[Senate Hearing 113-145]
[From the U.S. Government Printing Office]


                                                        S. Hrg. 113-145

 
  HOUSING FINANCE REFORM: FUNDAMENTALS OF A FUNCTIONING PRIVATE LABEL 
                   MORTGAGE-BACKED SECURITIES MARKET
=======================================================================


                                HEARING

                               before the

                              COMMITTEE ON

                   BANKING,HOUSING,AND URBAN AFFAIRS

                          UNITED STATES SENATE

                    ONE HUNDRED THIRTEENTH CONGRESS

                             FIRST SESSION

                                   ON

 EXPLORING THE STATUS OF THE PRIVATE LABEL MORTGAGE BACKED SECURITIES 
               MARKET SINCE THE FINANCIAL CRISIS OF 2008

                               __________

                            OCTOBER 1, 2013

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


                 Available at: http: //www.fdsys.gov /




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York         RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon                 MARK KIRK, Illinois
KAY HAGAN, North Carolina            JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia       TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts      DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota

                       Charles Yi, Staff Director

                Gregg Richard, Republican Staff Director

                  Laura Swanson, Deputy Staff Director

              Erin Barry Fuher, Professional Staff Member

                      Elisha Tuku, Senior Counsel

                 Riker Vermilye, Legislative Assistant

                  Greg Dean, Republican Chief Counsel

            Chad Davis, Republican Professional Staff Member

                Hope Jarkowski, Republican SEC Detailee

                       Dawn Ratliff, Chief Clerk

                      Kelly Wismer, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                        TUESDAY, OCTOBER 1, 2013

                                                                   Page

Opening statement of Chairman Johnson............................     1

Opening statements, comments, or prepared statements of:
    Senator Crapo................................................     2

                               WITNESSES

Martin S. Hughes, Chief Executive Officer, Redwood Trust, Inc....     4
    Prepared statement...........................................    29
    Responses to written questions of:
        Senator Kirk.............................................    62
        Senator Coburn...........................................    63
John Gidman, President, Association of Institutional Investors...     5
    Prepared statement...........................................    34
    Responses to written questions of:
        Chairman Johnson.........................................    65
        Senator Kirk.............................................    65
        Senator Coburn...........................................    69
Adam J. Levitin, Professor of Law, Georgetown University Law 
  Center.........................................................     7
    Prepared statement...........................................    40
    Responses to written questions of:
        Chairman Johnson.........................................    71
        Senator Kirk.............................................    72

                                 (iii)


  HOUSING FINANCE REFORM: FUNDAMENTALS OF A FUNCTIONING PRIVATE LABEL 
                   MORTGAGE-BACKED SECURITIES MARKET

                              ----------                              


                        TUESDAY, OCTOBER 1, 2013

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Tim Johnson, Chairman of the 
Committee, presiding.

           OPENING STATEMENT OF CHAIRMAN TIM JOHNSON

    Chairman Johnson. Good morning. I call this hearing to 
order.
    Today we meet to examine the private label mortgage-backed 
securities market, the barriers that exist in the current 
market that prevent private capital from reentering, and how 
this market fits into any housing finance reform effort.
    At the height of the housing boom, private capital 
represented more than 50 percent of the mortgage market. Today 
it is closer to 5 percent. While Government-backed loans 
represent 95 percent of the current market, the volume of 
Government-backed loans has not changed that much. What has 
changed is a major reduction in volume by the private market.
    I think we can all agree that the private market should 
play a more substantial role in our housing finance system than 
it is currently. That said, we must be certain that any new 
system we design will actually attract private capital.
    For securitization to work well, especially in the PLS 
market, the underlying loans must be well underwritten and 
there should be greater transparency. The Wall Street Reform 
Act includes key reforms, such as QM, QRM, and disclosure 
requirements, that will help prevent another crisis caused by 
high-risk loans that were bundled and sold to investors. Final 
rules, along with higher guarantee fees, will provide strong 
incentives for the private market to return.
    Additionally, the recent crisis showed us weaknesses in the 
current loss mitigation and foreclosure process. We should look 
at ways to eliminate barriers to reasonable loss mitigation 
efforts that are ultimately in the borrowers' and investors' 
interest.
    With any reform, we must create the necessary conditions to 
bring private investors into this market while at the same time 
sustaining structures like the To-Be-Announced market. The TBA 
market is a key component to ensure access, affordability, and 
liquidity for borrowers and investors, and it allows for the 
existence of the 30-year mortgage, important to millions of 
Americans. We will have future hearings on these issues, but if 
private capital were to take any first-loss position ahead of a 
future Government-guaranteed security, we must make sure it is 
compatible with the TBA market.
    These are extremely complex issues, and there are no easy 
answers. That is why we are exploring the role of private 
capital early in our series of in-depth housing finance reform 
hearings this fall. We must get this part right. As we have 
learned, private capital may not always participate in all 
segments of the housing finance market under all economic 
conditions. Any steps this Committee takes to refocus and 
redefine the Government's role and improve the securitization 
process in the housing finance system must foster stable 
private capital flows, provide access to smaller lenders, and 
not price the middle class out of affordable mortgage products.
    Clearly, we have our work cut out for us, and I look 
forward to this morning's discussion.
    Senator Crapo, do you have any opening statement?

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Yes, and thank you, Mr. Chairman.
    We have just passed the 5-year anniversary of the 
conservatorship of Fannie Mae and Freddie Mac, and now the 
Federal Housing Administration has announced that it will 
require a nearly $2 billion draw from the Treasury, almost 
double the amount that was projected in the President's 2014 
budget. This announcement highlights the reality that we must 
act now to reform the Government-sponsored enterprises and the 
larger housing market.
    As we noted during our last hearing, the Committee will 
examine individual components of our housing finance system 
through a series of hearings intended to produce bipartisan 
agreement by the end of the year.
    Today we take a more in-depth look at our first issue as we 
hear from witnesses on the private label securitization market. 
This being one of the first topics we discuss should indicate 
just how important a vibrant, well-functioning private 
mortgage-backed securities market is to our housing finance 
system.
    Unfortunately, today's private label market is a tiny 
fraction of what it was prior to the financial crisis. The 
Federal Housing and Finance Authority's latest conservators' 
report showed that the Federal Government, through Fannie, 
Freddie, and Ginnie Mae, backed nearly 100 percent of the 
mortgage-backed securities that were issued in 2012 and the 
first quarter of 2013.
    It is clear that private capital is on the sidelines and 
that the Government needs to reduce its footprint. Our goal 
should be to identify what particular challenges face the 
private mortgage-backed securities market, be they regulatory, 
legal, or structural hurdles. To that end, this hearing gives 
us an opportunity to learn why private capital is sidelined in 
our mortgage market and what needs to be done to bring the mix 
of the private sector and the Government into an appropriate 
balance.
    We have seen some experimentation in the private label 
market this year, but it is too early to tell what momentum 
will flow from those deals. I welcome the recommendations our 
witnesses have to bring back private capital into this critical 
segment of our economy while protecting the U.S. taxpayer from 
a future bailout scenario.
    In particular, I am interested to hear your views on 
whether the private label inactivity is rooted in a lack of 
confidence in the transparency, in risk mitigation, and 
alignment of interests in the mortgage chain. Could a lack of 
confidence in the private label space drive investors to 
overvalue the Federal support afforded through GSEs by 
comparison? What commonsense reforms can we put in place to 
restore investor confidence?
    I have heard that a lack of standardized documentation for 
securities issuance and process for the review of mortgages 
within securitized pools is a reason why investors are hesitant 
to reenter the private label market. What reforms are necessary 
to achieve adequate uniformity? What kind of progress has there 
been for private label market participants to come to 
administration on standards for issuance of review of 
mortgages, including representations and warranties or other 
issues?
    I have heard that the question of eminent domain has 
created a lot of uncertainty with respect to investors' 
willingness to enter the private label market. What are the 
impacts that you see in the private label space from these 
eminent domain policies? I would also like to hear our 
witnesses' views on what they anticipate the private label 
market will look like in the future.
    I hope that as we proceed with these reforms we will build 
upon the momentum that has recently been generated on both 
sides of the Capitol and the White House.
    Time is of essence, and the GSEs continue in an 
unsustainable conservatorship, and the FHA's financial 
condition continues to deteriorate. Chairman Johnson and I 
moved the FHA solvency bill out of Committee earlier this year, 
and it is time for us to engage on broader reforms. And I want 
to take this opportunity to thank the Chairman for his eager 
willingness to work with us to build a bipartisan solution and 
to move forward expeditiously.
    I remain strongly committed to working with the Chairman 
and all of my colleagues toward a bipartisan solution and a 
process to fix these difficulties soon.
    Thank you, Mr. Chairman.
    Chairman Johnson. Thank you, Senator Crapo.
    Are there any other Members who would like to give brief 
opening statements?
    [No response.]
    Chairman Johnson. I would like to remind my colleagues that 
the record will be open for the next 7 days for additional 
statements and other materials. Before we begin, I would like 
to introduce our witnesses.
    Mr. Martin Hughes is the chief executive officer and member 
of the board of directors of Redwood Trust, Inc.
    Mr. John Gidman is an executive vice president and chief 
information officer at Loomis, Sayles & Company. Mr. Gidman is 
also president of the Association of Institutional Investors.
    And, finally, Mr. Adam Levitin is a professor at the 
Georgetown University Law Center and is the Chair of the 
Mortgage Committee of the Consumer Financial Protection 
Bureau's Consumer Advisory Board.
    Mr. Hughes, you may proceed.

STATEMENT OF MARTIN S. HUGHES, CHIEF EXECUTIVE OFFICER, REDWOOD 
                          TRUST, INC.

    Mr. Hughes. Good morning, Chairman Johnson, Ranking Member 
Crapo, and Members of the Committee. I appreciate the 
opportunity to be here today. My testimony will focus on the 
current state of the private MBS market and actions that can be 
taken to fully accelerate its return.
    Redwood currently operates a prime jumbo loan conduit where 
we acquire mortgages from originators for pooling and sale 
primarily through our Sequoia private securitization platform.
    In addition, we recently received our seller/servicer 
licenses from Fannie Mae and Freddie Mac. This will enable us 
to work with the enterprises to find ways for Redwood to invest 
in the first loss credit risk and the loans we sell to the 
enterprises, thereby putting the enterprises in a second-loss 
credit position.
    The private sector of the U.S. secondary mortgage market 
consists of portfolio lenders who are primarily banks and 
private label issuers such as Redwood, although banks may be 
issuers as well. I firmly believe over the long term private 
label mortgage securitization will remain a very necessary and 
efficient form of mortgage financing.
    Many have speculated on why the private label MBS market is 
not fully flourishing today. There is no single answer to this 
question, and there are a variety of factors that must be 
considered. Some of these factors will be self-correcting over 
time while others will require structural or legislative 
change. I have specific changes to recommend, but I would first 
like to offer the following broad observations that explain the 
current state of the private market.
    First, as a result of the increase in the conforming loan 
limit, there are simply fewer jumbo loans being created today.
    Second, the enterprises have had a significant pricing 
advantage over the private MBS market. This advantage has been 
reduced somewhat as guarantee fees have been increased over the 
past 2 years.
    Third, and importantly, major banks, which were significant 
issuers of private MBS, have made a business decision to hold 
significantly more jumbo loans in portfolio rather than 
securitize them or sell the loans.
    Fourth, AAA investors still have questions of confidence in 
whether their rights and interests in the securities they 
purchase would be respected and, consequently, that their 
investments would be safe and secure.
    And, fifth, it is a Catch-22, and that is, in order to for 
the private label market to attract more investors, the asset 
class needs to be larger and more liquid. On the other hand, 
the private lable MBS asset class cannot achieve a larger 
liquid critical mass as long as it is too small for investors 
to justify allocating analytical and monetary resources to 
private label MBS.
    These issues are solvable. Market and Government policy 
makers can work together to fully restore the private label MBS 
market. The key to our success will require a primary focus on 
the needs of institutional investors that buy the senior 
classes of mortgage-backed securities. Simply put, these 
investors have the money, and without their participation, 
there is no market.
    Fortunately, addressing investors' concerns is not a 
complicated task. It requires better risk mitigation, 
transparency, and alignment of interests throughout the 
mortgage chain. We can achieve this by correcting the 
structural deficiencies and conflicts in securitization that 
became apparent in the wake of the financial crisis.
    My written testimony goes into more detail about the 
following recommendations: We must establish best practices for 
representations and warranties and other key securitization 
terms. We must establish binding arbitration as the minimum 
standard for dispute resolution of representation and warranty 
breaches. We must require that securitization trusts create the 
position of a credit risk manager. We must address servicer 
responsibilities and conflict of interest issues. We must also 
control the systematic and loan-level risk of second-lien 
mortgages by giving first-lien holders the ability to require 
their consent to a second lien if the combined loan-to-value 
with all other liens will exceed 80 percent. And we must reduce 
the Government's participation in the mortgage market by 
reducing the enterprises' conforming loan limits on a safe and 
measured pace.
    In conclusion, the U.S. mortgage market is a complex system 
with many parts and key participants. Each plays a supportive 
role in creating a highly liquid and efficient market. The 
private label MBS market will once again assume a major role, 
alongside the Government-supported sector, as the issues I have 
discussed begin to get resolved.
    Thank you, and thank you for being here on this important 
day.
    Chairman Johnson. Thank you.
    Mr. Gidman, please proceed.

      STATEMENT OF JOHN GIDMAN, PRESIDENT, ASSOCIATION OF 
                    INSTITUTIONAL INVESTORS

    Mr. Gidman. Thank you. Chairman Johnson, Ranking Member 
Crapo, and Members of the Committee, thank you for inviting me 
here today to testify regarding the fundamentals of a 
functioning private label mortgage-backed securities market.
    My name is John Gidman. I am an executive vice president of 
Loomis, Sayles & Company in Boston, Massachusetts, but I am 
testifying here today in my role as president of the 
Association of Institutional Investors. The association is an 
organization of some of the oldest and largest institutional 
investment advisers in the United States. All our firms have a 
fiduciary duty to put our clients' interests first. Put simply, 
it is not our money.
    Collectively, the association's members manage investments 
for more than 80,000 pension plans, 401(k)s, and mutual funds 
on behalf of more than 100 million American workers and 
retirees. Our clients include companies and labor unions, 
public and private pension plans, mutual funds, and families 
who rely on us to prudently manage their investments, in part 
due to the fiduciary duty we owe these organizations and 
families.
    We recognize the vital role housing finance markets play in 
our society. These markets have traditionally provided 
generations of families pathways to gain home ownership. For 
decades, this defined the American Dream. Much of this mortgage 
financing has ultimately been provided by our clients who 
relied on the strength and depth of these markets to provide 
them the income they needed for retirement.
    The PLS market has improved since the bottom of the 
financial crisis. However, the absolute volume remains a very 
small fraction of what it was before the crisis. And there is a 
vast gulf between the types of loans funded by the private 
label securitization market and those that are supported by the 
GSEs.
    Typically now PLS loans average approximately 66 percent 
loan-to-value and a 760 FICO score, with very few second liens 
and no mortgage insurance. Borrowers have 20 to 50 percent 
equity in the property, and the average home price of these 
mortgages is over $1 million. These high prices, combined with 
large downpayments and very high credit quality, have led to a 
situation where the current PLS standards cannot be used to 
finance mortgages for the majority of Americans.
    Institutional investors want to be able to invest in the 
full range of the mortgage sector on behalf of our clients. 
There is pent-up demand. However, as fiduciaries, we cannot 
increase our conviction in this market without meaningful 
structural reform. Therefore, we fully support Congress' 
efforts to reform the mortgage market. The recently introduced 
Housing Finance Reform and Taxpayer Protection Act has moved 
the debate in the right direction. The bill's risk-sharing 
mechanisms offer a promising solution that we believe could 
work if investors' concerns are addressed.
    The legislation also provides helpful language regarding 
issues like standardization of documentation and enforcing 
representations and warranties. The bill, however, does not 
address three fundamental investor concerns which we would like 
to touch on today.
    First, any mortgage market reform legislation should 
include, in our view, trustee fiduciary duties to oversee the 
maintenance of trusts and enforce put-back obligations for 
faulty loans with regulatory oversight and private causes of 
action for breaches. Situations like last year's AG mortgage 
servicing settlement, where trustees and servicers were able to 
sacrifice the assets of trust investors' pension plans in favor 
of their bottom line, underscore the need for these duties.
    Second, we believe the ability-to-repay rulemaking will 
lead institutional investors to avoid the PLS market. We agree 
with holding originators accountable for predatory lending by 
allowing defaulting borrowers to sue lenders for irresponsible 
lending. However, the rule includes assignee liability which we 
believe allows the borrower to sue any subsequent buyer of the 
loan, even if they were not the lender who made the bad loan in 
the first place.
    And, third, certain jurisdictions are considering 
implementing a program designed and aggressively marketed by a 
private fund. Under the program, the city would rent out its 
local eminent domain power to seize performing mortgages, held 
in interstate trusts, in order to restructure the mortgages at 
a profit for the fund's investors. If mortgage market reform 
does not address this scheme and eminent domain is used, we 
will have to weigh the possibility that all future mortgage 
contracts might not be upheld, and our clients could lose their 
value in those investments.
    As the Committee continues to consider housing finance 
reform, we hope these perspectives support your efforts. Each 
suggestion is intended to help rekindle a vibrant secondary 
mortgage market, accomplish your goal of reducing the 
Government footprint, and avoid adverse consequences that will 
ultimately affect the millions of Americans who rely on these 
markets to save for their families' needs.
    Thank you for your time today, and I look forward to 
answering your questions.
    Chairman Johnson. Thank you.
    Professor Levitin, you may proceed.

