« Artifacts of Finance: 18-Karat Monopoly Set | Main | Black-Litterman's Model: Portfolio's Friend or Foe? »


A Blueprint for Mortgage Finance Reform

Click to Print This Page


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.

The question is how does one effectively get to this private system given the current state of mortgage finance? We call this the “genie in the bottle” problem. A quarter century ago, the proverbial “genie” was let out of the bottle when mortgage markets were deregulated yet left the government guarantees and special treatment of Fannie Mae and Freddie Mac (the “government-sponsored enterprises”, or GSEs) in place. Capital markets over the past twenty five years have developed to be reliant on these guarantees. To wean the system off these guarantees—to put the “genie back in the bottle”—we need to transition away from a government-backed system to a private-based one. The problem is that the transitional process will only succeed if private markets are not crowded out, regulatory capital arbitrage by private guarantors is averted, and systemic risk inherent in mortgage credit and interest rate risks is managed.

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

(I) an exact timeline and implementation plan corresponding to our proposal;

(II) a set of questions and answers relating to our proposal; and,

(III) a detailed evaluation of the Obama Administration’s plan.

Continue reading "A Blueprint for Mortgage Finance Reform" »

–Viral V. Acharya, Matthew Richardson, Stijn van Nieuwerburgh, and Lawrence J. White are the authors of 

Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance



Related Posts Plugin for WordPress, Blogger...


These are fantastic treats for folks of all ages. It reminds us of loved ones on holidays. It's great to indulge to such treats and enjoy it using the people that matters to you.

Mortgage rates would have to rise enough to entice private investment capital, in addition to strict underwriting.

It’s a positive move toward consumer protection and housing market stability.
I think inaccurate appraisals influenced by lenders and brokers contributed to the industry breakdown,so more reliability is a necessity to protect consumers and investors.

In these years come, some mortgage rates still stable but some are increase their rates due to real estate market housing crisis.

The comments to this entry are closed.


NYSSA Job Center Search Results

To sign up for the jobs feed, click here.


NYSSA Market Forecast™: Investing In Turbulent Times
January 7, 2016

Join NYSSA to enjoy free member events and other benefits. You don't need to be a CFA charterholder to join!


CFA® Level I 4-Day Boot Camp

Thursday November 12, 2015
Instructor: O. Nathan Ronen, CFA

CFA® Level II Weekly Review - Session A Monday

Monday January 11, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level III Weekly Review - Session A Wednesday

Wednesday January 13, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level III Weekly Review - Session B Thursday
Thursday January 21, 2016
Instructor: O. Nathan Ronen, CFA

CFA® Level II Weekly Review - Session B Tuesday
Thursday January 26, 2016
Instructor: O. Nathan Ronen, CFA