannie CEO Daniel] Mudd and [Freddie CEO Richard) Syron, but I didn't get very far with them. In some cases, principal reductions malee sense. And principal reduction is one of the things we've been talking about at WL Ross, and this is outside Fannie and Freddie in private-label securities.

I have one chart that I use in some of my speeches that shows that about 9 percent of mortgages are now in private-label mortgage securitizations [PLS] and about 56 percent are in Fannie and Freddie - owned by or in securitizations by them. But [mortgages in privatelabel securitizations] have 27 percent of seriously delinquent mortgages - way out of proportion to their share of the mortgage market. With six times the amount of mortgages, the enterprises have the same 27 percent [of] serious delinquencies. We need to think in some cases about ways to have principal reductions in PLS, especially if there is shared appreciation [when the house is sold and there is a recovery in the value of the house].

We've talked for many years about giving some shared appreciation after there is a principal reduction. I think that's a good idea. In securities there is often pooling and servicing agreements that make it hard to do principal reductions. One of the things we suggested is to have Treasury encourage mortgage servicers to sell the mortgages at a discount and then let the new buyers rework the mortgages and do principal reductions.

Q: So, those restrictions in pooling and servicing agreements would not apply because the securities have been sold?

A: Yes. Our view is that under HAMP (the Home Affordable Modification Program], Treasury would have the authority to encourage servicers to do that and maybe pay a small fee for that. One of the problems is that many of the servicers are so overwhelmed that they are not really working the mortgages as aggressively as they should. Certainly our view is that if they sold at a discount to an investor aligned with a special servicer, we could help keep more people in their houses.

Q: If is certainly the view of the handful of banks that ended up holding all those option adjustable-rate mortgages ioption ARMs] in portfolio that principal reductions can reduce overall losses for the bank and keep people in homes at the same time. It seems to be working.

A: There is a legitimate argument on the other side - the moral hazard. But I believe that you have got to be careful about principal reductions and do it in a way that you don't encourage people to default on their mortgages. But there is certainly a class of underwater mortgage homeowners that principal reductions would help, and I think that would help stabilize the market.

Q: What do you make of New York Attorney General Eric Schneiderman's rejection of a nationwide (attorneys generalj settlement with big banks against lawsuits brought by the states claiming misconduct in the mortgage servicing market?

A: You know, it's very, very hard to get all 50 states' attorneys general to agree on most anything. I'm not surprised, as he feels he has more powers than some of the others. It's tough. The robo-signing thing is a year old and we still haven't settled it. That's just one of the many uncertainties in the market that is making it hard to muddle our way through. The suit by the FHFA is another uncertainty. The Consumer Financial Protection Bureau is another uncertainty. And there are all the [future regulations] from Dodd-Frank [Wall Street Reform and Consumer Protection Act] floating around. It's hard to restore confidence in this market when there is so much uncertainty out there. So, you have a variety of people refraining from buying houses as a result.

Q: Do you think the FHFA has neglected its conservatorship mandate to ensure that the GSEs help stabilize the housing market? Or are those goals really in conflict?

A: I think both goals are very important. Fannie and Freddie were created to provide liquidity and stability in the mortgage market, and affordability. Just because they are in conservatorship, I don't think that mission should be ignored. You have to balance both of them. In my view, as they own or guarantee 56 percent of the mortgages in this country, providing stability and liquidity in the mortgage market will help them and their finances as well.

Q: It will help the mortgage market overall and also help the GSEs?

A: Right. Maybe in some cases, maybe there could be a short-term hit, [but] in the long run they will be better off the sooner we can get the market stabilized and turned around.

Q: The FHFA has lowered its estimate of the maximum amount Fannie Mae and Freddie Mac may ultimately require from Treasury, from $363 billion to $311 billion. This may mean that in the worst-case scenario - a double-dip, for example - the two GSEs need to drawn down another $142 billion on top of the $i6q billion they have already drawn from Treasury under their senior preferred stock purchase agreements. Subtracting dividends paid, the GSEs would need another $142 billion. FHFA lowered the maximum exposure because the GSEs are doing better financially.