  STATEMENT OF ADAM J. LEVITIN, PROFESSOR OF LAW, GEORGETOWN 
                     UNIVERSITY LAW CENTER

    Mr. Levitin. Good morning, Mr. Chairman Johnson, Ranking 
Member Crapo, and Members of the Committee. Thank you for 
inviting me to testify this morning, and thank you for 
continuing today with your important work on housing finance 
reform.
    Housing finance is a huge market, some $11 trillion of debt 
outstanding, and it is vitally important to our economy as it 
affects things ranging from the home-building and home-
furnishing industries to the value of what is the single 
largest asset for many families.
    There is widespread recognition that reforms are needed in 
the housing finance market, and yet this is also an area in 
which reforms must proceed with caution as there are 
potentially serious consequences from getting it wrong. Rule 1 
in housing finance reform should be, ``Do no harm.''
    Now, there is reasonable disagreement on the details of 
reform, but the overwhelming evidence makes clear that we 
cannot rely on private label mortgage-backed securities, or 
PLS, to be the backbone of the housing finance system.
    PLS are mortgage-backed securities that lack any sort of 
Government or GSE guarantee whatsoever. I want to make clear 
that when I refer to PLS, I am not talking about what S.1217 
envisions for the FMIC guaranteeing with a 10-percent first-
loss piece.
    Historically, prior to 2004, PLS were a small part of the 
housing finance market, never accounting for more than 15 
percent of the financing in the market. Between 2004 and 2007, 
however, PLS provided the high octane rocket fuel that drove 
housing prices into the stratosphere before the bumpy reentry 
that we all know all too well.
    The PLS market has not rebounded. Indeed, it remains 
basically dead. There have only been around 17,000 mortgages 
that have been financed by the PLS market since 2008. That is 
fewer than the number of mortgages financed in the District of 
Columbia last year. And as Mr. Gidman laid out, these have been 
ultra, ultra prime mortgages.
    There are many reasons why the PLS market has not 
rebounded, but key among them is it has not solved many of its 
internal market structure and incentive problems relating to 
the roles of trustees, servicers, and enforcement of 
representations and warranties. And there are reforms, as I 
discuss in my written testimony, that can be undertaken to 
improve PLS.
    Ultimately, though, even an improved PLS market cannot 
change the fundamental math. By a very generous estimate, 
capital markets will be able to support no more than around 
$500 billion annually in mortgage credit risk. The U.S. housing 
finance market needs anywhere between $1.5 trillion and $4 
trillion in annual financing, depending on market conditions.
    Capital markets are insufficient to support the amount of 
credit risk needed to sustain the U.S. housing market. They can 
plan an ancillary role, but they are simply incapable of 
providing the foundation for the market.
    Instead, a discussion of how to rebuild the housing finance 
system needs to be based around some form of a hybrid public-
private structure with first-loss private capital sitting in 
front of a public guarantee.
    A rebuilt housing finance system also needs to have the 
capacity for the Federal Government to step into the breach as 
needed during countercyclical events when private capital flees 
from the market.
    And I would say there are really two salient lessons that 
we should have in mind from the recent financial crisis and how 
the housing market responded. The first is that when things 
started getting hairy in 2007 and 2008, private capital fled. 
But for the continued operations of the GSEs and FHA, the 
market would have entirely collapsed, and we would have been in 
another Great Depression.
    But there was a consequence from the Federal Government 
stepping into the breach, and that is the second lesson: that 
the Government is on the hook for the losses in the system, and 
herein lies the challenge, I think. There is a fine line to 
walk between needing to preserve the stability of the housing 
finance market, particularly in times of economic crisis, and 
that is something that only a Federal guarantee can really do 
credibly; but also wanting to avoid the problems that come from 
public allocation of capital, such as politicized underwriting 
and the socialization of losses.
    There are reasonable disagreements on how exactly to craft 
a solution to that, but I think it is going to have to take the 
form of some sort of hybrid public-private housing finance 
system. S.1217, the Corker-Warner bill, represents one possible 
template for doing so. Another possible template would be based 
on amending the charters for the existing GSEs and, among other 
things, requiring first-loss private capital on their MBS.
    I believe there is more work to be done on these proposals, 
but bills like S.1217 are moving in the right direction. I am 
happy to discuss the technical details of S.1217 and other 
proposals, but I would emphasize that it is important not to 
lose sight of the forest for the trees in housing finance 
reform. The structure of a housing finance market is a means 
toward housing policy, not an end in and of itself, and, 
therefore, it is critical that any redesigned system be 
charged, I think explicitly, with preserving the widespread 
availability of the 30-year fixed-rate mortgage, the continued 
existence of a TBA market that allows for interest rate risk 
hedging and preclosing rate locks, as well as fair access and 
affordable housing and multifamily housing options.
    I look forward to your questions.
    Chairman Johnson. Thank you all very much for your 
testimony.
    As we begin questions, I will ask the clerk to put 5 
minutes on the clock for each Member.
    Professor Levitin, what is the one key lesson the market 
learned about MBS investing after the financial crisis?
    Mr. Levitin. I think the key lesson we learned is just how 
flighty private capital can be. The housing finance market 
needs constant reinvestment flows in order to sustain housing 
prices in the market. And what we learned from 2008 is that 
private capital will flee to safe assets in times of economic 
uncertainty, and this can actually have the effect of worsening 
an economic downturn because of the critical role of the 
housing market in the economy.
    So I think the critical lesson we have learned is that we 
need to have some sort of Government and I think explicit 
Government role in the market for market stability purposes.
    Chairman Johnson. Mr. Hughes, would standardization of 
private label MBS terms and documentation be an effective means 
of bringing private capital back into the market?
    Mr. Hughes. Yes. I would think--you know, there has been 
some standardization so far. I think there needs to be farther 
to go both on representations and warranties, both the 
definition of what those representations are, and then, more 
importantly, what the enforcement mechanisms are.
    But I think there is a number that I lay out in my written 
testimony where I think the securitization terms, reps, 
warranties, can be improved and standardized.
    Chairman Johnson. Mr. Gidman, in MBS pools with troubled 
loans, how do we address conflicts or barriers affecting 
private label MBS mortgage trustees and servicers?
    Mr. Gidman. I think in terms of lessons learned from the 
financial crisis, many of those have been talked about today by 
other witnesses and alluded to in your opening statement and in 
others. The central issue for us in GSE reform going forward is 
really the role of the trustee and also the role of the 
servicer. For us, we believe that transparency in their 
activities and alignment of interests, specifically with an 
enumerated fiduciary duty, is a critical gap in the existing 
PLS market that has not yet been fixed, and without it being 
fixed going forward, it is hard to see how investors could come 
back into the PLS market in a meaningful way.
    Chairman Johnson. Professor Levitin, is there enough stable 
private capital to stand in front of a Government guarantee for 
MBS in good and bad economic times? Is this compatible with the 
TBA market?
    Mr. Levitin. Well, the answer really depends on how much 
private capital you want, first-loss private capital you want. 
If you are looking for 10-percent first-loss private capital, 
such as envisioned in the Corker-Warner bill, I think there is 
a bit of a question about that, whether there is enough private 
capital, and part of the answer depends on how you are going to 
define capital. Does it have to be real capital in terms of, 
you know, dollars or Treasury securities in an escrow account 
backing something up? That I am skeptical that there is enough 
if we define capital in very strict terms.
    If we define capital more loosely, allowing derivatives to 
be counted as capital, for example, then, yes, there would be, 
but there are risks because that is not the same quality of 
capital if we do that.
    As far as a TBA market goes, the critical thing for having 
a TBA market is having interchangeable liquid securities. A TBA 
market is a market in forward contracts on mortgage-backed 
securities. So parties are buying and selling these securities 
before they come into existence.
    If there is geographic information about the loans in an 
MBS pool, it is not possible to have a TBA market, and this 
means there is a real conflict between private label securities 
which do not have a TBA market and actually having a TBA 
market, because private label securities include information 
about geographic--about the geography of the loans in the pool 
because investors know that affects credit risk. But when you 
have credit risk in the equation, you cannot have a TBA market.
    Chairman Johnson. Mr. Gidman, the GSEs have started a 
credit risk sharing program for their mortgage pools. What is 
attractive and unattractive to private investors in these 
deals?
    Mr. Gidman. We think generally the approach that has been 
advocated in the recent housing reform package that has been 
drafted and circulated to the members and in the industry is a 
promising approach. Referencing specifically, I think, the 
STACR deal that recently came out, we found that to be 
promising in many ways structurally. The sole deficiency that 
prevented firms like mine from taking a substantial position 
really related to the absence of a rating because our 
investment guidelines require that. But generally the structure 
of the approach we think is attractive and interesting and 
merits further development.
    Chairman Johnson. Senator Crapo.
    Senator Crapo. Thank you, Mr. Chairman.
    Mr. Hughes, I noted in my opening statement that it is time 
for the Government and, thus, the U.S. taxpayer to reduce their 
footprint in the mortgage market. In your testimony, you note 
that the Government should begin to reduce its participation at 
least in one way by the reduction of conforming loan limits.
    As we consider appropriate transition away from the status 
quo, do you have suggestions as to what rate and on what 
timeline we should proceed? Do you believe that the private 
market could readily absorb a larger percentage of the mortgage 
market now?
    Mr. Hughes. Yes, I would think it would have to be done on 
a safe and measured basis. You know, I can see it coming down--
if it came down by 5, 10 percent each year for several years, 
to bring it back down in line. I think the conforming loan 
limit, if we went back to the old OFHEO standards on how it 
would be calculated, the loan limit today would probably be 
$330,000. So I think it is--but it needs to be done on a basis 
where there is not a shock to the system, and I do think 
private capital steps in in one of two ways: either through 
banks' balance sheets or through private securitization.
    Senator Crapo. Thank you. And, again, Mr. Hughes, on 
another matter, investors in the mortgage markets need 
certainty. Senate bill 1217 in Section 223 calls for the 
development of uniform securitization agreements and 
definitions of reps and warranties for securities that are 
covered by the guarantee.
    As one of the few people who have been able to put together 
a private label deal in this crisis, could you please describe 
how you have approached these issues?
    Mr. Hughes. Yes. So when we initially opened up or tried to 
open up private securitization, we reverse-engineered from 
investors to figure out what would be best practices. And for 
us, best practices are, again, a complete rewrite of reps and 
warranties, binding arbitration, and another feature that 
Redwood has is that we invest in the credit securities. So you 
as a senior investor know that the person that is actually 
selling you the securities has, in Dodd-Frank parlance, ``skin 
in the game.'' But we have found that, you know, investors will 
come back to the extent that there are best practices.
    Senator Crapo. Thank you.
    And, Mr. Gidman, you noted in your testimony that some 
local governments are exploring utilizing eminent domain to 
seize underwater mortgages from private investors and 
restructure them into more favorable terms for the borrowers. 
In fact, one municipality--Richmond, California--has even voted 
to move forward with the idea and is actively recruiting other 
cities to join it.
    As a long-time industry participant in the mortgage-backed 
securities market, what have you observed to be the impact of 
this proposed use of eminent domain on prospective investors in 
private mortgage securities?
    Mr. Gidman. Thank you, Senator. I think there has not been 
an impact yet because our industry generally believes that it 
is highly unlikely to occur. However, the recent action you 
alluded to in California, it certainly becomes more possible.
    Speaking specifically about the legacy PLS issue and the 
challenges that homeowners face with mortgages that are 
underwater and struggling to pay those mortgages every day, we 
strongly advocate for the expansion of HARP to private label 
securities. We think that provides a transparent, public 
policy, standardized mechanism to address many of these needs.
    With regard to eminent domain, when we look at the recently 
introduced Housing Finance Reform and Taxpayer Protection Act, 
it is well structured. It is comprehensive. It aligns 
interests. It promotes transparency. But a critical component 
of it is investors taking first-loss risk. If the Federal 
Government allows, in our view, the use of local eminent domain 
powers to undermine national housing policy going forward, 
investors will not be able to take on the first-loss risk in 
the future.
    In our view, in order for GSE reform to have a chance at 
success, the Federal Government needs to use its tools now 
preemptively to protect the housing finance market.
    Senator Crapo. Thank you, Mr. Gidman. And one more question 
for you on another topic--assignee liability. You noted in your 
testimony that Dodd-Frank expanded legal vulnerabilities that 
creditors, assignees, or other holders of a residential 
mortgage loan may be subject to if they initiate foreclosure. 
This creditor or assignee liability has been cited by many 
experts and participants, such as you, as being one current 
impediment to the return of private investment in mortgage-
backed securities.
    Could you please explain further why you believe the 
assignee liability issue is so negatively impactful on how 
private capital views the mortgage market?
    Mr. Gidman. So I think this really goes back to the central 
role and the question of the trustees and whether or not they 
have a duty to act solely in the best interests of the trust or 
whether or not conflicts inherent in vertically integrated 
financial services organizations that provide origination, 
issuance, servicing, and trustee services will be so conflicted 
that they are not able to act in the best interests of the 
trust.
    We believe that, given our recent experience with the AG 
settlement, where originators of bad loans, organizations that 
were involved in predatory lending were able to pay with funds 
by trust investors, including pension funds and other 
institutional investors. There has been a recent case that is 
in the press which is not yet settled, but we are very 
skeptical about where $4 billion of those dollars might come 
from, because we saw what happened in the AG settlement.
    And so the shame for us is that without greater 
transparency and alignment of interests, particularly around 
the role of the trustee but also the servicer, it is really 
putting a gate in front of the entire trillion dollar PLS 
market potential.
    Senator Crapo. Thank you.
    Chairman Johnson. Senator Warren.
    Senator Warren. Thank you, Mr. Chairman, and thank you, 
Ranking Member Crapo, for having this hearing.
    And I particularly want to welcome Mr. Gidman. Thank you. I 
am glad you are here from Massachusetts. I understand you are 
from Hull, and so welcome and thanks for your work with the 
Association of Institutional Investors. It is really important 
work.
    I want to ask a question about countercyclicality. You 
know, we have seen that the housing market is naturally 
procyclical, that when things are going well, lending becomes 
overextended; and when things are going poorly, lending 
decreases dramatically.
    So I believe it is important for regulators to have the 
authority to exert countercyclical pressure on the housing 
market. Peaks will not be so high, but the valleys will not be 
so low, and that reduces the risk of a future taxpayer bailout.
    So one way to exercise countercyclical pressure is to raise 
Government guarantee fees during boom periods and lower them 
during declines in the market. But that will not work unless 
the regulators have authority to exert countercyclical pressure 
on the private label market as well. Otherwise, when guarantee 
fees go up during the boom period, it will just drive everyone 
over to the private label market.
    So my concern is how regulators can exert countercyclical 
pressure on the private label market. Professor Levitin, could 
you weigh in on that?
    Mr. Levitin. Sure. There is a tool missing in the 
regulatory toolbox, and that is that regulators do not have the 
ability to control the amount of leverage in the housing 
finance market. In other words, the tool regulators need to 
have is the ability to limit combined loan-to-value on new 
mortgages being originated at any point in time.
    So regulators can affect the housing market by interest 
rates, but that affects--that is a blunderbuss. It is not a 
surgical tool for the housing market. It affects other markets. 
Controlling loan-to-value limits, if you gave it to a 
regulator--I am not sure which, but let us say the Federal 
Reserve--that would give them a targeted tool for dealing with 
overheating of the housing finance market, and this is 
something that is actually done outside of the United States in 
some countries. Hong Kong--it is a small market, but Hong Kong 
does this. Canada and Spain have systems that get to a similar 
result even though it is not formally through LTV limits that 
apply to originators.
    Senator Warren. Yes. So let me just ask, Mr. Hughes, do you 
agree as an issuer of private label securities that the 
Government should address the inherently procyclical nature of 
private label housing finance market?
    Mr. Hughes. I would agree.
    Senator Warren. And would you agree with Professor 
Levitin's suggestion of a tool doing it by regulation of loan-
to-value ratios, or would you do it a different way?
    Mr. Hughes. I think loan-to-value ratios are important. 
They have been overlooked in QM or QRM. I think, you know, what 
investors look at from an investor side, the most important 
criteria in determining whether there is a risk of default, it 
is the amount of equity in the property. Yes, I think that 
would be one important way of----
    Senator Warren. So you would support some regulation in 
this area.
    Mr. Hughes. Correct.
    Senator Warren. And, Mr. Gidman, would you like to weigh in 
on that?
    Mr. Gidman. I agree with your observation completely. The 
GSEs or the Federal Government play an important role in 
housing finance to provide that countercyclical capability. You 
know, I think QM and the LTV ratios have been discussed as a 
key component, but another one could be in terms of levers that 
are available to the Federal Government is capital ratios with 
the originators.
    Senator Warren. Got it.
    Mr. Gidman. But there are tools, there are mechanisms, and 
what we do not want to happen is for GSE reform to be 
procyclical rather than provide the backstop that is necessary 
in terms of crisis.
    Senator Warren. Right. Thank you very much.
    Let me ask one other question. Even if the private label 
market represents only 20 percent ultimately of the overall 
housing market, it still would be a multi-trillion-dollar 
market that it is dealing with. Given the size and importance 
of the market, I worry that there will still be an implicit 
Government guarantee that will affect the risks taken on by 
private actors.
    So I hear from a lot of people that the new QM and QRM 
rules, along with the SEC's eventual revisions to Regulation 
AB, will adequately limit the risk that can be taken on by 
participants in the private market.
    Professor Levitin, do you agree with that?
    Mr. Levitin. I am not sure, but I have concerns. We do not 
know exactly what the final QRM rule will look like, much less 
Reg AB, which seems much less advanced in its promulgation.
    To the extent that loans are QM, it will significantly 
limit market risk by ensuring the borrowers have the ability to 
make monthly payments, but there is not an LTV component to QM, 
as noted.
    What makes me more skeptical--what makes me skeptical here 
is that I think that a fair amount of the market eventually 
will not be QM. My impression is that a lot of the financial 
services industry does not fully understand QM and the 
consequences of a mortgage not being QM. There is actually a 
fairly weak remedy provision.
    If a mortgage is underwritten without ability to repay--I 
guess it is not underwritten in that sense--and it does not 
happen to meet the QM safe harbor, there is no penalty just for 
that. There has to also be a default on the mortgage. There has 
to be a foreclosure following that default. The homeowner is 
going to have to be willing to litigate the foreclosure. So we 
are talking about really a very small number of cases. And then 
if that happens, the homeowner has a defense in the way of set-
off against the amount of money owed, but it is actually a very 
small set-off by statute. I think there is some interpretive 
room in the statute, but I think in most cases we are probably 
talking basically about set-off of attorneys' fees plus $4,000. 
That is not a lot. There really is not much risk from a 
mortgage not being QM. I think once the market understands 
that, a lot of mortgages will not be QM.
    Senator Warren. All right. Well, I am very concerned about 
this, but I see that I am over my time, so I am going to--I 
very much want to hear from the others. I will submit questions 
for the record.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank each 
of you for coming in and for meeting with members of the staffs 
and members here just about the best way to go forward and for 
the work of your organizations.
    I think what all of you have said is that the model that a 
large group on the Committee are looking at that puts private 
capital in front of any kind of Government backstop is a very 
good model to go alongside private label financing. Is that 
correct? And would you like to expand? Go ahead.
    Mr. Hughes. Yes, I do think it is a good model. Obviously, 
you know, if we develop into three markets where you have a 
totally Government-supported market, a hybrid market where 
private capital takes the first risk, and then a totally 
private--you know, through private label securities, I think is 
the right blend of mortgage tools to have adequate liquidity in 
the marketplace for borrowers.
    Mr. Gidman. When we look at the mortgage markets, we look 
