Reforming the US Housing Finance System: A Proposal
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At a US Senate Budget Committee hearing in March 2009, Federal Reserve Board Chairman Ben Bernanke declared that “If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one, than AIG.” Chairman Bernanke was referring to the $550 billion worth of insurance that AIG had written on so-called AAA-rated securities with little or no capital, putting the stability of the world financial system at risk.
THE NEED TO REFORM HOUSING FINANCE IN THE UNITED STATES: WHERE'S THE OUTRAGE?
Chairman Bernanke should have been even more outraged at the government-sponsored enterprises (GSEs) of the United States, Fannie Mae and Freddie Mac. Together these enterprises wrote $3.5 trillion worth of insurance—seven times that of AIG—on mortgage-backed securities (MBS) much riskier than AIG’s; they also made a portfolio investment in another $1.5 trillion in mortgages and MBS, a significant proportion of which was again of dubious quality. How much capital did regulators require to support that $3.5 trillion in insurance? Just a little over $15 billion—a very small fraction in the face of bearing the inherent credit risks on a third of the entire residential mortgage market in the United States.
Nevertheless, it took the Obama Administration until February of 2011—more than halfway through its first term, and over 30 months since Fannie and Freddie’s conservatorships under the US Treasury began in September of 2008—to make any type of formal statement about these GSEs. And despite substantial argumentation during the Dodd-Frank Reform and Consumer Protection Act’s financial reform debates, the GSEs were not addressed.1
Since then some progress has been made by a series of Fannie and Freddie–related bills passing the relevant House subcommittee in July of this year. If implemented, the eventual result of these bills will effectively close these institutions. However, as of November 2011, no action has been taken on these bills—and no one appears to be concerned. The media and the public at large are uninterested, even though Fannie and Freddie’s losses far exceed those of all other financial firms combined. Moreover, the precrisis salaries of Fannie and Freddie management were commensurate with those of other large Wall Street firms, so the lack of outrage is not the result of reasonable salaries for their executives.
FIGURE 1: GSE Growth, 1980–2010
A possible explanation for the lack of interest in addressing one of the exacerbating causes of the crisis of 2007–2008—the government’s overreach, through the GSEs, in influencing the way residential housing finance works in the United States—might be that in general everyone wants the Fannie and Freddie mortgage guarantee to continue just “a little bit longer.” This desire to continue an unsustainable guarantee can be considered a form of addiction. As private companies, Fannie and Freddie have supplied their own form of pain killer to the US housing market for over 40 years; each year, the mortgage finance system has been getting a little sicker and more addicted, yet it has remained numb to the pain. By the time of the crisis, through their insurance guarantees and mortgage purchases, Fannie Mae and Freddie Mac controlled almost 50 percent of the entire mortgage market (see Figure 1), but they held very little capital against highly risky mortgages, and were arguably the most systemically risky financial institutions in the world. In fact, if allowed to fail, their collapse would have almost certainly caused a sovereign debt crisis for the United States because foreign investors, often other governments, have always believed that Fannie and Freddie are implicitly guaranteed by the US government.
This was not the original intent of these agencies. Although Fannie Mae, founded in 1938, was originally a government agency, it was privatized in 1968 not because of any deep belief about the efficiency of private versus public institutions, but instead, and incredibly, primarily for accounting purposes. The Johnson Administration wanted Fannie Mae privatized to remove its debt from the federal government’s books, thereby reducing the size of the national debt. Fannie’s special privileges were kept in place, and with them came the financial markets’ belief that the government would support Fannie’s debt. Freddie Mac, created by Congress two years later, followed suit.
The US government finds it useful to have an entitlement program that is off its balance sheet. Fannie and Freddie have been just that. The government backstopped the creditors of these firms, yet provided no upfront funding and wrote legislation that encouraged banks (through lower capital requirements) to trade with them. This effectively transferred massive subsidies to the housing market—a process that worked until it stopped working, and the whole pyramid structure collapsed.
These schemes are reminiscent of the other entitlement programs such as Social Security, Medicare, and Medicaid. It is worrisome that it took the worst financial crisis in 75 years to begin to address the issues inherent in Fannie and Freddie, even though analysts and researchers have railed against them for over a decade. Even more alarming is that, after all the economy has been through in the last three years, legislation is barely moving along.
Before we offer our concrete proposal to unwind Fannie and Freddie, we provide a brief summary of how the mortgages they underwrote deteriorated in quality, especially starting in 1992, and how there emerged a race to the bottom between the GSEs and the large complex financial institutions (LCFIs) in the private sector during 2003–2007 that culminated in the housing price bust and the financial crisis.