A: I think, certainly, if we have a real double-dip, that could be a realistic number. Without a double^dip, I see the impact closer to the lower end of the range.

Q: 5 The New York Times has reported that a Securities and Exchange Commission [SEC[ settlement with Fannie and Freddie is near over charges that the GSEs failed to adequately disclose their risky exposure to subprime loans. Reportedly the settlement will involve no admission of fraud, but it could lead to a recognition that the GSEs played a central role in the housing boom and bust.

A: The whole definition of what [constitutes] a subprime mortgage is always a troublesome thing, because no one really had a good definition in those days. Fannie and Freddie used to say it was subprime if the loan was originated by a subprime mortgage originator. So, they would take what other people would call a subprime mortgage, but if it came from a prime originator, they wouldn't classify it as subprime. But on the other hand, they did disclose loans originated within certain credit-score ranges.

Q: Didn't that disclosure come after they were placed into conservatorship in 2008?

A: One definition of subprime is any loan where the borrower had a FICO® score of 660 and below. I did a chart that looked at Fannie's 660s and below and I went back to 2000, and during all that time they reported it.

Q: Is that where you get your 15 percent estimate of the share of subprime done by the GSEs?

A: Actually it was 16 percent to 18 percent. I looked at the numbers when I was testifying before the Financial Crisis Inquiry Commission iFCIC] about a year and a half ago. It's in their public financiáis. You can go back and see the numbers.

Q: Was this released after 2008 or before in the GSEs' quarterly earnings reports?

A: During that whole period, 2000 to 2008 and after, the GSEs were releasing their FICO scores. And it was actually relatively flat during that whole period of the 2000S in terms of mortgages they bought or guaranteed.

Q: So, the fact they did not call them subprime, they would argue [that was] semantics because they were revealing the actual FICO scores so people could go and see for themselves what loans were being made that could be classified as subprime.

A: Yes. They did make statements, like only 5 percent of their loans were from subprime originators.

Q: Sometimes . . . they would say they made no subprime or less than 1 percent.

A: Yes.

Q: They would often say there was more or less no subprime in their book of business.

A: But then they were saying from subprime originators. It may have been playing with words, but there was no standard definition of subprime.

Q: That, of course, is what the SEC is trying to get at.

A: I don't know where they will end up on that. But it's interesting that they might be close to a settlement.

Q: Reportedly the criminal investigations against four individuals came to an end, and so far no charges have been filed. ...If, in the end, the SEC does not manage to [win admissions from anyone that] they engaged in fraud, will this not be [seen as] yet another example of top financial executives earning huge bonuses and compensation and yet escaping any consequence for alleged wrongdoing that might have occurred on their watch? Won't this look bad to the American public?

A: Yes, probably. We [at FHFA] cut off their bonuses when they left and did not give them any severance pay - unlike many other executives that left under clouds. 1 really don't want to get at who was culpable on this whole thing. Certainly Fannie and Freddie took excessive risk. So did a lot of other companies, unfortunately. We were in a bubble economy.

Q: Of course, taking excessive risk does not necessarily mean you engaged in fraud.

A: Right. Freddie finished its registration with the SEC through this period in June of 2008. They put out their first timely filing of an SEC quarterly report in the second quarter of 2008. Those were passed by the SEC.

Q: The SEC then appears to have given its blessing to what they were doing in terms of reported earnings.

A: It seems to me so. At any rate, it's hard to say how the American people are going to react. Fannie and Freddie have been demonized. There's no doubt about it. For many years they served a great purpose and [they] are the main support of the housing market today. I think they were forced to take more credit risk than they should have taken. That was partially because of the affordable-housing goals. But it was also partially because management wanted to keep their market share up and keep their profits up. MB

"The private-label mortgage-backed securities market is going to have to be reborn."

"It's hard to restore confidence in this market when there is so much uncertainty out there."

"Certainly Fannie and Freddie took excessive risk. So did a lot of other companies, unfortunately. We were in a bubble economy."

Robert Stowe England is a freelance writer based in Arlington. Virginia, and author of Black Box Casino: How Walt Street's Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon. com. He can be reached at [email protected].