at it as a whole. We think there is a component which is a GSE 
and an explicit Government guarantee, and there is a purely 
private, but they need to work hand in glove. And when we look 
at the framework that has recently been introduced, we think it 
is thoughtful, and it is well structured, and it provides a 
mechanism that would naturally provide that to happen.
    Going with, you know, reducing conforming limits on their 
own, no matter how measured the pace, will not bring private 
money back into the market without the kind of structural 
reforms specifically around the role of the trustee, reps and 
warranties, and transparency and timeliness of loan-level data. 
But we think there is more than enough room and there is 
certainly pent-up demand.
    Senator Corker. OK.
    Mr. Levitin. I would agree with everything that Mr. Hughes 
and Mr. Gidman said, that we have three markets: the 
Government, the hybrid, and the private label market. All of 
them need reform. I think the Committee is quite well aware of 
the issues with FHA right now, but the core part of the market 
is going to be the hybrid, and that is I think where we need to 
pay a lot of attention, but we still need to also do reforms, 
as Mr. Gidman noted, for PLS
    Senator Corker. So one of the things the bill seeks to do 
is to create uniform PSA to have a clear definition of reps and 
warrants, to have electronic registration so that it is 
regulated, create uniform data so investors can actually 
analyze data sets, and very importantly, I think, make sure 
that second liens cannot just be piled on the first liens 
without the first-lien investor being aware of that.
    Are these helpful, are these steps that are in this bill, 
proposed bill--an actual bill, I guess, are these helpful in 
bringing in private capital? And would they also be helpful if 
some of those standards, as I think Ms. Warren was alluding to, 
if those standards were also evident in the private label 
market itself?
    Mr. Gidman. We think that that language and those 
provisions that you mentioned are extremely helpful, but they 
are not sufficient without some of these other structural 
reforms that all of us have talked about.
    We think that, you know, it is a really promising approach. 
It is very well engineered in terms of the overall bill, and it 
addresses almost all the concerns that institutional investors 
would have.
    Senator Corker. OK.
    Mr. Hughes. I would echo that. I also thank you for putting 
in the second-lien provisions. But we would be an investor. We 
invested in the Freddie Mac transaction in STACRs. We are a 
company looking to take and invest in mortgage credit risk. And 
there are different ways to express it. If we can express that 
through the private label market, totally private, we will do 
it there. But we would also, you know, be very open to putting 
private capital ahead in a hybrid type model.
    Senator Corker. OK. Well, listen, thank you for your 
testimony, and especially mentioning some of the things that 
you think can make legislation even better. I think all of us 
who have been working on this for some time realize there are a 
lot of improvements that can be made, and we appreciate your 
testimony and look forward to trying to incorporate some of the 
suggestions you have made into the bill that has been produced. 
So thank you very much.
    Chairman Johnson. Senator Reed.
    Senator Reed. Well, thank you very much, Mr. Chairman, and 
thank you, gentlemen, for your testimony.
    Mr. Hughes, you suggest in your testimony the need for 
service performance triggers, servicers, so that servicers 
effectively can be, you know, removed if they are not 
functioning properly. And Chairman Johnson and Senator Crapo 
were very helpful in getting language in the FHA Solvency Act 
which would have a similar situation where a servicer could be 
removed and an approved servicer would replace them.
    Can you comment on just the need for these triggers for 
servicers?
    Mr. Hughes. Yes. I think it is critically important that 
from an investor's standpoint, if a servicer is not following 
their responsibilities under the agreement, that there is some 
mechanism to remove them. If there are conflicts, if they are 
not resolving problem loans on a timely basis, if they are not 
giving good service, you know, like under any other contract, I 
think there should be provisions, if you do not live up to the 
terms of the contract, you should be in a position where you 
could be removed.
    Senator Reed. Thank you.
    Professor Levitin, I want to get back to a point that you 
raised with the Chairman, and that was--and I think both 
Senator Corker and Senator Warner have done a superb job in 
sort of advancing dramatically the progress on the bill. But 
one of the premises is 10-percent private capital up front. The 
question is: Is that sufficient? Or is it too much?
    The other question is: It could be private capital in the 
transaction investing into the entity, but it could be raised 
by debt on the other side, which would--essentially be a lot of 
leverage that is--we saw that in the crisis. Do we have to 
worry about both those things?
    Mr. Levitin. I think potentially we do. Whether 10 percent 
is the right amount, I do not have an opinion on that. I think 
we would want to get as much first-loss private capital as we 
can. You know, the higher you raise it, the better that would 
be in terms of protecting the public fisc. But it is also a 
question of what constitutes that first-loss capital and what 
is really backing it up. And I think you are right to be 
concerned about the need to look through what is capital for, 
let us say, FMIC purposes in S.1217 and say, well, really, that 
is only backed up by more borrowing. Are we just building a 
pyramid of leverage? I think that is a concern.
    And one area that I think S.1217 could be improved in is 
being more explicit in what constitutes capital for bond 
guarantors and for any kind of private label execution of the 
10-percent first-loss piece.
    Senator Reed. There is another aspect, too, as you alluded 
to in your responses, that there are times when the market can 
provide adequate capital, the market is, you know, actively, 
and eagerly looking. And then there are times of economic 
distress when there has to be more sort of Government 
involvement. So that would suggest that this capital number 
would have to be sort of adjusted, if you will, for public 
policy purposes by the Government.
    Is that a fair, general assumption?
    Mr. Levitin. I think it is, and I think that there is 
reason to have some concern about that, because to the extent 
that you have an accordion-like Government commitment to the 
market, that raises the possibility of--it raises the question 
of who is exercising--who is playing the accordion and how 
politicized is the accordion going to be played.
    The Corker-Warner bill is cognizant of the need--you know, 
of the need for the Federal Government to step in if the market 
runs into real trouble. There is a provision in the Corker-
Warner bill; it is a limited provision, though. It lets FMIC 
step in and waive the 10 percent for, I believe, 6 months. 
Hopefully that would be enough time, if necessary, for FMIC to 
get an extension from Congress. But I worry about any bill that 
requires the system to come back to Congress. I mean 
particularly with what is going on right now----
    Senator Corker. Yes.
    Mr. Levitin. ----I worry about whether the political system 
is going--will function.
    Senator Warner. Shocked. Shocked.
    [Laughter.]
    Senator Reed. I have another question, but I think you have 
answered all the questions with your last response.
    I think one of the issues that we are trying to 
collectively come up with an appropriate response to, is how do 
we have a system that is, you know, independent of pressures 
other than responding to the market conditions. I mean, one of 
the examples that we have lived through, the long, long, slow 
rise of the mortgage market from the depths of 2008, 2009, if 
there had been a 6-month statutory window, that window might 
have been too small.
    So, again, I think we have got to think harder on some of 
these issues. But what Senators Warner and Corker have done 
already has been extraordinarily helpful.
    Thank you.
    Chairman Johnson. Senator Toomey.
    Senator Toomey. Thank you, Mr. Chairman, and thank you to 
the witnesses for being here.
    In the interest of time, maybe I could just posit an 
assumption--and by all means, correct me if I am wrong--that 
all three of the panelists would agree that if municipalities 
did begin to claim eminent domain as a power, a justification 
for confiscating mortgages, that that would have a chilling 
effect on the ability to attract private capital into the 
mortgage market. Mr. Hughes, do you agree with that premise?
    Mr. Hughes. Absolutely.
    Senator Toomey. Mr. Gidman, I think you generally did in 
your response to Mr. Crapo's----
    Mr. Gidman. You would have no need to proceed with GSE 
reform.
    Senator Toomey. OK. And----
    Mr. Levitin. I am not prepared to totally agree.
    Senator Toomey. OK.
    Mr. Levitin. I think it really depends on the scale that we 
see. To the extent that there are eminent--I am not a supporter 
of the eminent domain proposals that exist. But I think it is 
important to recognize why they exist. They exist because of a 
failure in the servicing of mortgage loans, and that needs to 
be addressed. Once it is, we will not have the eminent domain 
proposals.
    Senator Toomey. And presumably one of the reasons for 
concern about using eminent domain this way is the rule of law 
and the sanctity of the contract and the importance that--well, 
our entire society, but in particular private investors would 
place on being able to rely on a contract. So I wonder if 
anybody has any concerns about the FHFA's third amendment to 
the preferred stock agreement where it could be argued that the 
Government unilaterally changed the terms of an agreement that 
had been in place. I want to give a quick quote and ask your 
reaction.
    Randy Guynn is the head of the Financial Institutions Group 
at Davis Polk and an expert on bankruptcy and related matters 
for decades. He stated last week at an NYU seminar on the 
GSEs--and I will quote. He said, ``If the Government gets away 
with the dividend sweep of Fannie and Freddie, it will 
establish a dangerous precedent for the rights of analogous 
stakeholders of failed banks and systemically important 
financial institutions under the FDIA and the OLA.'' And I 
might add to that list any potential successor to Fannie and 
Freddie.
    Do any of you share a concern about that? Mr. Hughes.
    Mr. Hughes. I am not an expert in the area. I really do not 
have any insights.
    Senator Toomey. OK. Mr. Gidman.
    Mr. Gidman. I do not either. I am sorry.
    Mr. Levitin. I do share your concerns on this, and I would 
note it does not just affect investors, but it also affects the 
Affordable Housing Trust Fund, which the Federal Government has 
not been paying into.
    Senator Toomey. Thanks. Then let me switch topics here 
since we did not get too much discussion on that topic.
    Dr. Levitin, you indicate in your testimony that you 
believe that the capital markets would be able to support no 
more than $500 billion annually in mortgage credit risk, which 
considering the size, the multi-trillion dollars of credit risk 
that investors routinely take, private investors take in 
corporate bonds, commercial paper, financial--you know, short-
term financial paper, consumer credit of various kinds, how do 
we know that there is only $500 billion worth of demand for 
credit risk in the mortgage market?
    Mr. Levitin. Sure. I cannot say precisely that it is $500 
billion and not 499. This is a ballpark figure. But I think 
that we can see the ballpark figure is not even close.
    The reason that we--the basis of my analysis is looking at 
the private label market in the past, that before 2004, we had 
a private label securitization market, and it never amounted to 
more than 15 percent of----
    Senator Toomey. But didn't it always have to compete with 
the Government-guaranteed market, at least implicitly?
    Mr. Levitin. Sure, but to the extent that you do not have a 
Government-guaranteed market, if you just got right of it----
    Senator Toomey. Right.
    Mr. Levitin. ----the money that is invested in the 
Government-guaranteed market is not money that is investing 
in--that is taking on credit risk. Those are interest rate risk 
investors. Some of them might be willing to take the A piece in 
a private label securitization, sort of the senior piece, but 
placing the B piece is much more difficult, and it is just 
not--I do not see any indications that there is a large pool of 
money willing to take on first-loss credit risk on U.S. 
mortgages.
    Senator Toomey. Isn't it true that the nature of the credit 
risk on a mortgage declines over time? I mean, if you--the 
duration of a mortgage, the average life weighted by any 
reasonable measure, is typically less than 10 years. By the 
time you are approaching 30 years on a mortgage, credit risk is 
often becoming de minimis because the loan-to-value ratio is 
becoming so good.
    Mr. Hughes, do you agree that there is only $500 billion 
worth of private capital willing to take credit risk in 
mortgages?
    Mr. Hughes. I think it is probably not a--probably a fair 
estimate, but the real questions are--you know, the way I would 
look at it is if you did some tranching of the 10 percent, such 
that you could get people like Redwood, who would be, you know, 
happy to come in and try and take the first-loss credit risk 
and then tranche it up so that you access different pockets of 
investors with different risk profiles rather than just say put 
everybody in the 10 percent.
    You know, having said that, the 10 percent is a pretty 
large number, and I look forward to understanding more about 
how much that is going to be capital, can you use any kind of 
leverage, and how would it work. But I think in particular, 
some tranching of that so that those people best able to take 
the risk, the deep credit risk, are in that position.
    Senator Toomey. I see I am out of time, Mr. Chairman, but I 
would just observe that we have private investors who routinely 
take trillions of dollars worth of credit risk year in and year 
out across an enormously wide range of securities, and why we 
would assume that suddenly there would not be a willingness or 
ability to match investor demand with the corresponding section 
of the mortgage industry, I find that baffling.
    Chairman Johnson. Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. I want to thank 
you and Ranking Member Crapo for your work in holding these 
hearings.
    Picking up on Professor Levitin's comment about our 
functionality, or lack thereof, I just want to again make the 
appeal to you--and I know the staff is working very hard on 
this issue--that time is not on our side in GSE reform, that 
this may be the one area under your leadership where there is 
broad bipartisan agreement and we could actually not only get a 
bill out of Committee but on to the floor.
    I am afraid that the forces of the status quo at some 
point, and the notion that we would have a system, when you 
kind of reflect back, that has a private entity in the old 
model, that has shareholder value, appreciation goals, 
Government backstop, and public service goals all wrapped into 
one in any kind of ongoing, functioning entity just, you know, 
as somebody who has looked at this, does not seem like it makes 
a lot of sense.
    I do want to make a couple comments following up on Senator 
Toomey's comment. Professor Levitin, I do not know whether your 
$500 billion number is right or not. It seems relatively 
reasonable to me. I would argue that in the hybrid proposal, 
S.1217 has suggested we expect to see a growing PLS market. 
That is going to take private capital. And with the 10-percent 
private capital risk guarantee on the hybrid model, that is 
going to take capital, too. So I think, you know, that number 
may expand a bit, but I think that it is kind of a reasonable 
assumption. And I will come to a question here ultimately.
    I guess the other part I would make--and I think that both 
Senator Reed and Senator Warren raised this issue on the 
countercyclical, and I think there are ways perhaps it could be 
improved, but there is this notion--I think there is a 
recognition that 1217 has, that there are ability of three 
keys--we put the Fed, FMIC, and Treasury to turn that down if 
private capital flees. So we do not have a system where we are 
kind of left without any tools at all. Maybe there are ways to 
improve it. And I think Senator Reed's comments were good as 
well, and I want to again come to Mr. Hughes.
    One of the things that I have thought--and we have had a 
lot of discussion on the 10-percent number. We all believe skin 
in the game. You have talked about the value of private label, 
Mr. Gidman has as well, skin in the game. Clearly, 1217 puts a 
lot of skin in the game, which, again, better guarantees that 
that Government backstop will never be hit. That is more than 
double what would have been required in the last crisis. And 
Professor Levitin has raised I think the appropriate question. 
You know, does 1217 get the definition of capital right? Which 
is terribly important, and I am anxious to hear more feedback.
    But I want to come back to Mr. Hughes and maybe all three 
of you to comment, not only definition of capital, but if you 
have got that 10 percent--let us assume for argument's sake 
that we have struck a bit too high, which I would rather err on 
the side of safety. But shouldn't there be an ability perhaps 
to tranche part of that? Can't the market be a better--have a 
better ability to figure that out--and, respectfully, as smart 
as these Senators are and our staff are--than a group of 
legislators? So can you drill down a bit more on that tranching 
idea? And I would like to hear from each of you.
    Mr. Hughes. Yes, I think it is incredibly important to do 
some tranching because investors have different risk profiles, 
and on the private side, totally private side, in, you know, a 
PLS transaction, the senior investors are bringing most of the 
capital, but most of the risk is in the subordinate securities, 
you know, below that. So, again, I would think, you know, if 
the number was 10 percent, or something, breaking that down 
probably--if you would expect in this pool of loans probably 
you are going to have--25 basis points of loss would probably 
be a reasonable assumption for well-underwritten that maybe, 
you know, you tranche out the first 2 percent, which would be 5 
times--which would be 10 times coverage and then, you know, 
move up from there. But, yes, I think it would be a very 
appropriate way of attracting capital.
    Mr. Gidman. So we think we agree that the tranching is 
particularly important, but in terms of the absolute number or 
prescribing the number at 10 percent, we really believe that it 
is an important lever, countercyclical lever for the market, 
and that it should not be necessary to come back to Congress to 
change that lever. We think that it is something that the 
Federal Mortgage Insurance Company should have as a tool in its 
toolkit.
    Mr. Levitin. There are certainly ways to tranche the 10 
percent. It could be tranched on the initial issuance, or it 
could be tranched subsequently. Basically you could--someone 
could buy that 10 percent and resecuritize it, issue tranched 
credit link notes. There are lots of ways to allocate that 10-
percent credit risk within the market.
    I am not real concerned about that, even though there may 
need to be some adjustments to the QRM rulemaking to make sure 
that if the market wanted to retranche the credit risk, it 
would not--there would not have to be extra capital help 
because of that.
    Senator Warner. Well, again, I want to thank all the 
witnesses for their testimony and the fact that they have 
endorsed the directional approach, and I am, again, looking 
forward to working with the Chairman and the Ranking Member to 
fine-tune and get this right. Again, I just hope and pray that 
we do not miss this window.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Johanns.
    Senator Johanns. Mr. Chairman, thank you, and let me, if I 
might, join with the comments of Senator Warner. I think we 
have a window of opportunity here, but I think that window 
closes for a whole variety of reasons that I will not go into. 
But I really appreciate what the Chair and Ranking Member are 
doing here because I think they are laying out a process by 
which we take some bipartisan ideas and then build a final 
piece of legislation.
    In that vein, some months ago the Chairman brought us all 
together in kind of an informal work session and went around 
the room to the Banking Committee Members and said basically, 
``Tell me what you would like to accomplish through GSE 
reform.'' And we had an opportunity to list the three, four, 
five, six things, whatever, that were important to us.
    I would suggest in a pretty bipartisan way members listed 
the 30-year mortgage as one of the things that they would like 
to preserve at the end of GSE reform.
    We have not touched on that today that I recall, and I 
would like to hear your thoughts on the importance of making 
sure that whatever structure we end up with keeps that 30-year 
mortgage opportunity in place. And, Mr. Hughes, I will start 
with you, but we will just go right on down the table.
    Mr. Hughes. Yes, I think keeping a 30-year fixed-rate 
option available to borrowers I do think is very important. 
There are all sorts of other options down the spectrum that you 
can get through hybrid loans, whether it is 5 years, 10 years. 
But I think giving a borrower the option where they can be 
fixed for 30 years, if that is what they want, is important.
    Senator Johanns. Great.
    Mr. Levitin. From a policy perspective, we agree that a 30-
year mortgage is an important vehicle for borrowers.
    Senator Johanns. Great. Professor.
    Mr. Levitin. A 30-year fixed-rate mortgage is the keystone 
of the American housing finance system. It is a uniquely 
American product, and it is one that has served the American 
people very well for nearly 75 years now.
    It is important to recognize that the private label 
securitization market has never produced 30-year fixed-rate 
mortgages on a wide scale by itself. Basically, if you want to 
do lots of 30-year fixed-rate mortgages, you need to have some 
sort of Government guarantee. That is how the 30-year fixed was 
created in the first place.
    Senator Johanns. Mr. Gidman, do you have something to offer 
on that? I noticed that you were listening to that testimony 
closely.
    Mr. Gidman. Well, I think the professor is generally right 
in terms of the history, but I think there is room in the 
market for private label securitization out, you know, well 
beyond 10 years. But as a foundation of the housing finance 
market in the United States and uniquely American, the 30-year 
mortgage is very important.
    Senator Johanns. Great. There has been a lot of discussion 
as the legislation was put together about the 10-percent--I do 
not know what you would call it--``skin in the game'' 
provisions or whatever. We had a witness a few weeks ago that 
talked about 5 percent, you know, and I guess you can debate 
those numbers.
    I am fascinated by this idea of tranching, and I would like 
to hear from somebody a little more thoroughly on how that 
would be set up, how that would work, because the one thing I 
want to avoid from my vantage point is, you know, the wizard 
adjusting the dials on the economy and dial this and dial that. 
I want more market forces involved in this. So talk to me about 
how the tranching--Mr. Hughes, we will start with you again.
    Mr. Hughes. I would envision very similar to how the PLS 
market works right now. So in our transactions, there is 
tranching of bonds of--up to probably 93 percent is AAA.
    Senator Johanns. OK.
    Mr. Hughes. And then 7 percent below that is a series of 