TABLE 1: GSE Affordable Housing Goals, Share of Mortgage Purchases (1993–2008)
TICKING TIME BOMB
On October 28, 1992, President George H.W. Bush signed into law HR 5334, the Housing and Community Development Act of 1992. Title XIII of this law, Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA), created rules for the two largest GSEs, Fannie Mae and Freddie Mac. In his remarks, President Bush said:
This legislation addresses the problems created by the rapid expansion of certain GSEs in the last decade. It establishes a means to protect taxpayers from the possible risks posed by GSEs in housing finance. The bill creates a regulator within the Department of Housing and Urban Development (HUD) to ensure that the housing GSEs are adequately capitalized and operated safely...I regret, however, that the Congress chose to attach these important reforms to a housing bill that contains numerous provisions that raise serious concerns. My Administration worked diligently to craft a compromise housing bill that would target assistance where it is needed most, expand homeownership opportunities, ensure fiscal integrity, and empower recipients of Federal housing assistance.2
Title XIII was a compromise between those politicians who wished to restrain the GSEs and those who wanted to unleash them. On the one hand, the FHEFSSA created a separate regulator for Fannie Mae and Freddie Mac to provide a measure of safety and soundness: the Office of Federal Housing Enterprise Oversight (OFHEO), which was lodged in HUD. At the time, however, many observers thought that a policy-oriented department such as HUD was not the appropriate agency for lodging a prudential regulator. While there may have been a policy angle to allowing this, it should also be noted that Fannie and Freddie spent over $200 million lobbying the Congress to avoid tighter oversight. The GSEs were essentially a government-supported banking system and should have been regulated as such.
On the other hand, the FHEFSSA specified a set of “mission goals” that comprised efforts to help support housing for low- and moderate-income households as well as a special “affordable lending goal” intended to serve “underserved areas” (formerly inner-city areas). It established HUD (but not OFHEO) as the mission regulator. The mission goals essentially gave the GSEs a mandate to purchase lower-quality, higher-risk mortgages that nevertheless received the same implicit government guarantee.
Below, we provide evidence of GSEs increasing use of riskier mortgages from the mid 1990s until 2003, as a result of (or at least justified by) the 1992 Act. With good reason, many analysts point to the behavior of Fannie and Freddie in 2004–2007 as a rationale for the ramping up of the risk of their portfolio. Actually the origin of this behavior and the GSEs’ eventual collapse had begun a decade earlier. Analysts, regulators, and politicians, however, did not realize that the GSEs were a ticking time bomb because aggregate US housing prices increased every month from July 1995 until May 2006, thus obscuring the ever-increasing credit risk that Fannie and Freddie were taking on.
The Mission to Support Affordable Housing
The new mission laid out in the FHEFSSA was quite specific and encompassed three related goals for the GSEs. The overarching theme of the mission was for the GSEs to reach a target percentage of their mortgage purchases in terms of homeownership for lower- and middle-income households. The first goal was directed toward low-income housing, defined as household incomes that were below the area median. The second goal chose underserved areas, as defined by census tracts with median household incomes that were less than 90 percent of the area median, or else in census tracts with a minority population of at least 30 percent and with a tract median income of less than 120 percent of the area median income. The final goal, named “special affordable housing,” targeted census tracts with family incomes that were less than 60 percent of the area median (or else in tracts with incomes less than 80 percent of the area median and also located in specified low-income areas). Table 1 provides the detailed goals for 1993 and after.
Until the late 1990s, Fannie and Freddie shared in the general process of encouraging buyers to make more expensive purchasing decisions, buying larger houses on larger lots than they would have otherwise. Most of this business occurred in upper-income communities—as Jonathan Brown explains in Peter Wallison’s book, Serving Two Masters, Yet Out of Control, Fannie and Freddie were doing little business in the inner city with poor households and more business in the suburbs. These patterns led HUD in 2004 to step up their targets, which, in turn, led Fannie and Freddie to undertake a greater proportion of high-risk mortgages. This increase followed on the heels of the large target increases of 2001.
FIGURE 2: Risky Mortgage Loans per Year
It is an interesting counterfactual question to ask whether the GSEs’ foray into risky lending would have occurred without these mission goals. In other words, in their desire to expand, would they still have moved along the increasingly risky mortgage credit curve? Given the GSEs’ cheap source of financing and weak regulatory oversight, it is entirely possible that they would still have moved in this direction. Nevertheless, the FHEFSSA made the point somewhat moot.
