GSEs (Fannie/Freddie),FHA&HUD

A Blueprint for Mortgage Finance Reform

Posted on Monday, February 14, 2011

Special Report: The Future of the Mortgage Finance System
• The federal government has effectively become the nation's mortgage lender—a role no one thinks is sustainable or desirable.
• Options for reforming the mortgage finance system include full nationalization and full privatization.
• A hybrid system can combine the benefits of the two, while mitigating the disadvantages of each.
• Government would backstop mortgage lending but only under catastrophic conditions, while providing oversight and regulation.
• Subsidies would be explicit and transparent, and there would be incentives for prudent lending.
• Borrowers would face slightly higher costs in a hybrid system, though less than if the mortgage system were fully privatized.
The nation’s housing market has gone from boom to bubble to bust over the past decade, with a devastating impact on the global economy and financial system. Millions of bad mortgage loans were made—loans that would have been hard to repay under the best of circumstances—and millions lost homes as a result. As the financial institutions with stakes in these bad loans buckled, credit stopped flowing and the U.S. economy experienced its worst recession in decades.
This was not supposed to happen. After the Great Depression, the federal government established the FHA, Federal Home Loan Banks, and Fannie Mae to prevent such wild swings in the housing market as well as to promote homeownership. The system worked reasonably well for more than 60 years. As a consequence, the U.S. homeownership rate rose steadily from about 45% after the Depression to 65% by the mid-1990s.

During the 2000s, however, the mortgage finance system changed dramatically, pulled by the growth of private-label mortgage securitization. Securitization was not new: The FHA, Fannie Mae and Freddie Mac had been packaging mortgage loans into securities for sale to investors for more than 25 years. But as the new century began, securitization surged in both size and scope, incorporating more types of mortgages, including subprime and Alt-A loans. Securitization also grew so complex that even the most sophisticated investors had trouble evaluating deals.
A lack of oversight
Critically, moreover, no participant in private-label mortgage securitizations had the responsibility for ensuring that the process worked. Mortgage banks and brokers originated loans but quickly sold them to investment banks, which packaged the loans into securities. Credit rating agencies assessed them, often using faulty information provided by the investment banks. Investors who purchased the securities took the ratings largely on faith. And government regulators provided little oversight, feeling the private market could regulate itself. Yet as the events of the past three years show, it clearly could not. Today, the private-label securities market is comatose.

The system’s fault lines were stressed by the flood of capital that poured into the U.S. from China and other emerging economies. With trillions of dollars in reserves earned in trade with the U.S., investors in these economies found U.S. mortgage securities particularly alluring. They offered good returns, particularly given their brief historical credit performance. The easy monetary policies of central banks such as the Federal Reserve only added to the flood of global capital, which stretched the faulty securitization pipeline to the breaking point as it rushed through.

U.S. policymakers’ aggressive pursuit of homeownership also contributed to the problem. Since the 1930s, single-family housing has received more government help than any other sector of the U.S. economy. Subsidies are provided via the mortgage interest and property tax deductions, favorable capital gains treatment, the lower mortgage rates, and affordable housing mandates of Fannie Mae and Freddie Mac, among other channels. The Clinton and Bush administrations often pointed to the rising homeownership rate as evidence of their economic policies’ success. With both parties set on this policy objective, many households that should not have received mortgage loans got them.
The collapse of Fannie and Freddie
Once the system began to break, the process was exacerbated by the collapse of Fannie Mae and Freddie Mac. While these institutions had been small contributors to the housing bubble, they were too thinly capitalized for the risks they were taking and were thus overwhelmed by the housing downturn and subsequent rise in mortgage defaults. Yet Fannie and Freddie were much too big to fail; because of their size and importance to the global financial system, both were put into conservatorship in September 2008. A string of massive financial failures followed, which led to the near collapse of the financial system.