securities. The deepest credit securities is probably 2 
percent, and then you work your way up from BBB, A, AA 
securities. And really what happens and why tranching is 
important is losses go from the bottom such that if there are 
losses in a Redwood deal, the first bond that gets torn up is 
our bond, but the bond above us is protected until our bond 
goes away.
    So, therefore, investors have a different risk depending on 
where they are on that tranching. So somebody may be more 
comfortable at the AA level. Where we would be more 
comfortable, you know, we think there is more yield and 
opportunity at the deep credit level.
    Mr. Levitin. The one concern I would raise with tranching 
is that tranching creates conflicts between investors 
potentially, that when you have a security that is not a 
complete pass-through for all investors, you are binding longs 
and shorts together in the same deal, and they are not going to 
want the same things, be it on interest rates, on things like 
cleanup calls and deals, on servicing, and I think that puts a 
lot of pressure then on making sure that the trustee and 
servicer provisions and the deals are done right, and there is, 
I think, a very important set of reforms that need to be done 
in that space.
    Senator Johanns. OK. Mr. Gidman, did you have anything to 
offer?
    Mr. Gidman. I do, yes. Tranching opens up the deals to a 
greater world of investors because it allows you to taper the 
risk and target it to the investors that have the appropriate 
appetite. But what the absolute number is and how that tapering 
or tranching occurs I think is a market force that could be 
guided by a Federal institution.
    Senator Johanns. OK. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Heitkamp.
    Senator Heitkamp. Thank you so much, Mr. Chairman and 
Ranking Member. I think these hearings have been 
extraordinarily helpful to me as we kind of work through this 
process.
    My questions are really just twofold, and one is about the 
timing of reform. And I think what you hear is a sense of 
urgency in this room that if we do not do this fairly soon, we 
will not have the opportunities for reform, even in a year, 
that we have today. And I just want to get kind of affirmation 
of that because I sense some urgency, but like we know, nothing 
very--nothing happens very quickly in this place, as I am 
finding out as a new Member.
    Professor, can you tell me what you think is right now the 
window for the maximum number of options that we have to do 
reform correctly?
    Mr. Levitin. I want to be careful that I do not expressing 
my opinions on what is politically feasible.
    Senator Heitkamp. Just imagine the moon. Imagine the moon. 
They will do whatever we want to do.
    [Laughter.]
    Mr. Levitin. We need to fix this market. It is not in an 
acute condition where it needs to be fixed tomorrow. I think it 
is more important that we get this right than that we do it 
sooner. I would, therefore, probably err on the side of 
caution.
    Senator Heitkamp. What timeframe?
    Mr. Levitin. Timeframe, I mean ideally, you know, all else 
being equal, you want this done as soon as possible, but I 
think it has to be done right. I do not think I can really lay 
out a timeframe for doing this.
    Senator Heitkamp. Mr. Gidman.
    Mr. Gidman. Our view really is that the time is now. The 
framework that has been laid out there is very thorough, it is 
comprehensive, it is well engineered. The structural fixes that 
we have sort of identified we think are--there should be 
bipartisan agreement on that.
    The thing that we are concerned about that makes this more 
timely from our standpoint, again, is back to the eminent 
domain issue. If a single municipality exercises eminent domain 
to seize performing loans, regardless of the public use 
arguments, regardless of fair value arguments, if they do that, 
it will make it very difficult for institutional investors to 
remain in that market let alone increase our involvement in 
that market, which could make efforts toward GSE reform moot.
    Senator Heitkamp. If I could just, before we move on to Mr. 
Hughes, make the point, I think you said earlier in your 
testimony that there have not been adjustments for the eminent 
domain issue as of yet because you do not see this as catching 
fire and spreading across the country in a large way today. Is 
that correct?
    Mr. Gidman. We think it is so harmful to the national 
mortgage markets that ultimately the Federal Government will 
step in with its tools to make sure that it does not happen.
    Senator Heitkamp. So your risk evaluation on the eminent 
domain issue is more based on being able to come here and, you 
know, create a firewall, so to speak.
    Mr. Gidman. Well, we look at the recent letter from the 
FHFA, which directed the GSEs and how they should act with 
regard to the municipality. But we think it is really not an 
issue of a single municipality or a single approach. We think 
it is a national housing finance policy that you all would be 
highly incented to protect.
    Senator Heitkamp. Mr. Hughes, your thoughts on timing?
    Mr. Hughes. Yes, I have a high sense of urgency to get 
something done. I would think you would want to do changes to 
the PLS market hand in glove with anything that may get done 
with the enterprises. I think there will always be arguments it 
is too complicated, the TBA market is not going to do it, and 
there will be all sorts of bogeymen out there. But at the end 
of the day, you need to tackle it. You need to start it. You 
need to begin a process and to resolve those things.
    Senator Heitkamp. One last question, and it is directed to 
you, Mr. Gidman. You had suggested that there was room in the 
private market for the 30-year fixed-rate mortgage. Can you 
tell me what the impediments are today for the private market 
to get involved in the 30-year fixed-rate mortgage and explain 
why it is that in your earlier testimony you were talking about 
million-dollar houses with 50-percent equity? You know, why 
aren't you taking the $300,000 home on a 30-year fixed-rate 
today?
    Mr. Gidman. Well, I think, you know, the critical factors 
for us are not the size of the loan. It is the quality of the 
loan, it is the amount of equity in the property, it is the 
lack of other liens and weights on that loan. And I think 
without the structural repairs with regard to the role of the 
trustee, the uncertainty around assignee liability or eminent 
domain, it is very difficult for us on behalf of our clients to 
embrace innovation further down the range of the mortgage 
market.
    Senator Heitkamp. Just begging the indulgence of the Chair, 
so if some of these issues were addressed, you would see more 
active participation.
    Mr. Gidman. Yes, I think you would.
    Senator Heitkamp. Thank you.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Brown.
    Senator Brown. Thank you, Mr. Chairman and Senator Crapo. 
Thank you both for doing this hearing.
    In 2011, Congressman Brad Miller of North Carolina and I 
introduced the Foreclosure Fraud and Homeowner Abuse Prevention 
Act to make the securitization process work better for 
investors and for borrowers. You have in your testimony 
supported some provisions of that bill which I would like to 
ask you about--mention and then ask you about: one prohibiting 
mortgage servicers from holding a second lien on property that 
has a mortgage they service. Senator Corker mentioned that. Mr. 
Hughes and Professor Levitin suggest that second liens can 
create perverse incentives, as you know, particularly when the 
same party is servicing the first lien.
    Like Mr. Gidman, I was concerned about the national 
mortgage settlement affecting mortgage investors. I warned 
Secretary Donovan that investors in pension funds for working 
Ohioans, for example, should not pay for Wall Street mistakes. 
Unfortunately that is what happened.
    My legislation with Congressman Miller would clarify that 
bond holder protections in the Trust Indenture Act apply to 
mortgage-backed securities investors, as Professor Levitin 
suggests.
    Mr. Gidman, you noted that vertically integrated financial 
institutions often serve as issuers, trustees, originators, and 
servicer, sort of the whole vertically integrated, if you will, 
creating conflicts of interest and incentives not to identify 
deficiencies that harm investor trust. If all three of you 
would briefly in a minute or so discuss why the reforms that 
you have proposed that are in our bill are important 
protections for investors, including applying the Trust 
Indenture Act, and how these reforms will address these clear 
conflicts. Mr. Gidman, do you want to start?
    Mr. Gidman. Yes, I think that the current language that has 
been proposed goes a long way toward addressing those 
structural issues that we have all talked about, whether it is 
standardization of reps and warranties, ready availability and 
timely access to loan-level data, and alignment of interests.
    Mechanically--you know, we use the term ``fiduciary duty'' 
in my industry because that is what we know, that is what we 
live under. Whether it is a fiduciary duty or whether it is a 
fix to the Trust Indenture Act, I am not sure what the right 
mechanics are. But we certainly know that the trustee needs to 
act solely in the best interest of the trust, and they need to 
have the capacity to have effective oversight of their 
servicers and there needs to be mechanisms for the end 
investors to be able to have enforcement that has teeth and 
rights of private action for breach. We think all of those are 
important.
    Senator Brown. OK, and the fiduciary duty is part of this.
    Mr. Hughes.
    Mr. Hughes. I would echo most of that. I do believe you 
need a mechanism within the trust to actually enforce rep and 
warranty claims. I would say to me the biggest single failure 
of private label was the fact that the reps and warrants either 
were weak, they became unenforceable, and it was the basis for 
all the lawsuits that we have today. So I think having 
discipline beforehand very clear on servicers' 
responsibilities, representations and warranty, what the 
authority of the trustee is, what the authority of a credit 
risk manager is, is incredibly important in bringing back 
institutional money to this space.
    Senator Brown. Professor Levitin.
    Mr. Levitin. Yes, there is really nothing new under the sun 
in the financing world. The Trust Indenture Act was a response 
to vertical integration in the mortgage bond market in the 
1920s. There is a huge SEC report from 1936 written by William 
O. Douglas and Abe Fortis, two future Supreme Court Justices, 
detailing all of the abuses. It reads like the playbook for 
what we have seen going on in the last few years.
    I think the ultimate--you know, fiduciary duties are 
important, but trustees have fiduciary duties after there is an 
event of default for a trust. The problem is getting to that 
event of default, and I think what the--part of the solution 
needs to be to split up the different duties the trustees do. 
They have some ministerial functions, they have some financial 
guarantor functions, and they also have an enforcement 
function. The enforcement function needs to be split off from 
the other functions and given to a party with no conflicts 
whatsoever, and also fiduciary duties.
    Senator Brown. Thank you. Let me ask Mr. Gidman and Mr. 
Hughes a question about PLS accountability in terms of both 
employees and institutions, and I want to read something that 
was in Mr. Levitin's written testimony: a ``study by the Center 
for Public Integrity found that senior executives from all of 
the 25 top subprime lenders during 2005-2007 were back in the 
mortgage business as of 2013 . . . it is easy enough to move 
from the securitization desk of a failed investment bank to 
another or to an investment fund. The lack of SEC and DOJ 
prosecution of either individuals or institutions related to 
pre-2008 PLS merely underscores the lack of consequences of 
securitizing noncomplying mortgages . . . it is unlikely that 
reputational sanctions are sufficient to keep the PLS market in 
check.''
    Just briefly, do you agree or disagree, Mr. Gidman and Mr. 
Hughes?
    Mr. Gidman. I had not heard that statistic before. What I 
do know is that greater transparency and alignment of interests 
can go a long way toward protecting the integrity of the market 
going forward, and those are lessons that we should have 
learned from the crisis.
    Senator Brown. Mr. Hughes.
    Mr. Hughes. A couple things. First, I sign a certificate 
with each securitization we do that goes out under my 
signature.
    And I would say, second, I think a very important part of 
it from a Redwood Trust standpoint is that we actually hold 
skin in the game. We actually hold the credit securities as 
incredibly important because, you know, we represent 
shareholders. If we are putting together a bad pool and there 
are consequences to investors for that pool, the person that is 
going to bear the most risk for that pool is Redwood Trust.
    Senator Brown. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Merkley.
    Senator Brown. He is not here.
    Chairman Johnson. Senator Hagan.
    Senator Hagan. Thank you, Mr. Chairman and Ranking Member, 
and I do appreciate you holding the hearings, and I, too, agree 
that there is a sense of timing for GSE reform, and I 
appreciate this hearing.
    I wanted to follow up on Senator Heitkamp's question on 
eminent domain, and I know that Senator Toomey also started 
talking about eminent domain. Mr. Gidman, you reiterated to 
Senator Heitkamp your thoughts. I was just wondering, Mr. 
Hughes, if you could talk about the eminent domain proposals 
that are out there and how that could be bad for investors and 
for businesses--and for borrowers.
    Mr. Hughes. You know, if it went through and that became a 
way of taking over property that would belong to investors, I 
think it would have a dramatic effect on private 
securitization.
    Senator Hagan. And when you say ``dramatic effect,'' can 
you expand on that?
    Mr. Hughes. I think if you are an investor and you now have 
a risk that someone could take your collateral out of your pool 
and you do not get adequate compensation for that, yes, I think 
that would be a risk that you had not planned on.
    Senator Hagan. Mr. Gidman.
    Mr. Gidman. It would lead us to have to price that risk 
into our decision making, and given a world of asset classes to 
invest in, I think it would have an immediate and chilling 
effect on the entire asset class.
    Senator Hagan. And how do you correspond that with the use 
of eminent domain today?
    Mr. Gidman. In the case eminent domain today--we will use 
the Big Dig as the example. It was real property. There was an 
unquestioned public interest and public use, and the owners 
were compensated according to objective measures of fair value.
    In the case of eminent domain that has been most recently 
discussed, you know, a local municipality is seeking to use 
eminent domain to seize assets that are held by retirees and 
pension participants across the United States, and it is 
unclear both of the public use in terms of the likely effect of 
that action within the municipality, and then because it is a 
private for-profit enterprise driving the deal, it is hard to 
see how fair value could be paid and have it work out.
    We think that this issue is really a public policy issue, 
and expanding HARP is the approach to keep homeowners in their 
homes and really have that effort be in lockstep with a broader 
housing market finance reform.
    Senator Hagan. Thank you.
    Mr. Levitin, in your testimony you indicated that the PLS 
can only provide the financing for at most an eighth of the 
U.S. housing market's peak annual financing needs. Can you 
discuss what constrains the size of that market? And how can 
Government guarantees work together with the private label 
securitization?
    Mr. Levitin. There is a limited amount of market demand for 
credit risk on mortgages that--you know, I might be wrong on 
the actual number there, but----
    Senator Hagan. How did you come up with that number?
    Mr. Levitin. By looking historically at the level of 
investment in the private label securitization market before 
the bubble, basically taking even--I am assuming that the 
bubble starts in 2004. Some people might disagree with me. But 
at 2004 levels, we would only get up to around $500 billion in 
investment in private label securities.
    Even if I am wrong by a factor of 2 or 3, the problem is 
the math is not even close, that if in peak years we have 
needed as much as $4 trillion of investment, private label just 
is never going to be able to support that. It may be an 
important component of the market, but it is not going to be 
the backbone of the market. And I think that we need to try and 
improve the private label component, but we also have to 
remember that it is not going to be the core of the market.
    Senator Hagan. Mr. Hughes, you mentioned in your testimony 
that Redwood recently invested in Freddie Mac Structured Agency 
Credit Risk notes. Can you discuss the benefits of that 
transaction in more detail? And how are the products able to 
distribute the credit risk from the GSEs into the private 
sector?
    Mr. Hughes. Yes, we participated in the transaction. Again, 
we are in the business of investing in credit risk. We found 
the bonds to be attractive.
    I would note that one of the things in that transaction 
that I would hope in future transactions they could fix is that 
they kept 30 basis points of risk at the Freddie Mac level. If 
you think 30 basis points of risk is the risk in the pool, 
well, then, it really did not sell the actual risk. And I know 
part of it was to facilitate getting a transaction done, 
getting investors in, ``Hey, investors, you do not have to 
worry.'' My hope would be over time that they would begin to 
sell first-loss credit risk to private investors----
    Senator Hagan. Thank you, Mr. Chairman.
    Mr. Hughes. ----I think second getting a rating on the 
bonds would also bring more liquidity because more investors 
could participate.
    Senator Hagan. Thank you.
    Chairman Johnson. I would like to thank the witnesses for 
being here today. This hearing is adjourned.
    [Whereupon, at 11:27 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
                 PREPARED STATEMENT OF MARTIN S. HUGHES
              Chief Executive Officer, Redwood Trust, Inc.
                            October 1, 2013
Introduction
    Good morning Chairman Johnson, Ranking Member Crapo, and Members of 
the Committee. My name is Marty Hughes, and I am the CEO of Redwood 
Trust, Inc., a publicly traded company listed on the New York Stock 
Exchange. I appreciate the opportunity to testify on what can be done 
to accelerate the return of a robust private secondary mortgage market.
Background on Redwood Trust
    Redwood Trust commenced operations in 1994 as an investor in 
residential mortgage credit risk. We do not originate or directly 
service residential mortgages. We currently operate a prime jumbo loan 
conduit through which we acquire individual closed loans from banks and 
mortgage companies, primarily for pooling and sale through our Sequoia 
private securitization platform, which creates and issues mortgage-
backed securities (MBS).
    Senior investors in MBS issued through our platform have protection 
from credit risk as a result of our investment in the subordinate 
securities issued in each securitization, which enables the senior 
securities to obtain triple-A ratings. Although this has not been the 
case for most issuers of MBS, in Dodd-Frank parlance, having ``skin in 
the game'' has always been a component of our business model, which 
demonstrates our alignment of interest with senior investors.
    From 1997 through 2007, Redwood securitized more than $35 billion 
of mortgage loans through 52 securitizations. The average loan size was 
$372,000 and, interestingly, 27 percent of the securitized loans were 
prime loans with balances under Fannie Mae and Freddie Mac's (the 
``GSEs'' or the ``Agencies'') conforming loan limit. Since we resumed 
the securitization of newly originated jumbo mortgage loans in 2010, we 
have securitized an additional $8 billion of loans in 20 transactions. 
As a result of our securitization and investment activities, we feel 
well qualified to comment on the state of the private residential 
mortgage market and the steps needed to increase the participation of 
the private sector in the broader housing finance market.
    To supplement our jumbo mortgage loan business, we recently 
received our Seller/Servicer licenses from both Fannie Mae and Freddie 
Mac and we intend to add Agency conforming loans to our product menu. 
Additionally, we invested in Freddie Mac's recently issued Structured 
Agency Credit Risk (STACR) notes. This was the first Agency transaction 
completed as part of the strategic initiative of distributing credit 
risk from the GSEs into the private sector. Furthermore, we look 
forward to working with the Agencies to find ways for Redwood to invest 
in the ``first loss'' credit risk on the loans we sell to the Agencies, 
thereby putting the Agencies in a ``second loss'' credit position.
    If we achieve our goals, our business would include investing in 
the credit risk on both jumbo prime loans (through private 
securitization) and Agency conforming loans (through contractual 
arrangements with the Agencies and investments in STACRs and similar 
investments).
Overview
    Broadly speaking, I view the mortgage market as having two distinct 
sectors. The first is the Government supported sector, which includes 
the FHA/VA, Fannie Mae, and Freddie Mac. The other is the private 
sector, which consists of portfolio lenders, primarily banks, and 
private label MBS issuers, such as Redwood Trust.
    Each of these sectors has made vital contributions to the 
development of the mortgage market over time, for the benefit of 
millions of homeowners. However, in the wake of the financial crisis, 
Congress is now appropriately considering how to reform and improve 
each sector. My testimony will focus on the private label MBS sector of 
the mortgage market, although it is not possible to discuss reform of 
one sector in isolation of consideration of reforms in the other 
sector, as the two impact each other significantly.
    The U.S. mortgage market needs multiple financing sources to ensure 
there are deep sources of liquidity for good borrowers to readily 
obtain affordable mortgage loans. I would argue that it is critically 
important for private label MBS to return and play a significant role 
in mortgage finance, as it has in the past. This can be accomplished by 
bringing traditional institutional senior investors back to the private 
label MBS market to efficiently address borrowers' credit needs.
    I firmly believe that over the long-term, private label mortgage 
securitization is a very efficient form of mortgage financing. As a 
Federal Reserve staff working paper described securitization, it ``has 
the potential to lower the cost of credit to businesses and households 
by reducing financial institutions' funding costs'' and ``it can 
produce securities that cater to the risk-return preferences of 
investors.'' Through the securitization process, an investor is able to 
buy assets that match their appetite for risk, using variables such as 
duration, interest rate risk, and high or low credit risk. This 
tailoring of risk is what draws trillions of dollars into the U.S. 
mortgage market.
    Many have speculated on why private label MBS is not fully 
flourishing today while other asset-backed markets for commercial MBS 
and credit cards have rebounded. There is no single answer to this 
question. There are a variety of factors that must be considered to 
explain the current state of the private label MBS market. Some of 
these factors will self-correct over time, while others will require 
structural and legislative change.
    Later in this testimony, I will offer specific recommendations for 
possible structural and legislative changes. But first, I would like to 
offer the following broad observations about the market:

    As a result of increases in the conforming loan limit, 
        there are fewer non-Agency jumbo loans being created.

    The GSEs have had a significant pricing advantage over the 
        private MBS market. This advantage has been reduced as 
        guarantee fees have increased over the past 2 years.

    Pre-crisis, major banks were significant issuers of private 
        jumbo MBS (especially for 30-year fixed-rate loans). These 
        banks now have over $2 trillion in excess reserves at the 
        Federal Reserve and have made an investment decision to hold 
        significantly more jumbo loans in portfolio to build their 
        asset base and increase net interest income, rather than 
        securitize or sell the loans. For example, in 2012, jumbo loan 
        originations totaled $200 billion and private label MBS 
        securitizations totaled only $3.5 billion.

    Traditional senior investors still have questions of 
        confidence regarding whether their rights and interests in the 
        MBS they purchase will be respected and, consequently, that 
        their investments will be safe and secure.

    My last observation is a Catch-22. For private label MBS 
        financing to attract more investors willing to invest at 
        attractively priced levels, the asset class needs to be larger 
        and more liquid. But in order to attract more investors, the 
        asset class first needs a larger critical mass, so investors 
        will see the value in dedicating resources to analyze and 
        monitor the sector.
The Current Private MBS Market
    The mortgage loans that are currently being securitized through our 
platform are probably more similar than many perceive to the loans 
currently being guaranteed by the GSEs, except for the average loan 
amount, as noted in the table below.


    The GSEs have done a very good job of building loan quality. A 
large percentage of the loans currently guaranteed by the GSEs would 
meet Redwood's guidelines and, while our primary focus has been on the 
prime jumbo mortgage market, we are prepared to securitize prime loans 
of any size if the conforming loan limits are reduced.
    We believe that if and when the conforming loan limits are lowered, 
both banks and securitization sponsors will step in to finance loans 
above the lowered limits at affordable rates, and the typical jumbo 
loan characteristics will increasingly resemble conforming loan 
characteristics. As for credit quality, the credit performance of our 
post-crisis securitizations has been stellar. No investor in the senior 
securities has incurred a credit loss and currently we have only one 
loan that is more than 60 days delinquent.
    Interest rates to borrowers on conforming versus jumbo loans are 
narrowing closer to historical norms. On September 25, 2013, Redwood 
was purchasing prime 30-year fixed-rate jumbo mortgages within a rate 
of 4.875 percent. This compares to Wells Fargo's prime 30-year fixed-
rate Agency conforming rate of 4.375 percent for the same date. The 
spread between these two rates of 0.50 percent is about 0.25 percentage 
points higher than the historical average. That also represents a 
dramatic improvement from the 2.00 percentage point spread that was in 
effect at the peak of the financial crisis in 2008. The current spread 
is solid evidence that private capital will provide borrowers with 
loans on reasonable terms if investors are presented with well-
structured securitizations that also have a proper alignment of 
interests between the sponsor and the senior investors.
How To Build a Robust Private MBS Market
Focus on Investor Concerns
    Investors are the single most critical variable to consider as you 
take steps to promote a robust private MBS market. Simply put, 
investors have the money, and without their participation, there is no 
market. Many potential senior MBS investors, who previously had 
significant asset allocations to invest in private MBS, now have little 
or no participation at all. This is unfortunate because the financial 
world has ample liquidity and investors are combing through different 
asset classes in search of safe, attractive yields. On a relative value 
basis, there is no logical reason why private MBS should not play a 
much larger role as an attractive investment class, as it was in the 
past.
    So how is confidence restored among investors? Broadly speaking, I 
believe we need to first address investors' demands for better risk 
mitigation, transparency, and alignment of interests throughout the 
mortgage chain. Redwood's transactions prove that it can be done. We 
have listened to investors and worked hard to meet their new 
requirements for investing in private MBS by putting together 
transactions that included comprehensive disclosures, better and 
simpler structures, new enforcement mechanisms for representations and 
warranties, and skin in the game.
Correct MBS Structural Deficiencies and Conflicts
    The private market will have difficulty growing at the velocity 
needed without the combined efforts of market participants, Congress, 
and regulators to correct structural deficiencies and conflicts in 
securitizations. It is critical that we strengthen the structural 
foundation that supports securitization so that investor protections 
are given greater emphasis. In traditional securitization structures, 
investors have relied on a trustee and a servicer to administer a 
securitization. The governing documents have not always addressed or 
contemplated all of the potential situations that could face the 
servicer or trustee, nor have they always provided an investor-friendly 
mechanism for initiating and resolving disputes. The following 
recommendations will correct the structural deficiencies and conflicts:

    Establish best practices in representations and warranties 
        and other key securitization terms through the creation of a 
        Private Market Advisory Committee (with investors holding a 
        majority of the membership) that is given responsibility for 
        developing new best practice standards. The standards would not 
        be mandatory, but each securitization would be required to 
        clearly disclose any variation from the standards.

    In many cases, representations and warranties have been weak and 
inconsistent and have been difficult for investors to compare from one 
sponsor to another and from one transaction to another. In addition, it 
has been costly or difficult to enforce the originator's or sponsor's 
obligations to repurchase loans where there has been a breach. We 
believe the representations and warranties now required by the GSEs 
serve as a strong benchmark.

    Establish binding arbitration as a minimum standard for 
        dispute resolution of representation and warranty claim 
        disputes in private label MBS.

    The Agencies are large and powerful institutions that have the 
ability to effectively enforce representation and warranty claims 
relating to loans they purchase and guarantee. In the private label MBS 
sector, however, there has not been a comparable force behind the 
enforcement of representation and warranty claims. Some originators 
have resisted or stalled the process for legitimate claims, resulting 
in costly litigation. These circumstances have led to deep investor 
mistrust. Furthermore, investors unable to rely on this protection have 
fled the securitization market and continue to sit on the sidelines. In 
order to correct this problem, we recommend requiring a formal dispute 
resolution process for ensuring enforcement--specifically, a binding 
arbitration standard. New best practice standards for representations 
and warranties, coupled with binding arbitration, would provide 
investors with assurance that any allegation of a violation of 
representations and warranties will be thoroughly investigated and 
pursued in an efficient manner.

    Require that securitization trusts create the position of 
        Credit Risk Manager to manage representation and warranty 
        claims and monitor servicer performance and actions.

    The Credit Risk Manager (CRM) would be an independent third-party 
unaffiliated with any interest in the transaction and would have two 
primary responsibilities. The first would be to identify, investigate, 
and pursue claims for breaches of representations and warranties. This 
is important in the event the senior investors and the party that owns 
the first loss security disagree on whether or not to pursue a claim. 
The second responsibility would be to conduct ongoing surveillance of 
the servicer's activities and report to the trustee and investors the 
results of the review. Although a servicer is engaged to service 
mortgage loans in a securitization pool for the benefit of the 
investors, the investors have no real way of ensuring that the servicer 
is performing its duties because no independent review or quality 
control of the servicer's decisions currently exists. The 
securitization documentation should provide for the CRM to have the 
same access to loan information and original loan files as the servicer 
to ensure that the CRM has the information necessary to perform its 
responsibilities.

    Establish clear and objective uniform standards governing 
        the responsibilities and performance of a servicer in its role 
        as a fiduciary of the trust.

    When we focus on the role of servicers in the securitization 
structure, we note they have sometimes been placed in the position of 
having to interpret vague contractual language, ambiguous requirements, 
and conflicting directions. In their role, they are required to operate 
in the best interest of the securitization trust and not in the 
interest of any particular bond investor. In practice, without any 
clear guidance or requirements, they invariably anger one party or 
another when there are disagreements over what is and is not allowed--
with the result of discouraging some senior investors from further 
investment in private MBS.

    Prevent servicer conflicts of interest by prohibiting the 
        owner of a second lien mortgage from being the servicer of the 
        first lien mortgage on the same property.

    Currently, most second lien mortgage loans are owned by the same 
banks that perform servicing on the homeowner's first lien mortgage. 
Because these banks generally do not own the first lien mortgage they 
are servicing, they have a strong incentive to place their financial 
interests as a second lien holder ahead of first lien investors when 
taking actions as servicer on behalf of a securitization trust. For 
example, a servicer could refuse to approve a loan modification or a 
short sale that would benefit both the first lien mortgage holder and 
homeowner, because doing so would directly harm their financial 
interest as the owner of the second lien mortgage loan.
    Fortunately, there is a simple fix to this problem. Simply prohibit 
the owner of a second lien mortgage from operating as the servicer of 
the first lien mortgage on the same property. Servicing a delinquent 
loan is a nuanced, complicated process and investors must believe that 
their servicers are acting as honest agents throughout. No amount of 
disclosure or other half-measures will alleviate these concerns. The 
only meaningful solution is to definitively break the economic link 
between first lien mortgage servicers and second lien mortgage holders.

    Establish servicer performance triggers to serve as 
        benchmarks and as an objective means for possible removal of 
        the servicer.

    Servicers need to live up to servicing performance standards and 
triggers should be established to give investors the ability to hold 
servicers to these standards. The triggers, which could be set by the 
Private Market Advisory Committee I proposed above, might include, 
among other things, average loss severity, adherence to foreclosure 
timelines, and average REO liquidation timelines. The triggers should 
be reviewed on a periodic basis. If a servicer fails a trigger, 
servicing could be terminated. Mechanisms must be established to 
facilitate collective action by investors when a trigger event occurs 
and there is a failure on the part of the trustee to take action.

    Control the systemic and loan level risks relating to 
        second lien mortgages by giving first lien holders the ability 
        to require their consent to a second lien if the combined loan 
        to value (CLTV) with all other liens will exceed 80 percent.

    During the housing bubble, homeowners extracted record levels of 
home equity through second lien loans. Second lien loans also acted as 
a substitute for cash downpayments to purchase houses. At the peak in 
2006, these loans totaled $430 billion.
    The rise of home equity lending increased the monthly payment 
obligations for borrowers and reduced the amount of equity remaining in 
their homes, leaving borrowers vulnerable to home price declines. As a 
result, 38 percent of the borrowers who used these loans found 
themselves underwater (or owing more than the value of their houses), 
compared to only 18 percent of those who did not. Even for well-
underwritten, prime loans, the presence of a second lien correlated 
with increased defaults by as much as 114 percent.
    The rise of second liens has had another, less-widely understood 
effect: it substantially increased losses for investors and chilled 
their interest in investing in newly issued MBS. To understand why, it 
is necessary to understand how investors evaluate mortgage loans. While 
a borrower's credit report, income verification, and other underwriting 
factors are important to investors in evaluating credit risk, perhaps 
the most important factor is the amount of a borrower's equity, or the 
borrower's downpayment. The amount of a borrower's equity is probably 
the most predictive factor of a borrower's future performance: 
borrowers with 20 percent or more equity have lower default rates, 
while those with no equity are quicker to default and walk away from 
their home.
    Second liens undermine an investor's ability to analyze risk by 
making downpayment information unreliable. Imagine this scenario: a 
borrower applies for a first mortgage with a 40 percent downpayment--
this is a loan that would historically have very low default risk. As a 
result, the borrower is offered a great loan at a low rate. One week 
after taking out the loan, the borrower takes out a second mortgage 
from a different lender for the remaining 40 percent of the property 
value. The borrower no longer has any equity and the default risk and 
potential loss severity on the first lien is higher than before. This 
is not a fantasy scenario: approximately 70 percent of borrowers in 
prime, privately securitized mortgages issued between 2004 and 2007 
took out second liens subsequent to obtaining a first mortgage.
    This level of uncertainty has a highly consequential impact on how 
investors assess mortgage related investments. Since investors have no 
way of knowing which borrowers will cash out their equity, they must 
assume that everyone will. This uncertainty leads private investors to 
demand higher rates in return for the increased risk, and the cost of 
home ownership goes up for everyone.
    We believe that placing some reasonable restrictions on the 
origination of second lien mortgages will restore investor confidence 
and speed the transition of the mortgage market away from taxpayer 
exposure. We propose that first lien holders have the ability to 
require their consent to a second lien if the combined loan to value 
(CLTV) with all other liens will exceed 80 percent. If the consent is 
not given, then the borrower can still obtain a home equity loan, but 
will need to refinance the first mortgage (and pay off the first lien 
holder) using a standard cash-out refinance loan product. This proposal 
would allow borrowers to tap into their equity, while preserving a 
level of protection for investors in first liens. This new restriction 
is intended only to protect first-lien lenders, and investors, from 
excessive equity being extracted later, without their knowledge or 
consent.