To reach the new targets, the FHEFSSA called for a study of the “implications of implementing underwriting standards that (A) establish a down payment requirement for mortgagors of 5 percent or less, (B) allow the use of cash on hand as a source for down payments, and (C) approve borrowers who have a credit history of delinquencies if the borrower can demonstrate a satisfactory credit history for at least the 12-month period ending on the date of the application for the mortgage.”3
A study commissioned by HUD in 2002 found that, over the previous decade, Fannie Mae and Freddie Mac had in fact adopted more flexible underwriting guidelines in terms of (A) through (C) above.4 While the HUD report was describing these changes in Fannie and Freddie’s underwriting as a success, it also confirms the impact of the FHEFSSA. Examples of such underwriting practices include Fannie Mae’s introduction of their Flex 97 product, which required a down payment of only 3 percent if the borrower had a strong credit history.
As the MBS market took off in the 1980s, Fannie and Freddie dominated the growth in this market as a result of their government support. The credit-risk profile of Fannie and Freddie’s mortgages in those days, however, was reasonably safe: (1) low- to medium-sized loans, (2) loan-to-value (LTV) ratios of less than 80 percent, (3) high standards for a borrower’s creditworthiness, and (4) income documentation of the borrower’s ability to make interest payments on the loans. This does not mean that Fannie and Freddie were not without risk. But many analysts and economists at the time considered the greater source of risk to be the interest rate risk of Fannie and Freddie’s mortgage portfolio, not the credit risk of their portfolio plus their outstanding MBS.
But something dramatically changed with the FHEFSSA. Although the 1992 Act required Fannie and Freddie to hold only conforming mortgages, there was considerable flexibility. A conforming mortgage had to be less than a certain dollar amount (the “conforming loan limit”), have an LTV ratio of less than 80 percent (or, with flexibility, a higher LTV with private mortgage insurance), and meet unspecified “investment quality standards.” Not surprisingly, the above housing goals combined with the ambiguity of what constitutes a conforming mortgage translated into considerably riskier credit portfolios.
Consider data on Fannie Mae’s year-by-year mortgage purchases over the next decade from 1992 onward. Although complete data are not available, using the annual reports of Fannie and Freddie, along with date recently released by the FHFA, Figure 2 graphs the share of risky mortgage loans each year, as defined by either LTVs greater than 90 percent or between 80 and 90 percent.5 While it was commonly known that the Federal Housing Administration (FHA) and the Veterans Administration made risky loans, it is less well-known that Fannie (and Freddie) already had a growing presence in the high LTV mortgage market during the 1990s. Fannie’s role generally increased over the next several years both in dollar amounts and market share. For example, from just 6 percent ($11.6 billion) of loans having LTVs greater than 90 percent in 1992, by 1995, the number of loans with LTVs greater than 90 percent had doubled to $20.9 billion and 19 percent of Fannie Mae’s purchases. Though the percentage of loans with LTVs greater than 90 percent dropped to 13 percent by 2001, by that time the dollar amounts had increased substantially to $68.3 billion.
Although Freddie Mac’s annual reports provide only a snapshot of their mortgage holdings by year, the data tell a similar story. For example, in 1992, their mortgage book held just 3 percent of its loans with original LTVs greater than 90 percent, and 13 percent with LTVs between 80 and 90 percent. The next year, this number increased to 4 percent and 15 percent respectively, and by 1994 to 9 percent and 18 percent. By the late 1990s, the number had steadied to around 10 percent of loans with LTVs greater than 90 percent and 15 percent with LTVs between 80 and 90 percent.
The entry of Fannie and Freddie into high-risk mortgages had an unfortunate but subtle effect. Their critics’ primary concern had been that of interest rate risk: both GSEs held hundreds of billions of dollars of long-term fixed-rate mortgages in their portfolios. They funded these mortgages, to a large extent, with debt that had shorter maturities. Both GSEs claimed that they had engaged in derivative transactions (interest rate swaps and options) in order to eliminate any significant interest-rate risk from their overall asset-liability positions. But the specifics of the hedging were obscure, and critics were doubtful.
At the same time, however, the credit risks on the mortgages that the GSEs bought (and either held or securitized) were not considered by the critics to be a problem. The GSEs had a reputation for high underwriting standards, and their loss experiences supported this view. Except for a few years in the early 1970s for Freddie Mac, the credit loss experience of the GSEs had always been below the “guarantee fees” that they were charging on the MBS that they issued.
This observation ignored two important facts:
- Prior to the mid 1990s, the GSEs guaranteed only safe, conforming mortgages with generally low LTVs, good income coverage, and borrowers with high credit scores. So, even with small-to-medium downturns in the economy, mortgage defaults were not that likely.
