Federal regulation of the scandal-shaken Ginnie Mae forward commitments market now appears almost inevitable. Sen. Harrison Williams (D-N.J.) will introduce a bill later this month establishing a new entity to oversee dealers, authorizing the Federal Reserve to set margin requirements and encouraging creation of a centralized clearing facility.
For nearly three years since the magnitude of speculative losses began to become evident, the industry, with the backing of federal regulators, energetically had sought to police itself. Public Securities Association Self Regulation Inc. (PSA-SRI) was organized last year to set up a code of conduct for its 30 member firms, which account for 90 percent of the Ginnie Mae trading. Last month the SPA-SRI admitted publicly for the first time it was not up to the task by calling for discussion of "alternatives that might be developed under federal law."
PSA general counsel Joseph W. Sack said the prime reason for the avowal was the Justice Department's ruling that antitrust laws would not permit an industry group to set mandatory uniform margin requirements for Ginnie Mae dealers. Only a handful of dealers have done so voluntarily. Then, too, market factors have taken their toll. Continually rising interest rates have caused a landslide in bond prices and often have spelled disaster for speculators who were betting on a rate decrease that thus far has not materialized.
Ginnie Mae is the nickname of the Government National Mortgage Association (GNMA), a part of the Department of Housing and Urban Development. GNMA issues securities called Ginnie Maes that represent shares in pools of mortgages insured by the Federal Housing Administration (FHA) and the Veterans Administration (VA.
Since its inception 10 years ago, GNMA has guaranteed $96 billion in these pools, which in turn have financed construction of 3 million houses, according to R. Frederick Taylor of GNMA. About $80 million is still outstanding. The growth of these instruments has accelerated significantly in recent years, with guarantees rising from $15.4 billion in 1978 to $25 billion in 1979.
But a much larger Ginnie Mae futures and forwards market is based on theseunderlying securities. A study of this market by R. Shriver Associates estimates that all trades, including secondary ones, now amount to somewhere in the range of $350 billion to $500 billion a year. Although Ginnie Mae securities, which sell in minimums of $25,000, are considered very safe investments by the institutions thay buy most of them, Ginnie Mae futures and forwards are deemed highly speculative.
The object of regulation not only is to protect investors, but to assure the integrity of the underlying securities. For a loss of public confidence in Ginnie Mae certificates could have grave consequences for the housing market, according to GNMA's executive vice president, R. Frederick Taylor. Sales of these securities now account for 80 percent of the funds obtained for FHA-and VAinsured homes and for 40 percent of the entire secondary mortgage market. Their share is expected to continue growing as the shortage of housing funds becomes more acute.
Ginnie Maes originate with mortgage bankers or lenders who make real estate loans. A banker keeps the mortgages until there are enough to make up the amount of the pool, usually $1 million. Certificate holders are reimbursed as the payments on the mortgage in the pool are collected.
In order to get enough money to make the mortgages in the first place, lenders line up investors who will commit themselves to buying the certificates four or 12 months later at a given rate. Or speculators can pay a fee for a standby commitment. In each case an individual is betting that interest rates on the certificates will be lower than what he or she contracted for. In this way the speculator closes out the contract with a profit. If rates go the other way, he or she takes a loss.
Such a Ginnie Mae futures contract is traded as a commodity on the Chicago Board of Trade according to an organized method with quotations of bid and asked prices and specified margins (the amount of down payment on a credit purchase). Recently the Chicago Board of Trade raised margin requirements on all GNMA and U.S. Treasury bond futures. Speculators now have to put up $2,500 rather than $2,000 to initiate a trade and maintain $2,000 instead of $1,500 in their accounts to continue. All hedging margins will rise from $1,500 to $2,000. THE (CBOT has a central clearing house that maintains collateral, thus assuring that neither buyer nor seller will default on the transaction.
By contrast, Ginnie Mae forward commitments or contracts are sold by dealers over the counter on a negotiated basis with no quoted prices. In addition to the basic contracts, there are many risky variations sold, such as pair-offs and reverse repurchase agreements. A pair-off involves simultaneosly buying a cash forward and selling a standby commitment, where delivery is at the seller's option. A reverse repo enables a customer to finance securities bought from a dealer by selling the securities back to the dealer with an agreement to repurchase them later.
Because there is no down payment or margin on borrowed money required, almost anyone can speculate in Ginnie Maes. Speculators purchasing forward commitments need put up no money until settlement. A half dozen dealers, including Dean Witter and First Boston, recently have instituted informal, small (usually one percent or less) margin requirements. One dealer said the margin depended on the size and reputation of the customer. In any case it appears the customer still puts no money up front and has to meet a margin call only when the value of his holdings dips below a certain point.
Because dealers in Ginnie Mae forwards are not regulated, there are no competency, minimum capital or suitability requirements. These last refer to the dealer's responsibility to learn his client's resources and investment goals before recommending purchases. Before the PSA-SRI developed such a code of conduct, some dealers managed to get their clients in way over their heads, committing themselves to purchases far in excess of their assets.
For example, credit unions had $700 million in forward commitments in early 1979 at a time when the assets of all federal credit unions totaled $37.5 million. Some sellers of government securities allegedly preyed upon the naivete and greed of small and large institutions. In addressing the Psa -- SRI last fall, National Credit Union Administrator Lawrence Connell said the same boiler rooms and bucket shops that characterized the operations of some sellers of municipal securities before they were regulated, are evident in the way Ginnie Maes and other government securities still are being sold.
There are no aggregate figures to indicate how large the Ginnie Mae scandal is, but losses are said to have been larger than those suffered in similar commodities scandals. The securities and Exchange Commission first got on the trail in early 1977 when Winters Governments Securities of Fort Lauderdale went out of business owing $3 million to Wall street GNMA dealers. This occurred because 25 banks and credit unions had refused to pay $8 Million in losses on forward contracts.
The most celebrated case involved the University of Houston. Its manager of short-term investments used repurchase agreements in a pyramid scheme. He built a portfolio of $250 million in government securities, most of them Ginnie Mae forwards. When the pyramid collapsed, the university was out $17 million.
According to the comptroller of the Currency, approximately 40 cases of trading abuses and speculative investment practices have been discovered by bank examiners.
Last fall Connell told the PSA -- SRI that eight credit unions had overextended themselves in Ginnie Mae trading to the point where the NCUA had to bail them out. Assistance to credit unions with investment problems amounted to $7.5 million, and Connell said he expected that figure probably would double. In January Connell reported 40 instances of "trading abuses and speculative investment practices," but said no disciplinary action had been taken.
Several lawsuits have been filed against dealers by institutional investors charging they were "induced" or" high-pressured" into buying Ginnie mae forwards. In the one known adjudicated case, a Newark, N.J., court decided in favor of the dealer, observing that in the absence of outright fraud it was question of buyer beware.
In the wake of the scandal, the National Credit Union Administration and the Federal Home Loan Bank Board already have taken steps to educate their members about the pitfalls of Ginnie Mae trading and to limit their participation in it. Bank regulators have been slower to act, counting on the industry to regulate itself.
While most of the activity -- and the abuses -- have occurred in connection with Ginnie Mae forwards, other government securities such as Treasury bills and Freddie Macs (another mortgage-backed security) also are traded in like fashion. Cognizant of the problem, the Treasury in conjunction with other federal agencies in researching the other markets with a view to developing legislative recommendations. The report is expected by April.