    The Government should begin to reduce its participation in 
        the mortgage market, gradually and at a measured pace by 
        reducing the conforming loan limits.

    For many years prior to the financial crisis, the Government 
mortgage market (GSEs, Federal Housing Administration, and Veterans 
Administration) and the private mortgage market have coexisted to serve 
the needs of borrowers. In the aftermath of the financial crisis, the 
Government's share of the mortgage market has increased to 
approximately 90 percent. If the conforming loan limits are reduced, I 
believe the private market would aggressively compete for those loans 
that exceed the new limit without any market disruption, similar to 
when the temporary increase in the conforming loan limit (from $625,500 
to $729,750) was allowed to expire in September 2011.

    Remove the uncertainty caused by unfinished regulations.

    The incomplete status of regulations required by the Dodd-Frank Act 
has constrained the development and growth of the private MBS market. 
Markets require certainty about the rules of operation so that 
regulatory compliance can be assured. Investors will continue to be 
cautious about entering the private MBS market out of concern that 
final regulations might soon turn a good business decision into a bad 
one. Markets typically manage to adapt to new regulations and continue 
operating under the new rules. The private label MBS market is no 
different.
Conclusion
    The U.S. mortgage market is a complex system with many parts and 
key participants. Each plays a supportive role in creating a highly 
liquid and efficient market. The private MBS market will once again 
assume a major role, alongside the Government supported sector, as the 
issues I have discussed begin to get resolved. Thank you.
                                 ______
                                 
                   PREPARED STATEMENT OF JOHN GIDMAN
           President, Association of Institutional Investors
                            October 1, 2013
    Chairman Johnson, Ranking Member Crapo, Members of the Committee, 
thank you for inviting me to testify here today in support of your 
overall efforts toward housing finance reform and specifically 
regarding fundamentals of a functioning private label mortgage backed 
securities (PLS) market.
    My name is John Gidman. I am an Executive Vice President of Loomis, 
Sayles & Company in Boston, Massachusetts, and am testifying here today 
in my role as President of the Association of Institutional INVESTORS 
(the Association). The Association is an organization of some of the 
oldest and largest institutional investment advisors in the United 
States. All our firms have a fiduciary duty to put our clients' 
interests first. Put simply, it's not our money.
    Our member firms manage investments for more than 80,000 pension 
plans, 401(k)s, and mutual funds on behalf of more than 100 million 
workers and retirees. Our clients include companies and labor unions, 
public and private pension plans, mutual funds, and families who depend 
on us to help them provide for their retirements, to have funds 
available to educate family members, and to support their financial 
aspirations.
    Our clients are able to rely on us to prudently manage their 
investments in part due to the fiduciary duty we owe these 
organizations and individuals. We recognize the significance of this 
role and my testimony today is intended to reflect not just the views 
of the Association but the financial interests of the companies, labor 
unions, municipalities, workers, and retirees we ultimately serve.
    We recognize the vital role robust housing finance markets play in 
our society. These markets traditionally provided generations of 
families, across a variety of income levels, pathways to gain home 
ownership. For decades, this defined the American Dream. Much of this 
mortgage financing has ultimately been provided by pension plans, 
401(k)s, and similar funds whose investors valued collateralized 
income. Through these investment mechanisms, workers and retirees 
relied on the strength and depth of these markets to provide them 
income they needed for retirement.
Lessons Learned From the Housing Crisis
    Institutional investors, like all participants in the mortgage 
market, have learned many lessons from the financial crisis. We learned 
that the stress of high unemployment and the decline in housing prices 
exposed certain structural weaknesses in the securitization framework.
    We recognize the critical role trustees play in the functioning of 
PLS mortgage markets but believe that they were not and are still not 
legally compelled, nor financially incented, to appropriately safeguard 
the interests of the trusts they represent.
    We are keenly aware that the incentives of the originator and the 
buyer of the risk were not and are still not aligned, because the 
originator typically sells all, or nearly all, of their economic 
interest in the securitization. This is a fundamental difference from 
other securitization markets, such as automobile or credit card 
markets, where the issuer retains significant first-loss risk and has 
very strong incentives to underwrite conservatively.
    Institutional investors see that documentation was not and still is 
not standardized and that the strength of representations and 
warranties varies depending on the issuer.
    Institutional investors also consider that the enforcement of 
existing contracts was and is still weak, particularly where vertically 
integrated financial institutions often serve as issuers, trustees, 
originators, and servicers, creating conflicts of interests and 
incentives not to identify deficiencies that harm investors' trusts.
    As a result of these structural weaknesses, little has improved in 
legacy residential mortgage backed securities (RMBS) reporting, 
enforcement of representations and warranties, or oversight of servicer 
performance. A typical monthly report today for legacy RMBS securities 
is not transparent as to who is servicing the loans, on what basis 
particular actions were taken by the servicer, or even regarding 
reconciling cash that came in and out of the trust. Recently, large 
portions of the legacy RMBS market have also seen servicing duties 
transferred from one firm to another, without investor consent or 
effective challenges from trustees, even in situations where investors 
would have likely been opposed to such a change.
Overview of the Current PLS Market
    The absolute volumes of new issuances remain a very small fraction 
of what they were before the 2008 crisis. However, today, the quality 
of the collateral underlying the PLS market has generally improved. New 
issue RMBS markets have reopened as of 2011, and grew in 2012 and 2013, 
but with issuances primarily in the ``Jumbo Prime'' space, or high 
credit quality loan balances well above the conforming limits.
    The fundamental structural and process weaknesses for nonagency 
RMBS securitization have not been fixed in the current PLS market. The 
issuance process itself is very opaque. Ratings continue to be shopped, 
issuers are still incentivized to water down representations and 
warranties, and continued variability in structures and documentation 
make the market more challenging for investors and raise the costs of 
funding.
    Additional uncertainty has also been added to the market due to 
concerns that make it harder for investors to price risk, which 
consequently makes it harder for investors to justify investing in the 
sector. Included among the factors increasing uncertainty are: (a) the 
potential use of eminent domain by local governments to seize mortgages 
held in interstate trusts; (b) assignee liability; and (c) settlements, 
such as the Department of Justice's and various States Attorneys 
General settlement--the National Mortgage Settlement--using PLS trusts' 
funds to remedy allegations of inappropriate, unlawful, or illegal 
behavior on behalf of the issuer or servicer--behavior in which 
investors had no role.
    We do not believe that the PLS market is robust enough, given the 
current structural risks, to sustainably absorb significantly more 
supply, especially if the supply includes deals with lower 
subordination levels or collateralized by loans from borrowers with 
less pristine credit and lower downpayments (higher loan-to-value 
ratios). In other words, we are talking now about the vast gulf between 
home mortgages averaging between $250,000 to $300,000, supported by the 
agencies, and those for homes over $1,000,000 owned by borrowers with 
pristine credit and high equity.
    Buy-and-hold institutional investors will either require much 
higher yields--yields that are likely to render credit unavailable to 
those middle-class borrowers most in need of it--or will likely not 
participate in sufficient size to support the market without 
significant structural reforms.
Current PLS Market Borrowing Characteristics and Loan Level Data
    As I alluded to, from a credit perspective, the types of loans 
currently being securitized are of a very high quality. Typically, the 
loans have a 66 percent average loan-to-value and a 760 average FICO 
score, with very few second liens and no mortgage insurance, so 
borrowers have 20-50 percent equity in the property. In the majority of 
deals, only the senior (typically AAA-rated) part of the securitization 
is being sold, so the amount of risk being taken by the private market 
is relatively small. The average home price of the mortgages being 
securitized is over $1,000,000. These high prices, combined with large 
downpayments and very high credit quality, has led to a situation where 
the current PLS standards cannot be used to finance mortgages for the 
majority of Americans. It should be noted that the PLS market did 
provide loans of average and even below-average credit quality before 
the crisis and there is likely funding available to do so, if investors 
become convinced that the issues exposed by the financial crisis have 
been addressed.
    The following table shows the volume and average credit 
characteristics of Jumbo Prime issuance from 2011 through 2013.


    There is also a need for continued access to robust loan level 
data. Prior to the crisis, investors did receive some loan level data 
for RMBS. Today, data for new issue deals contains more information and 
more accurately represents credit risks. However, we do not have access 
to the actual loan documents. We believe that full access to actual 
loan documents is important and this data should not be restricted by 
requiring the use of expensive commercial data services. Immediate, 
free access to the actual loan documents should be reasonable, as the 
documents are readily available and investors in the trust legally own 
the documents as owners of the loans. However, even with complete data 
sets or access to the loan documents, we believe our information will 
never be as perfect as the originators' information. To level the 
playing field and promote an open and transparent market, we believe 
other factors, such the creation of a fiduciary duty for trustees, 
better quality reporting, and standardized representations and 
warranties are more important to investors than loan-level data.
General Thoughts on Housing Reform
    While the PLS market has improved since the financial crisis, in 
our view, meaningful regulatory and operational changes must be made 
before the market can fully recover. Institutional investors want to be 
able to invest in the mortgage sector, on behalf of our clients, as the 
credit quality of newly originated mortgages has improved. However, as 
fiduciaries, we cannot put our investors' savings and assets at risk in 
bonds that have a significant and unquantifiable downside risk.
    Therefore, we fully support Congress' efforts to reform the 
mortgage market. In doing so, we believe Congress should consider the 
agency market and the PLS market as part of one interconnected mortgage 
finance system. We believe that any regulation or legislation that 
reforms one market needs to consider the impact on the other market. 
Today, institutional investors favor investing in the agency market 
because there are fewer unknowns and many of the key investor concerns 
are mitigated when dealing with that market. The PLS market can 
redevelop, but the private market's reliance on the Government-
sponsored enterprises (GSEs) will not organically decrease unless there 
are safeguards put in place to protect the PLS market.
    S.1217, the Housing Finance Reform and Taxpayer Protection Act, 
which was introduced earlier this year by Senators Bob Corker (R-TN) 
and Mark Warner (D-VA), and is cosponsored by six other bipartisan 
Members of the Senate Banking Committee, addresses some of the 
Association's concerns and generally we think this legislation moved 
the debate in the right direction.
    The bill's risk-sharing mechanism offers a promising solution that 
we believe could work if investors' need for a fiduciary standard for 
trustees is mandated. In July 2013, Freddie Mac issued the first risk-
sharing deal in the RMBS market, called STACR 2013-DN1. We believe it 
was a positive sign that institutional investors were willing to take 
subordinate credit positions on this portfolio of agency mortgages, 
indicating that institutional investors may also be willing to take on 
risk under a Corker-Warner system.
    The legislation also provides helpful language to address investor 
concerns with the PLS market regarding issues like standardization of 
documentation and enforcing representations and warranties. Title II, 
Subtitle C of S.1217, in particular, reflects many of the transparency 
and oversight principles that we believe are vital to increasing 
investor confidence in the mortgage market. We appreciate the inclusion 
of these provisions and hope they are part of any other GSE reform 
legislation considered by the Committee.
    S.1217, however, did not address several fundamental investor 
concerns. These issues include: (1) creating a fiduciary duty for 
trustees and servicers; (2) addressing the assignee liability 
provisions included in Section 1413 of the Dodd-Frank Wall Street 
Reform and Consumer Protection Act (Dodd-Frank Act), now implemented by 
the Consumer Financial Protection Bureau (CFPB) in its Ability-to-Repay 
Rulemaking; and (3) limiting the ability of local municipalities to use 
eminent domain to seize residential mortgages held in trusts across 
State lines. Some of these concerns were highlighted by the crisis; 
others have arisen since the crisis. Each must be addressed by any 
mortgage market reform package that progresses through Congress, if one 
of the goals of the legislation is to incentivize private capital to 
return to the PLS market and stay in times of market stress. Each of 
these issues is addressed below.
Fiduciary Duty for Trustees and Servicers
    Investor confidence is a foundation of the PLS market, therefore 
investors should have proper recourse to the parties. However, since 
the financial crisis began, a failure in the structure of the PLS 
market has been apparent: trustees do not have a regulated fiduciary 
duty to bondholders.
    To address these concerns and create better investor confidence, 
any mortgage market reform legislation should include trustee fiduciary 
duties to oversee the maintenance of trusts and enforce put-back 
obligations for faulty loans with regulatory oversight and private 
causes of action for breaches.
    Recent developments have underscored the lack of trustee fiduciary 
duty as the ongoing critical gap in the PLS marketplace. Situations 
like last year's Attorneys General mortgage servicing settlement (the 
AG Settlement), where investors were not involved in the negotiations, 
and when faced with a significant conflict of interest, trustees and 
servicers were able to sacrifice the assets of trust investors in favor 
of their own bottom line. Without a clear fiduciary duty for trustees, 
trustees and servicers are incented to act as they did under the 
settlement. Servicers have overwhelmingly favored writing down loans 
owned by private PLS pension and fund investors rather than writing 
down principal on loans owned by the banks.
    The AG Settlement, while unprecedented, is also not an isolated 
example of a situation where trustees or servicers act in their 
financial interest rather than in the best interests of investors. 
Recently, for example, there have been media reports that a large 
vertically integrated bank may settle an $11 billion deal with State 
and Federal regulators related to investigations into the bank's sale 
of RMBS that were packed with bad loans. This amount reportedly would 
include $4 billion in relief for struggling homeowners, similar to the 
AG Settlement, and it is not clear at this point whether this 
settlement would allow that bank again to meet its obligations by using 
funds from PLS trusts. Like the AG Settlement, investors have not been 
involved in the negotiations, and if the settlement allows it, that 
bank would be incented to meet at least part of its obligations with 
trusts' assets, therefore assets of American savers, because no one has 
a fiduciary duty to act in the best interests of the trusts' 
investors--in effect, the $4 billion would be paid by American workers 
and retirees out of their pension assets.
    Implementing a fiduciary duty for trustees would also spur further 
investment in the market, because investors would be assured that the 
trustee was acting in the best interests of the trusts' investors and 
incentives were properly aligned. Further, a fiduciary standard would 
improve the quality of trusts, as only good mortgages would be placed 
into the trusts, and mitigate conflicts of interest for situations 
where the same entity serves as both servicer and trustee.
    In addition to incentivizing private capital to return because 
investors' rights would be better protected, creating a fiduciary duty 
would also reduce the incentives that currently exist to invest with 
the GSEs. Under the current model, the GSEs are often more attractive 
because they are partners to their own contracts. Investing with the 
GSEs ensures that an entity, the GSE, has proper recourse if there is a 
problem. By creating a fiduciary duty, private capital will be 
encouraged to continue investing in the PLS market, ultimately 
increasing the market share for the private market and reducing the 
Government footprint.
Assignee Liability
    We believe that assignee liability once implemented and as 
currently defined in regulation will lead institutional investors to 
avoid the PLS market.
    The Dodd-Frank Act and the CFPB's subsequent regulations create a 
path for a defaulting borrower to sue the lender for irresponsible 
lending. We agree with this principle and believe that it is good to 
hold originators accountable for predatory lending. However, the 
statute and regulations also create assignee liability, which 
essentially means that if the originator sells the loan, the buyer of 
the loan can be sued even though they were not the lender that made the 
bad loan in the first place. In the case of the PLS market, the trustee 
for the transaction would be the lawsuit target, and any legal, 
settlement, and damage costs would come out of collateral cash flows.
    Such lawsuits are also not limited to the loan amount. Rather, 
potential damages awarded against the PLS trust, as the assignee, could 
equal to the sum of all finance charges and fees paid by the borrower 
(up to 3 years' worth from the origination of the loan), plus actual 
damages, court costs, and attorneys' fees. We expect that damage awards 
could amount to thousands of dollars per loan, and a typical RMBS bond 
includes thousands of loans. Thus, an investor could face millions of 
dollars in losses from this liability on each bond. Furthermore, as 
trusts often have the ability to pay more than small originators, we 
believe that assignee liability could actually have the unintended 
consequence of weakening the liability of the originator, because 
plaintiffs' attorneys will focus the lawsuits on the entity with the 
deepest pockets.
    Given this potential liability, assignee liability risk may already 
be affecting the PLS market, even in advance of the CFPB's ability-to-
repay requirements going into effect in January 2014. Institutional 
investors in this market are not close enough to the origination 
process to determine for themselves if all loans are exactly as 
advertised at the time of purchase, and so institutional investors are 
not willing to take on the risk that they could be sued for others' 
actions. Further, although Dodd-Frank and the CFPB's regulations 
include a safe harbor for a certain subset of qualified mortgages 
(QMs), this does not assuage our concerns because even if the safe 
harbor qualifications are met, asset managers will be forced to expend 
resources to establish the applicability of the safe harbor in every 
case where the borrower asserts that the ability-to-repay requirements 
were violated, regardless of the merits of the claim. Unless 
legislative changes are made, we expect that the PLS market will 
deteriorate further once these rules go into effect in January.
    To address these concerns, we are supportive of any efforts to 
reduce the risk of assignee liability under Dodd-Frank and the CFPB 
regulations and to increase access to the ability-to-repay safe harbor. 
The best way to accomplish this goal would be by including language to 
eliminate assignee liability completely. Removing assignee liability 
would not reduce the protections afforded homeowners under the ability-
to-repay provisions, but rather would ensure that only those that are 
responsible for generating the loans will be held accountable for the 
loans that they generate. Under such a system, incentives will be 
properly aligned and institutional investors would not be held 
responsible for the bad acts of other players. Alternatively, although 
less ideal, the legislation could include a provision that would ensure 
that the CFPB must expand its ability-to-repay regulations to allow 
more loans to meet the conclusive safe harbor standard.
Eminent Domain
    It seems in every crisis, there are powerful and well-connected 
opportunists that prey again on the victims. Certain jurisdictions are 
considering implementing a program designed and aggressively marketed 
by a private fund whereby a city would rent out its local eminent 
domain power to seize performing high quality mortgage loans, held in 
interstate trusts, in order to restructure the mortgages at a profit 
for the city and the fund's investors. This unprecedented and misguided 
use of local eminent domain power could hurt the retirement savings of 
workers and retirees from across the United States, who currently 
invest in mortgages that would be seized, and significantly damage the 
overall PLS market.
    Under the fund's plan, cities would seize current performing 
mortgages that are in trusts held by pension plans, 401(k) plans and 
mutual funds across the United States and managed by our members. If 
mortgages are taken by eminent domain, we will take action to protect 
the assets of our clients.
    As fiduciaries, we have a duty to ensure that the investments we 
make on behalf of our clients are in their best interests. Therefore, 
after eminent domain is used, we will be forced to weigh the 
possibility that future mortgage contracts will not be upheld and our 
clients will lose value in their investments. Ultimately, we believe it 
will be difficult to continue investing in the mortgage markets if any 
local community uses eminent domain to seize assets out of interstate 
trusts.
    Given these concerns, the Association believes any GSE reform 
legislation should include language similar to the language in H.R. 
2733, the Defending American Taxpayers from Abusive Government Takings 
Act of 2013, which was included in the PATH Act (H.R. 2767). These 
provisions would prohibit the GSEs from purchasing, the Federal Housing 
Administration from insuring, and the Department of Veterans Affairs 
from guaranteeing, making, or insuring, a mortgage that is secured by a 
residence or residential structure located in a jurisdiction where 
eminent domain has been used to take a residential mortgage. We are 
also in favor of expanding the Home Affordable Refinance Program (HARP) 
to homeowners whose mortgages are held in PLS trusts, to provide these 
homeowners with relief.
Conclusion
    As the Committee continues to consider housing finance reform, we 
hope our perspectives support your efforts. Each of our suggestions is 
intended to help promote a vibrant secondary mortgage market, 
accomplish your goal of reducing the Government footprint in the 
mortgage market, and avoid adverse consequences that will ultimately 
affect the millions of American investors who rely on the continued 
vitality of these markets in order to save for their families' needs. 
We thank the Committee for its continued work and for focusing on this 
difficult issue. As the Committee progresses in its work, we stand 
ready to provide information and assistance as a voice for the millions 
of Americans who rely on these markets.
    Thank you for the opportunity to participate in today's hearing.
                 PREPARED STATEMENT OF ADAM J. LEVITIN
           Professor of Law, Georgetown University Law Center
                            October 1, 2013












































         RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK
                     FROM MARTIN S. HUGHES

Q.1. FHFA has taken several steps while Fannie Mae and Freddie 
Mac have been in conservatorship to preserve the assets and 
protect the taxpayers. These steps include enhancing the 
underwriting, credit risk pricing, and reps and warrants 
contracts of counterparties with Fannie Mae and Freddie Mac. 
These actions ensure standards being used by the two 
Enterprises are more updated, comprehensive, transparent, and 
that they more accurately reflect the risks assumed by the two 
Enterprises. Had these reforms been implemented prefinancial 
crisis much of the fraud, poor risk-management, and losses to 
the taxpayers could have been avoided. Going forward, these 
actions are providing for a more attractive and transparent 
agency market for investors, which is essential to ensuring the 
U.S. housing market continues to be attractive for global 
investment.
    Can you tell me if the private label security (PLS) market 
is adopting the same stringent transparency and contractual 
standards as the agency market? If not, why not?

A.1. Participants in the post crisis private label security 
(PLS) market have implemented increased transparency and 
contractual standards, but with variations among the PLS 
sponsors. For example, it is my understanding that most or all 
of the issuers have adopted the American Securitization Forum 
disclosure format, which contains approximately 150 fields of 
data per loan backing a PLS. This compares to approximately 35 
data fields disclosed by the Enterprises. Therefore, I would 
say that the PLS market provides far more data and transparency 
about the loans backing private securities than is currently 
being offered by the Enterprises. The contractual standards 
have also improved in the private market, but with variation 
among PLS sponsors. For example, some current securitization 
sponsors, mainly banks, have ``sunset'' clauses in their 
representation and warranties that they make to the 
securitization trusts, which we believe undermines confidence 
among the triple-A investors to purchase PLS. The PLS issued by 
Redwood do not have sunset provisions as we believe the PLS 
market needs to be held to a higher standard.

Q.2. What is holding back standardization of the PLS market? 
What is happening to PLS pools in the market today?

A.2. Simply stated, the lack of a self-governing organization 
or regulatory directed standardization is contributing to the 
holdback in standardization. As a result, PLS issuance 
represents a growing but still very small market. For example, 
in 2012, only $3.5 billion out of $200 billion of jumbo 
mortgage originations were securitized, representing less than 
2 percent of originations. For the first 6 months of 2013, $8.3 
billion of prime jumbo originations were securitized out of 
$113 billion of originations, representing 7 percent of the 
market. These percentages are much smaller than the period 
starting in 1995 through 2007 in which the percentage of jumbo 
loans securitized to total jumbo originations averaged 29 
percent.
    We believe that what is holding up the reemergence of prime 
PLS is a combination of structuring and monetary policy issues 
that currently incent large banks to retain mortgages on their 
balance sheets. The structuring issues that are holding up the 
reemergence of PLS include:

  1.  A need for standardized representations and warranties 
        for all securitizations that protect investors from 
        noncredit related losses. Any exceptions should have to 
        be noted clearly on a schedule so that investors do not 
        have to compare and contrast the rep's and warranties 
        from one deal to another against a standardized format.

  2.  A need to have a standardized enforcement mechanism (such 
        as binding arbitration) for rep and warranty breaches.

  3.  A need to empower the trustee to proactively monitor and 
        take appropriate actions for the benefit of the 
        security holders. We suggest the concept of the 
        ``controlling holder'' as is used in our Sequoia 
        securitizations.

  4.  A need for investors to have confidence that their 
        collateral will not be unfairly taken from them through 
        Government actions (such as through eminent domain) or 
        by third-party mortgage servicers that do not have an 
        economic stake in the securitizations they service by 
        modifying loans to further their own interests.

  5.  A need to protect investors from having their mortgage 
        collateral diminished in value by allowing borrowers an 
        unlimited ability to withdraw equity from their houses. 
        We suggest that any lender who proposes to provide a 
        subordinate financing on a property that would increase 
        the combined loan-to-value ratio above 80 percent 
        obtain the consent of the first mortgage holder, and if 
        the consent is not granted, the new lender can provide 
        a new first mortgage for the entire amount desired.

    We also believe that investors take comfort from issuers 
that have meaningful ``skin in the game.'' At Redwood, for 
securitizations we have sponsored post crisis, we hold 100 
percent of the noninvestment grade securities that are first in 
line to incur losses, which we believe provides a high 
alignment of interest with the investors in the senior 
securities. We realize that this issue is far more complicated 
than just risk retention, but it is unfortunate that it appears 
most residential securitizations will not require sponsors to 
retain risk. We expect to continue to hold all of the 
noninvestment grade credit risk tranches on our 
securitizations.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN
                     FROM MARTIN S. HUGHES

Q.1. One component of the housing finance system that has much 
received significant discussion over the last year is the role 
of recourse available to the lender. Recourse is available to 
lenders on a State-by-State level. States where recourse is 
available to lenders have a significantly lower risk of default 
as comp, especially among those who may strategically default. 
One Federal Reserve analyst found that for a sample of loans 
originated between August 1997 and December 2008, ``the 
probability of default is 32 percent higher in nonrecourse 
States than in recourse States.'' Borrowers who had a property 
value of $500,000-$750,000 at origination were over 100 percent 
more likely to default in nonrecourse States than in recourse 
States. In your view, would expanded availability of recourse 
strengthen our housing finance system? What is the impact of 
recourse availability on investors' decision making in real 
estate and private-label mortgage-backed securities?

A.1. On the subject of recourse lending, we are generally in 
favor of the concept and we understand that it has worked well 
in Canada and Australia. As a practical matter, when a lender 
has an option of using a nonjudicial foreclosure process that 
does not allow for a deficiency judgment, or a using a judicial 
foreclosure that provides the lender with a deficiency 
judgment, lenders overwhelming use the lower-cost nonjudicial 
foreclosure alternative. Borrowers that ``strategically 
default,'' despite having ample resources, inflict damage to 
the integrity of the mortgage market and ultimately force all 
borrowers to pay a higher price for a loan, since investors 
suffer additional losses.
    RMBS investors factor into their pricing models loss 
severities by loan, which is a function of where the property 
is located and the rules around the foreclosure processes in 
each State, which would take into account the ability to obtain 
a deficiency judgment.

Q.2. In your written testimony you said we should ``remove the 
uncertainty caused by unfinished regulations,'' referring 
specifically to the Dodd-Frank Act. You said the incompleteness 
``has constrained the development and growth of the private MBS 
market.'' As you know, some proposals for the future housing 
finance system would place a new Federal regulator in the 
system in the form of the Federal Mortgage Insurance 
Corporation. The Federal Reserve, Department of Housing and 
Urban Development, Securities and Exchange Commission, Office 
of the Comptroller of the Currency, and Consumer Financial 
Protection Bureau all already manage these regulations. In your 
view, what are the most significant outstanding regulations 
impeding the industry currently? Additionally, how do you 
believe the future complexity of navigating regulations by 
these different agencies will adversely impact innovation and 
flexibility in the marketplace?

A.2. As of October 1, 2013, only 40 percent of the 398 rules 
required by Dodd-Frank have been finalized. Various unfinished 
rules have a greater impact on some parts of the market than 
others. For the mortgage securitization market, one of the key 
unfinished rules is the risk retention, or QRM, rule. My point 
is not to single out any one rule as most important, rather the 
weight of all the unfinished rules is stifling growth and 
innovation. Markets cannot grow if businesses cannot understand 
the rules under which they will be required to operate. Perhaps 
some of the rulemaking delay is the result of having such a 
fragmented financial regulatory system. The addition of yet 
another regulator should be reason enough to step back and 
assess the need to streamline the current regulatory 
infrastructure.
                                ------                                


               RESPONSES TO WRITTEN QUESTIONS OF
               CHAIRMAN JOHNSON FROM JOHN GIDMAN

Q.1. Can Government guaranteed MBS with private capital first 
loss exposure (as described in S.1217) be structured to allow 
trading in the TBA market? If so, how?

A.1. The Association believes that Government guaranteed MBS 
with private capital first loss exposure can be structured to 
allow trading in the TBA market. However, in order to do so, 
there must be increased transparency, a fiduciary duty for 
servicers and trustees, and loan level disclosures.
    This year, Freddie Mac successfully marketed a new product, 
the Freddie Mac Structured Agency Credit Risk (STACR) 
securities, which shows that there is an appetite and it is 
possible to sell first-loss pieces of certain Government 
guaranteed MBS into the private market. However, deals like 
STACR 2013-DN1 did not include any new originations, and 
investors were able to review the history to appropriately 
price the risk.
    Unlike STACR 2013-DN1, under S.1217 investors are assuming 
the first loss position without the ability to review 
historical data related to the underlying collateral. In this 
type of scenario, increased disclosures and a fiduciary duty 
are necessary to attract institutional investment advisers to 
consider investing in the deals. Assuming increased 
transparency and a fiduciary duty provides institutional 
investors with more comfort in the quality of these 
investments, the Association expects these deals would be as 
reasonably attractive as any other subordination investment.
    Also, the STACR deal had Freddie Mac taking first 0.3 
percent of risk below investors, and ``catastrophic'' risk 
above the credit risk sold to investors. This created an 
alignment of interest between Freddie Mac and investors, with 
Freddie Mac having a strong economic interest to minimize 
losses--we think this is a very important credit consideration 
for investors. In a situation where all of the credit risk is 
sold to investors, this alignment of interests would not exist, 
and investors would likely demand a higher return for the 
increase in risk.
                                ------                                


         RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK
                        FROM JOHN GIDMAN

Q.1. FHFA has taken several steps while Fannie Mae and Freddie 
Mac have been in conservatorship to preserve the assets and 
protect the taxpayers. These steps include enhancing the 
underwriting, credit risk pricing, and reps and warrants 
contracts of counterparties with Fannie Mae and Freddie Mac. 
These actions ensure standards being used by the two 
Enterprises are more updated, comprehensive, transparent, and 
that they more accurately reflect the risks assumed by the two 
Enterprises. Had these reforms been implemented prefinancial 
crisis much of the fraud, poor risk-management, and losses to 
the taxpayers could have been avoided. Going forward, these 
actions are providing for a more attractive and transparent 
agency market for investors, which is essential to ensuring the 
U.S. housing market continues to be attractive for global 
investment.

    Can you tell me if the private label security (PLS) 
        market is adopting the same stringent transparency and 
        contractual standards as the agency market? If not, why 
        not?

    What is holding back standardization of the PLS 
        market? What is happening to PLS pools in the market 
        today?

    I would love to see the conforming loan limits for agency 
mortgage backed securities to be lowered, as it is one of the 
more obvious ways to increase and incentivize the private 
market back into this market space. I am concerned however that 
if the standards in the PLS market are not the same as the 
agency market--including to provide for clear and updated reps 
and warranties agreements and greater transparency--that 
investors will be hesitant to move to the PLS space.

    If the standards for risk-based pricing, reps and 
        warranties and standardization of agency securities are 
        improved for any ``agency-like'' security that is 
        developed post-housing finance reform, will investors 
        begin demanding these enhanced standards for PLS 
        investment? What more could be done to incentivize the 
        private market to adopt such standards?

    Do you think that the PLS market can truly be 
        optimized if loan limits are lowered before greater 
        transparency, contractual, and fiduciary changes/
        updates are adopted in the PLS market?

