GSEs (Fannie/Freddie),FHA&HUD

Restructuring the U.S. Residential Mortgage Market

Posted on Wednesday, March 16, 2011

There is wide bipartisan agreement that government housing policies, past and present, need to be re-evaluated given their role in the financial crisis. While the reform of Fannie Mae and Freddie Mac was not included in financial reform legislation last year, the Obama administration and congressional leaders are vowing action on these government-sponsored enterprises (GSEs) this year. Will the new majority in the House of Representatives wind down the housing giants and if so, how fast? Can the already weak housing market survive without some kind of an explicit government back-stop? Can consensus be reached?

On February 11, the Initiative on Business and Public Policy at Brookings hosted a day-long forum to discuss the issues and the options ahead as policymakers discuss the government's role in the U.S. residential mortgage market. Secretary Timothy Geithner remarked on the administration's strategy for reforming the nation's housing finance markets. Former Federal Reserve Chairman Alan Greenspan delivered the keynote address. Four papers written by experts in the housing market and finance field were released and discussed, and two panels tackled the broader issues the papers raise.

SECRETARY GEITHNER: So we obviously, got a lot of things wrong in the housing market in the United States. And it is a complex system. And reform requires a careful strategy that includes a number of different elements. And let me just lay out the basic pillars, the basic foundations, of what we think is a credible reform plan.

The first, of course, is that we need to wind down Fannie and Freddie, and substantially reduce the government’s footprint in the housing market. And that’s a process that has to happen gradually, because they are now the dominant source of housing finance. And we want to be careful that that process happen in a way that doesn’t interfere with or impede the process of repairing the housing market that still has a long way to go.

For the private market to take on a greater share of the burden of providing housing finance we have to have in place -- outlined and understood -- a new set of rules of the game for all the pieces of the mortgage market. And that means clarity on the capital banks have to hold against mortgage risks.

It means stronger underwriting standards so that homeowners have to hold more equity in their homes. It means better protection for consumers, comprehensive oversight of servicers and all others involved in the basic chain of housing finance. It means better incentives for securitization, clarification on risk retention. That comprehensive set of reforms that are laid out in Dodd-Frank have to be put out to the market to give investors and banks time to adjust, to understand, what will be the new economics of making mortgages in this country.

The third piece is to define a substantial but more targeted role for the government in supporting affordability -- both for people who want to own a home, and people who people who want to rent. And the paper lays out a series of basic elements of a reformed role for the government -- concentrating on the FHA -- in helping support those basic objectives.

And finally, of course, is the end game. And taking advantage of a lot of work that many of you have done, we provide a brief overview of the full spectrum of options out there for future reform. And we try to narrow the field to a more credible set of ultimate reform options. And the three we lay out in the paper -- just to summarize them briefly -- are an approach that is limited to the role the FHA provides, a proposal that would complement the FHA’s role with an emergency back-stop mechanism that would only be deployed in crisis. And a third option is an FHA, alongside a redesigned and much more limited but standing guarantee or insurance mechanism that would be available for a broader class of homeowners.

Toward A Three-Tiered Market For U.S. Home Mortgages
1. Home ownership has both positive and negative externalities, so we need to be careful in designing governmental subsidies for home ownership. Unfortunately, most of the current US subsidies for home ownership are not very effective, and some of these subsidies increase the default rate on home mortgages - a key negative externality.
2. The mortgage interest deduction (MID) is not well designed to promote home ownership and costs roughly $100 billion per year in lost tax revenues. To reduce the costs of the MID and strengthen its link to home ownership, Congress should:
a. eliminate the MID for second homes and home equity loans; and
b. provide a tax credit for mortgage interest on a primary residence, or reduce the ceiling on the MID from $1 million to $500,000 per couple.
3. Some states prohibit lenders from going after personal assets in collecting deficiencies after mortgage foreclosures. These states laws encourage home owners to make low down payments and walk away from "underwater" mortgages - when the mortgage amount exceeds the current value of the property. Therefore, Congress should:
a. supersede state laws prohibiting personal recourse on mortgages, and
b. allow individual hardship cases to be adjudicated by bankruptcy judges.
4. The FHA and VA programs for insuring home mortgage require minimal down payments, and set limits based on mortgage size rather than family income. Therefore, Congress should:
a. gradually raise the down payment requirement for these programs to a reasonable percentage of the purchase price, and
b. establish an income limit for these programs such as the median income level for the metropolitan area.
5. Ginnie Mae, a federal agency, that is part of HUD, already does a good job of securitizing mortgages insured by the federal government.
a. If Congress decides to expand federal subsidies for home mortgages, it should do so through direct appropriations reflected in the federal budget.
b. If Congress decides to provide government support for the securitization of these other mortgages, it should do so through Ginnie Mae.
6. Fannie Mae and Freddie Mac should be phased out gradually, by reducing the maximum size of conventional mortgages they may purchase. Most of their governmental subsidies have gone to shareholders and executives of these two corporations, and little has gone to homeowners.
a. Government subsidized mortgages should be securitized through Ginnie Mae - priced accurately and included in the federal budget.
b. Conventional mortgages should be securitized through the private sector, with appropriate reforms.
c. The Federal Reserve should provide liquidity to the mortgage securities market, if and when necessary.
7. To revive the private market for mortgage-backed securities (MBS), federal regulators should adopt a combination of measures.
a. Regulators should adjust capital requirements of bank sponsors of MBS to reflect the actual allocation of risks in these deals.
b. Regulators should require more disclosure on the individual loans in the pools supporting MBS, and encourage simpler structures for MBS deals.
c. Regulators should minimize ratings shopping by allowing an independent party to choose the ratings agency for large structured finance deals.
8. Congress has created a middle tier of MBS, above the private market but below the government guaranteed market, for qualified residential mortgages (QRMs). Since MBS based solely on QRMs would be exempt from risk retention requirements and other protections, regulators should mandate high downpayments and strict underwriting standards for QRMs.
9. In addition, the criteria for QRMs should be designed to:
a. Phase out Fannie Mae and Freddie Mac by limiting the QRM status of their mortgages to a specific numbers of years;
b. Promote long-term fixed-rate mortgages by allowing prepayment penalties for the initial 5 years of high-quality mortgages; and
c. Increase the standardization of home mortgages in the US, including flexibility for mortgage servicers to modify loans in appropriate circumstances.
Robert C. Pozen, Nonresident Senior Fellow, Economic Studies, The Brookings Institution

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