The government’s takeover of Fannie and Freddie effectively nationalized the mortgage finance system. Today the two institutions, along with the FHA and VA, account for nearly all new mortgage loans. No one is comfortable with this, and a debate on the future of the mortgage finance system has begun. There is general agreement that for the system to succeed, it must make reasonably priced mortgages available to qualified borrowers while limiting both risks and costs to taxpayers. The system should be resistant to the business cycle, so that mortgage credit remains ample during periods of market stress and is not excessive during periods of market hubris.
Nationalization vs. privatization
Maintaining the federal government’s current domination of the mortgage finance system is one approach. Fannie and Freddie could be put into receivership, and their activities subsumed into the federal government. Permanently nationalizing the system in this way would ensure that mortgage lending is not disrupted in bad times, but the cost to taxpayers could be enormous if the system is not well managed. There is also a reasonable concern that government would stifle innovation, preventing the development of mortgage products that could more efficiently meet borrowers’ needs.
At the other end of the spectrum is complete privatization of the mortgage finance system. The federal government would still regulate, but Fannie and Freddie would be downsized and their activities restricted. Some form of private-label securitization would have to be revived. Yet given recent history, it is unclear how well a purely private system would do during periods of financial market stress. It is also unclear whether the too-big-to-fail risk would be significantly mitigated; if the system were to fail again, the federal government would have to step in, at significant cost to taxpayers.
The fate of the 30-year mortgage
A private system would also likely mean the end of the 30-year fixed-rate mortgage as a mainstay of U.S. housing finance. A privatized U.S. market would come to resemble overseas markets, primarily offering adjustable-rate mortgages. Based on the experience overseas, the fixed-rate share in the U.S. would decline to an average of between 10% and 20% of the mortgage market compared with a historical average of closer to 75%. Reinforcing this likelihood are the limits placed on the use of prepayment penalties in the recently passed Dodd-Frank financial regulatory reform legislation. Adjustable-rate mortgages are not inherently bad loan products, but they do shift the risk of fluctuating interest rates onto homeowners. This would be a very significant adjustment for many U.S. homeowners who are not well equipped to handle such risk.
An appealing middle way involves a hybrid of nationalized and privatized systems. Such a system could take many forms, but the most attractive would retain several roles for the federal government—insuring the system against catastrophe, standardizing the securitization process, regulating the system, and providing whatever subsidies are deemed appropriate to disadvantaged households. Private markets would provide the bulk of the capital underpinning the system and originate and own the underlying mortgages and securities.
Designing a hybrid system
Catastrophic insurance would be provided on mortgage securities only after major losses, much as the FDIC insures bank deposits. The FDIC ended runs by scared depositors on U.S. banks during the Great Depression. Catastrophic mortgage insurance would eliminate runs by scared investors on the global financial system such as those that sent the economy reeling in 2007 and 2008, precipitating the Great Recession.
Catastrophic insurance would ensure that mortgage credit remains ample in the bad times, and—assuming it is properly priced—at no cost to taxpayers. It would also reduce the odds of bad lending in good times, since the insurance would be offered only to qualifying mortgages, or to others only at a high price. Since private financial institutions would put up the system’s capital, there would be significant incentive to lend prudently and, given the competition in a mostly private system, to innovate as well.
Insuring against house price declines
In a hybrid system, mortgage rates would be higher than they were before the housing crisis, but only because the previous system was undercapitalized. If the future system is capitalized sufficiently to withstand losses on defaulting mortgages that would result if house prices declined by say 25%—consistent with the price declines experienced in the current housing crash—mortgage rates would be approximately 30 basis points higher. The prefinancial crisis mortgage finance system was capitalized to losses associated with a 10% decline in house prices.

But mortgage rates in the proposed hybrid system would be almost 90 basis points lower than under a fully privatized system. This is a significant difference. The monthly principal and interest paid by a typical borrower who has taken out a $200,000 loan for 30 years at a 6% interest rate is $1,199 under the hybrid system. With a 90-basis point premium in the privatized system, the monthly payment increases to $1,317, a difference of $118, or nearly 10%. The difference in payments under the two systems would likely be even greater for borrowers with less than stellar credit or who are seeking loans with higher loan-to-value ratios. The greater the risk, the greater the rate premium under the privatized system.
Taxpayer bailouts would also be unlikely in the hybrid system, as homeowners and private financial institutions would be required to put substantial capital in front of the government’s guarantee, and there would be a mechanism to recover costs if necessary.
Reform is imperative
Given the fragile states of the U.S. housing market and economy, a transition from the current nationalized mortgage system to a hybrid system will take years and raise many issues, but these will be manageable. Given the expertise they have acquired over the past several decades, the downsized Fannie and Freddie could become federal catastrophic insurers. The transition would also involve establishing institutions and an infrastructure necessary to attract private capital.
Homebuyers will have to pay more for mortgage loans in the future than they did before the financial crisis. Given the nation’s fiscal challenges, the federal government cannot afford to continue large subsidies for homeownership. It is unclear that these subsidies were effective in any event, given the current foreclosure crisis. Nonetheless, it is critical that the mortgage finance system be better designed, or the costs for future prospective homeowners will be prohibitive, and the costs to taxpayers in the next financial crisis will be overwhelming
By Cristian deRitis and Mark Zandi in West Chester, MOODY’S ANALYTICS


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