A Blueprint for Mortgage Finance Reform
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The goal of reforming housing finance should be to ensure economic efficiency, both in the primary mortgage market (origination) as well as in the secondary mortgage market (securitization). By economic efficiency, we have in mind a housing finance system that
- corrects any market failures if they exist; notably in this case is the externality from originators and securitizers undertaking too much credit and interest rate risk as this risk is inherently systemic in nature;
- maintains a level-playing field between the different financial players in the mortgage market to limit a concentrated build-up of systemic risk; and
- does not engender moral hazard issues in mortgage origination and securitization.
Motivated from economic theory, we argue that such a mortgage finance system should be primarily private in nature. It should involve origination and securitization of mortgages that are standardized and conform to reasonable credit quality. The credit risk underlying the mortgages should be borne by market investors, perhaps with some support from private guarantors. There should be few guarantees, if any, from the government.
We envision that the initial phase of this process would preserve mortgage default insurance because such guarantees have been essential for the way that the securitization market for mortgages has developed. However, the government share of these guarantees would be steadily phased out. To achieve this, the transition should include a public-private partnership in which the private sector decides which mortgages to guarantee and sets the price for the mortgage guarantees but insures only a fraction (say 25%), while the government is a silent partner, insuring the remainder and receiving the corresponding market-based premiums. The public sector involvement should be limited to conforming, tightly underwritten mortgages (for example, to mortgages with loan to value ratios that are at most 80%). The private sector mortgage guarantors would have to be regulated to be well-capitalized and subject to an irrefutable resolution authority. This way, the market pricing of mortgage guarantees will reflect neither explicit nor implicit government guarantees. And, the government guarantees being offered in passive partnership to private markets, and importantly, at private market prices, will ensure that the private sector is not crowded out.
We envision that if such a transition plan were followed, then the private sector would be encouraged to shrug off any regulatory uncertainty and allowed to flourish. Financial innovation in these markets could return. New investors that are focused on the credit risk of mortgage pools would emerge. Mortgages would become more standardized and underwriting standards would improve. To help the transition process along its way to an efficient mortgage market in the long run, reliance on the GSEs’ guarantees should be mandated to end in a phased manner. One example of such a mandate would be a gradual reduction of the size limit for conforming mortgages; another would be an increase in the fees that the GSEs charge for their guarantees. These mandates could be implemented sooner if the private capital market develops more quickly.
Although our book, Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, was written before the Obama Administration’s recently announced plan, there is much common ground between the two: (a) The GSEs should be wound down; and, (b) Efforts to assure housing affordability for low- and moderate-income households should be explicit, on-budget, and primarily the domain of the Federal Housing Administration (FHA). However, the Administration does not currently have a specific proposal for the long-run future role of government guarantees in the U.S. housing finance. Instead, the Administration offers three possibilities, without indicating its preference: (i) a wholly private structure; (ii) a largely private structure, but with an agency that would provide guarantees to new mortgage-backed securities (MBS) at times of severe stress in the mortgage markets; or (iii) a largely private structure, with a government agency providing “tail risk” or catastrophic insurance in the event that a private mortgage guarantor defaulted on its obligations.
We believe that the first of these three possibilities is the appropriate long-term goal; but we believe that our transition plan offers a superior means of getting there. We believe that the Federal Reserve is already the agency for dealing with general and severe stress in financial markets, including MBS, so that any additional effort by a new agency would be duplicative. Further, we believe that the “tail-risk” government insurance will inevitably be underpriced and thus will likely end up being a “back-door” means of subsidizing general mortgage borrowing. Our proposal calls for the government providing side-by-side guarantees—only in the interim—and would explicitly use the market-based pricing of the private guarantors. Also, our proposal will encourage the private sector to develop tail-risk insurance capabilities, which can then expand and replace the government; the advocates of option iii have no such phase-out scenario.
In the following sections, we provide
–Viral V. Acharya, Matthew Richardson, Stijn van Nieuwerburgh, and Lawrence J. White are the authors of