A.1. Summary--The PLS market has not adopted the same stringent 
transparency and contractual standards as the agency market 
because institutional investors and their investment advisers 
are not parties to the agreements, unlike the Government-
sponsored enterprises (GSEs). Without being parties to the 
agreements, investors have little leverage to ``demand'' these 
enhanced standards for PLS investment. Further, the parties to 
the agreements have no incentive to enhance the underwriting, 
credit risk pricing, and representations and warranties.
    We believe Congress should consider the agency market and 
the PLS market as part of one interconnected mortgage finance 
system. We believe that any regulation or legislation that 
reforms one market needs to consider the impact on the other 
market.
    S.1217 considers the establishment and operation of a 
Federal Mortgage Insurance Corporation (FMIC) as playing an 
important role in structural reforms designed to align 
interests appropriately for the various parties engaged in the 
housing finance markets. It may be helpful to explore ways to 
support expansion of this concept to the PLS market though 
implementation of an agency-like entity, perhaps titled the 
Private Mortgage Assurance Corporation, which could provide 
many of the structural elements we have highlighted as 
important components of housing reform in support of the PLS 
markets.
    This type of private mortgage agency entity, while not 
providing a Federal backstop, could promote a variety of 
services including standards for documentation covering PSAs, 
representations and warrantees, enforcement mechanisms, due 
diligence, and identification of baselines for risk managers 
and servicers. Such an entity could be party to the contracts, 
similar to the way the GSEs are party to their contracts, and 
would have the authority to enforce these contracts on behalf 
of investors. We think this approach is better than the complex 
documentation and multiple levels of re-underwriting that is 
becoming prevalent in the PLS market, which increase costs 
without providing an enforcement mechanism.
    The Association's members support further standardization 
of documentation in the PLS market, as well as efforts to 
increase transparency and enhance representations and 
warranties. These changes will ultimately help create a more 
level playing field. However, we do not believe standardization 
should be the ultimate goal. Even without standardization, if 
servicers and trustees had a fiduciary duty to act in the best 
interest of investors, the Association believes that 
communication and trust would increase among the parties and 
the market would be strengthened.
    The PLS market already had loan-level data transparency, 
risk-based pricing, and many of the contractual protections 
that have come into the agency market in the past several 
years. However, the crisis exposed the fact that trustees are 
not required to enforce the documentation, and servicers (often 
the same banks that originated the faulty loans) are unwilling 
to hand over borrower credit files to be examined for Reps and 
Warrants breaches. In the end, investors have had very little 
actual success in enforcing their rights.
    Rather than looking to incentivize the private market to 
adopt such standards, the Association believes it would be 
better to focus on ensuring that servicers and trustees act in 
the best interests of the investors. Trustees would act more 
rapidly and decisively to protect a trust's assets if subjected 
to a fiduciary duty, and they would also better oversee the 
activities of servicers. Further, servicers would have the 
proper incentives to act transparently in their servicing 
duties. The Association believes the PLS market cannot be 
optimized if loan limits are lowered before a fiduciary duty is 
extended to these entities.
    Expanded Response--The fundamental issue across the PLS 
market is alignment of interests between the originator of the 
loans, the servicer, and the PLS investor. The simplest way to 
align interests (the way it is done in almost every other 
securitized market in the U.S., and also in most foreign 
mortgage markets) is for the originator to hold the subordinate 
position. Risk retention places the first-loss risk with the 
party that has the best information to evaluate that risk--the 
originator. It aligns the interests of the originator and PLS 
investor in the most straight-forward way. If risk retention is 
impossible, first-loss piece shifts to investors, who do not 
have the best information or control of the servicer. As a 
result, we think PLS investors need protections, such as very 
strict contractual protections and enforcement mechanisms.
    There is little homogeneity in ``to-be-announced'' (TBA) 
pools. The agency market is liquid because of the GSEs' 
guarantee, not because the market or the pools have become more 
standardized. Therefore, the Association believes that 
standardization may not be the major obstacle for investors to 
return to the PLS market. The Association agrees that there is 
a marginal benefit to standardization, as it avoids 
fragmentation. However, despite this marginal benefit, 
investors would prefer that Congress focus on creating 
transparency and ensuring that investors' interests are being 
protected, rather than focusing on standardizing documentation. 
As long as the market is transparent and investor rights are 
enforced, institutional investment advisers can appropriately 
price the risk and buy the assets.
    Transparency would be best created in a market where market 
participants are able to trust one another, rather than be 
concerned that each participant is only focused on their own 
best interests. To create such trust, it would also be helpful 
to have access to the actual loan files. Particularly when our 
clients are taking the first loss risk, the operational and 
borrower risk is documented in those loan files. Further, the 
Association recommends creating a fiduciary duty for trustees 
and servicers, which would better align interests among market 
participants. Such a change would best be achieved through 
amending the Trust Indenture Act, and specific language 
regarding such changes is detailed in the Association's White 
Paper submitted to the Committee on October 11, 2013.
    The Association agrees with Senator Kirk that FHFA has been 
far more successful in enforcing representations and warranties 
than the private market. However, this is largely due to the 
ways in which the GSEs are able to identify, find, and enforce 
the repurchase of defects, rather than the difference in the 
underlying contracts. If PLS issuers were obligated to operate 
in the same fashion, investors would benefit, but it is 
unlikely PLS issuers will ever do so. The GSEs are able to 
operate as they do simply because of their market power, not 
because of increased standardization or better reps and 
warranties. If, for example, a major bank says they will not 
buy back loans, the GSEs could in theory shut them out of the 
market. Institutional investment advisers and their clients do 
not have this type of negotiating power.
    If the standards for risk-based pricing, representations 
and warranties and standardization of agency securities are 
improved for any ``agency-like'' security that is developed 
post-housing finance reform, investors would ask for these 
enhanced standards to also apply to PLS investments. However, 
just as these requests are going unheeded in today's market, 
leading to a lack of new PLS pools, there would likely be no 
incentive for this to be created in the post-housing finance 
reform PLS market, unless a fiduciary duty is created for 
entities like trustees and servicers.
    As we mentioned above, we also believe it is worth 
exploring creating an organization that would standardize 
contracts and oversee that these contracts are enforced. The 
Association believes this concept could be built into the FMIC 
common securitization platform provisions of the Corker-Warner 
bill, if this is the base text of the Senate Banking 
Committee's mortgage reform proposal. We view this proposal as 
additional and complementary to assigning fiduciary designation 
to the trustees. Such an organization could be a party to the 
contracts, similarly to the way the GSEs are party to their 
contracts, and would have the authority to enforce these 
contracts in the best interests of the trust.
    Over the course of the Financial Crisis, because of 
thousands of PLS trusts (each with its own documentation) and 
hundreds of PLS investors, investors have found it challenging 
to coordinate their efforts in order to enforce their 
contractual rights. Often it is difficult to even determine who 
other investors in each trust may be, in order to reach minimum 
voting thresholds that would compel trustees to act. Existing 
trustees are typically themselves large banks, and have a 
multitude of relationships with the banks they are supposed to 
sue, causing conflicts of interest. Creating a central utility 
with standardized representations and warrants of underwriting 
quality and stringent enforcement mechanism would give all 
investors greater confidence to buy and give the originators 
the right incentives to securitize high-quality loans. This 
organization would also have the ability to set servicing 
standards and hold servicers accountable for acting legally and 
in the best interests of investors, something the GSEs do today 
but which is impossible in today's PLS market.
    Originators and Wall Street firms would still originate 
loans, create the liability structure and control pricing 
execution--assets and liabilities would remain priced by the 
market. We think this approach is better than the complex 
documentation and multiple levels of re-underwriting that has 
become prevalent in the PLS market in the past 2 years, which 
increase costs without providing an enforcement mechanism. A 
standardized platform may also reduce pressure for banking 
consolidation, by making it easier for midsize investors to 
perform due diligence on PLS, and making it cheaper for smaller 
banks to sell loans into PLS trusts. If investors found such a 
framework attractive, they would chose to buy securities issued 
under these contracts, offering lower cost of funds than is 
available through the current structure of the PLS market.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF SENATOR COBURN
                        FROM JOHN GIDMAN

Q.1. One component of the housing finance system that has 
received significant discussion over the last year is the role 
of recourse available to the lender. Recourse is available to 
lenders on a State-by-State level. States where recourse is 
available to lenders have a significantly lower risk of default 
as comp, especially among those who may strategically default. 
One Federal Reserve analyst found that for a sample of loans 
originated between August 1997 and December 2008, ``the 
probability of default is 32 percent higher in nonrecourse 
States than in recourse States.'' Borrowers who had a property 
value of $500,000-$750,000 at origination were over 100 percent 
more likely to default in nonrecourse States than in recourse 
States. In your view, would expanded availability of recourse 
strengthen our housing finance system? What is the impact of 
recourse availability on investors' decision making in real 
estate and private-label mortgage-backed securities?

A.1. Summary--The Association believes that to the extent that 
expanded availability of recourse lowers delinquencies and 
foreclosures, it would likely be helpful. However, in today's 
market, recourse is not enforced in any State, including those 
States where recourse is available. The Association believes 
that transitioning the U.S. to a full-recourse system would be 
very difficult, and instead efforts should be focused on 
ensuring that servicers and trustees use legal tools available 
to them today to act in the best interests of the trusts.
    History of Recourse Provisions--To fully understand why the 
Association believes it would be nearly impossible to implement 
a Federal recourse \1\ standard, it is helpful to consider some 
of the changes to the market that have been implemented since 
2008, when the Federal Reserve's study cited in the question 
concluded. The Association agrees that prior to the crisis, the 
probability of default was higher in nonrecourse States. 
However, since the financial crisis, the public policy trend 
has clearly been toward weakening recourse in all States.
---------------------------------------------------------------------------
     \1\ In this discussion, the Association is defining ``recourse'' 
as laws that: (1) permit the lender to seize any assets that were used 
as collateral to secure the loan, and (2) if money is still owned after 
the collateral is seized and sold, then take the borrower's other 
assets or sue to have his or her wages garnished.
---------------------------------------------------------------------------
    Much of this stems from Congress' implementation of the 
Home Affordable Modification Program (HAMP), which was designed 
to assist struggling homeowners. In order to entice servicers 
to work under the program, it included a servicer safe harbor, 
which ensured that investors and others could not sue the 
servicer. The HAMP program subsequently emboldened State 
legislatures to implement and enforce investor-unfriendly 
regulations. Today, not only is recourse no longer practically 
(and politically) enforceable, but lenders are effectively 
required to both allow the borrower to keep their house and 
forgive debt.
    Given this history, any Federal deficiency regulation would 
have to supersede State regulations, and Federal regulators 
would have to ensure that each State was enforcing the 
requirements. Until the housing market fully recovers, we 
believe that this would be very difficult, and recourse 
provisions would likely not be enforced.
    Potential Unintended Consequences of Expanded Recourse 
Provisions--Additionally, it is important to also consider the 
potential macro impacts of expanded recourse that may be less 
helpful to the market. Other systems, such as the housing 
market in Japan, have full recourse available, and it has 
actually harmed the system because it places too great of a 
burden on consumers. In practice, creating a system where there 
is no ability to forgive debt has led to situations where 
bursting asset class bubbles cause consumers to find themselves 
with so much debt that consumer attitudes shift against any 
future investment in that asset class--in this case, housing.
    Impact of Recourse Availability on Investors' Decision 
Making--Currently, since recourse provisions are almost never 
enforced, institutional investment advisers assign no value to 
the availability of recourse. Therefore, they currently have no 
impact on investors' decision making.
    Alternative Solutions--The Association believes there are 
better ways to protect investor interests than expanding the 
availability of recourse provisions, including creating a 
fiduciary duty for trustees and servicers. For example, if a 
fiduciary duty were imposed upon trustees and servicers in a 
similar manner as mutual fund or ERISA pension plan trustees, 
investors would have more reason to have confidence that their 
assets are protected because the servicer and trustee would be 
required to act in the investors' best interest. Additional 
information regarding how the Association would implement such 
a fiduciary duty is included in the Association's testimony, as 
well as the Association's White Paper submitted to the Senate 
Banking Committee on October 11, 2013.
                                ------                                


               RESPONSES TO WRITTEN QUESTIONS OF
             CHAIRMAN JOHNSON FROM ADAM J. LEVITIN

Q.1. Please detail the potential size of the market for private 
label MBS based on historical levels. In addition, please 
provide a comparison to the size of other fixed income markets.

A.1. At the peak of the PLS market in 2007, there were $2.2 
trillion in PLS outstanding. Over 90 percent of those PLS were 
investment grade (usually AAA-rated), indicating that there has 
never been more than $220 billion of true credit risk 
investment in the PLS market. Annual PLS issuance peaked at 
less than $1.2 trillion in 2005. Based on this, I cannot 
imagine a PLS market supporting more than $500 billion in 
annual flows--slightly more than the annual issuance of PLS in 
2002, before the housing bubble and PLS crazy took off. 
Correlations between flows and outstandings vary significantly, 
but a reasonable rule of thumb based on historical correlations 
is that outstandings are unlikely to be more than three times 
flows. Therefore, based on a peak possible flow of $500 
billion, a PLS market could probably support no more than $1.5 
trillion in housing finance needs. The current U.S. housing 
market has $11 trillion in financing needs.
    Relative to U.S. fixed income markets, the PLS market has 
always been relatively small. There were approximately $38.1 
trillion in U.S. fixed income securities outstanding as of the 
end of 2012. Of this $38 trillion, approximately $36.6 trillion 
(96 percent) of these securities--involve zero or quite limited 
perceived credit risk: Treasury securities; the debt of Federal 
agencies and GSEs; GSE MBS; money market instruments; 
investment grade corporate debt; investment grade municipal 
debt; investment grade structured financial products. Investors 
in these classes of fixed-income securities are not credit risk 
investors.
    This means that there is only perhaps $1.5 trillion in 
deliberate credit risk investment in U.S. fixed-income markets: 
high-yield bonds plus junior tranches in structured financial 
products. There is another $1 trillion in speculative grade 
leveraged-loans. This indicates that the total pool of 
investors willing to assume real credit risk on any fixed-
income security or the like in U.S. markets is around $2.5 
trillion.
    The limited pool of investment for real credit risk in 
fixed-income securities suggests that PLS cannot support 
anything close to the $11 trillion U.S. housing finance market, 
even with tranched credit risk. Assuming--perhaps generously--
that PLS could be tranched so that there was no real credit 
risk for 90 percent of investors, the market would still 
require $1.1 trillion in credit risk investment. It is hard to 
see that emerging given that most of the $2.5 trillion in 
credit risk investment is already committed to the high-yield 
loan and bond markets, with only a small part invested in PLS 
(around $100 billion outstanding now in junior tranches) and 
other asset-backed securities.

Q.2. How can variable or flexible LTV ratios (or other methods) 
improve countercyclicality in the PLS market? What can be drawn 
from methods used in other countries, e.g., Spain or Canada?

A.2. In theory, authorizing a macroprudential regulator, such 
as the Federal Reserve Board or the Federal Open Markets 
Committee to impose maximum LTV ratios would provide a tool for 
countercyclical regulation that is focused solely on the 
housing market, as opposed to macroeconomic tools such as 
interest rates that affect more than the housing market. Such a 
tool would, of course, only be as useful as a regulator's 
willingness to use it.

Q.3. What are the risks of the different types of capital that 
could support bond guarantors, in particular, if capital was 
not limited to common equity? What is the most realistic mix of 
capital for guarantor entities taking first loss risk, or who 
should determine this and how should it be enforced?

A.3. If capital in bond guarantors was not limited to common 
equity, there is a risk that bond guarantors could have an 
asset-liability duration mismatch: their funding might be of 
shorter duration than the bonds they guarantee, resulting in 
the bond guarantors facing a risk of frozen capital markets or 
runs. To put this in the most extreme example, a bond guarantor 
that finances its operations through overnight repo could find 
itself without funding the next day, making its guarantees 
worthless.
    I do not have an opinion on what is the most realistic mix 
of capital for guarantors entities taking first loss risk, but 
it is important that the capital requirements for bond 
guarantors not result in an arbitrage situation in which bond 
guarantors can hold less capital than competing methods of 
financing mortgages, such as depositories on balance-sheet 
operations. In general, any reform of the housing finance 
market should take care that there are similar capital 
requirements for all financing channels; if there is not, 
financing will flow to the channel with the lowest 
capitalization requirements, resulting in a less stable housing 
finance system.
                                ------                                


         RESPONSES TO WRITTEN QUESTIONS OF SENATOR KIRK
                      FROM ADAM J. LEVITIN

Q.1. FHFA has taken several steps while Fannie Mae and Freddie 
Mac have been in conservatorship to preserve the assets and 
protect the taxpayers. These steps include enhancing the 
underwriting, credit risk pricing, and reps and warrants 
contracts of counterparties with Fannie Mae and Freddie Mac. 
These actions ensure standards being used by the two 
Enterprises are more updated, comprehensive, transparent, and 
that they more accurately reflect the risks assumed by the two 
Enterprises. Had these reforms been implemented prefinancial 
crisis much of the fraud, poor risk-management, and losses to 
the taxpayers could have been avoided. Going forward, these 
actions are providing for a more attractive and transparent 
agency market for investors, which is essential to ensuring the 
U.S. housing market continues to be attractive for global 
investment.
    Can you tell me if the private label security (PLS) market 
is adopting the same stringent transparency and contractual 
standards as the agency market? If not, why not?

A.1. The PLS market is not adopting the same stringent 
transparency and contractual standards as the agency market. As 
an initial matter, the PLS market has been moribund since 2008, 
with less than 40 PLS securitizations done since then. This 
makes it hard to meaningfully talk about the PLS market 
adopting any particular standards. The post-2008 PLS deals have 
had pristine, ultra-prime credit quality, but representations 
and warranties and structures for their enforcement vary 
considerably among post-2008 PLS deals. The PLS market appears 
to be experimenting with deal structures as it attempts to 
figure out what structures will strike the right balance 
between investor protection and seller/sponsor comfort.

Q.2. What is holding back standardization of the PLS market? 
What is happening to PLS pools in the market today?

A.2. There are no formal legal barriers to standardization of 
the PLS market. Instead, PLS continue to be nonstandardized 
because deal sponsors see no immediate benefit from 
standardizing. While standardizing PLS would help create a more 
robust and liquid market overall, currently there are only a 
small number of deals and the market is still trying to 
determine the optimal post-2008 deal structure.

Q.3. I would love to see the conforming loan limits for agency 
mortgage backed securities to be lowered, as it is one of the 
more obvious ways to increase and incentivize the private 
market back into this market space. I am concerned however that 
if the standards in the PLS market are not the same as the 
agency market--including to provide for clear and updated reps 
and warranties agreements and greater transparency--that 
investors will be hesitant to move to the PLS space.
    If the standards for risk-based pricing, reps and 
warranties and standardization of agency securities are 
improved for any ``agency-like'' security that is developed 
post-housing finance reform, will investors begin demanding 
these enhanced standards for PLS investment? What more could be 
done to incentivize the private market to adopt such standards?

A.3. It is possible that reforms of the ``agency-like'' market 
will begin to set standards for PLS as well; this is something 
that can be observed elsewhere in fixed-income securities as 
many securities that are not subject to the Trust Indenture 
Act, such as sovereign bonds, nonetheless include deal terms 
required by the Trust Indenture Act. The PLS market could be 
incentivized to adopt such standards through the provision of 
regulatory safe harbors. I would nonetheless urge Congress to 
consider certain nonwaiveable minimum standards for PLS, akin 
to those required by the Trust Indenture Act of 1939 provides 
for covered debt securities.

Q.4. Do you think that the PLS market can truly be optimized if 
loan limits are lowered before greater transparency, 
contractual, and fiduciary changes/updates are adopted in the 
PLS market?

A.4. If conforming loan limits are lowered at this point, it is 
unlikely that the PLS market will expand rapidly to provide 
financing for homeowners with mortgage loans larger than the 
conforming loan limit. Instead, credit availability will likely 
significantly contract for these homeowners. Until and unless 
investors feel comfortable with PLS deal structures and have 
confidence that representations and warranties about the 
securitized loans will be enforced, I do not see the PLS market 
providing any meaningful level of financing for the U.S. 
housing market. Thus, I do not see lowering the conforming loan 
limits as precluding reforms in the PLS market so much as 
producing a decline in housing prices.