- After the mid 1990s, while the GSEs’ mortgage underwriting standards deteriorated and their mortgages became much riskier, there was no housing downturn and there was only one mild recession, in 2001. In fact, from July 1995 to May 2006, S&P/Case-Shiller Home Price Indices—the bellwether housing index for the US residential housing market—increased by 196 percent, with no months experiencing a decline.6 Many analysts and politicians did not think that credit risk was an issue, because they were neglecting the fact that homeowners do not default (i.e., if necessary, they sell) if their underlying house collateral has appreciated in value.
Point 2 above is important. Common wisdom is that Fannie Mae and Freddie Mac blew up because of their risky behavior with respect to 2006 and 2007 mortgage vintages, which consisted in a significant measure of high-risk mortgages. The 2009 credit reports of Fannie show, for instance, that in 2007, it had as much as 25 percent of its loans with LTV ratios above 80 percent and 18 percent with FICO scores below 660; in 2006, as much as 22.5 percent of its loans were in subprime and similarly high-risk mortgages and 15.2 percent in interest-only loans. It is certainly true that the majority of GSE losses derived from these vintages. But the losses were confined to 2006 and 2007 vintages—not because of prudent lending in prior years but instead because weaker loans in earlier years were masked by the continued rising in housing prices through mid 2006. Mortgages issued in 2003 and 2004 may have been just as substandard, but homeowners had built substantial equity in their homes by 2006 because of the large house price increases, which protected them (and Fannie and Freddie) against the subsequent price decreases.
In other words, the moment that the GSEs lowered their underwriting standards, there was no turning back, and as soon as housing prices started falling, serious problems were inevitable.
A final observation is that the GSE affordable housing goals were all stipulated as a percentage of their mortgage share. There were no growth targets. In fact, as Figure 1 shows, their mortgage portfolios remained steady in size during 2003–2007. It was the MBS guarantee element of the business that truly expanded. The government push for affordable housing does not explain why the GSEs chose to grow the MBS guarantee business so dramatically. Although HUD, the first entity to which the GSEs were accountable, might have been discontented with a lack of growth, the next—the GSEs’ shareholders—would have been even unhappier because investment banks had started generating substantial returns in lines of business that the GSEs could do. This is the issue that we turn to next.
A RACE TO THE BOTTOM
When the US Financial Crisis Inquiry Commission released its report in early 2011,7 there emerged—somewhat ironically—a crisis of its inquiry. The majority of the commissioners for this report attributed the credit boom and bust to greedy but incompetent bankers and lazy but ideological regulators. The dissenting commissioners focused more on poorly designed housing subsidies. While the two groups reached largely polarized views, consensus should have in fact been easy to reach.
There was, during 2003–2007, a race to the bottom between the huge GSEs—Fannie Mae and Freddie Mac—and the private financial sector, consisting of too-big-to-fail LCFIs. Both the GSEs and the LCFIs were making highly leveraged bets on the mortgage market at below-market funding rates in credit markets that were implicitly backed by the government.
The mortgage market in the United States increased dramatically in size during these years, especially starting in late 2003 with the sharp growth of the riskier subprime and Alternative A-paper (Alt-A—that is, lending where the risk profile falls between prime and subprime) mortgage lending (see Figure 3 for private-sector MBS growth starting 2003 and Figure 4 for the composition of private-sector mortgage originations). Since the too-big-to-fail LCFIs could not compete directly with Fannie and Freddie because of the GSEs’ access to government-guaranteed capital and their lower borrowing costs—roughly 40 basis points lower—instead they moved along the credit curve of increasingly unstable mortgage loans. These were loans with which the GSEs had difficulty competing because of the restrictions, even if somewhat porous, that the GSEs had on their underwriting standards. Also, the LCFIs greatly increased their leverage through the use of asset-backed commercial paper and sale-and-repurchase (“repo”) financing, allowing them to expand by issuing cheap debt.
The too-big-to-fail LCFIs were not only creating more toxic MBS, but they were also investing in those same securities. Over 50 percent of AAA-rated non-GSE MBS were held within the financial sector. It was not just the proverbial Norwegian village pension fund investing for the long run in AAA-rated securities to earn a higher yield than Treasury bonds that suffered when those MBS collapsed. It is inaccurate to accuse these firms of not having a high enough stake in the transactions (“skin in the game”) to ensure that their investment risk was sustainable; rather the LCFIs did not have enough capital to cover their stake.
This growth in private MBS was the culmination of the aim of the US 1982 Housing Commission. However, in what would have caused great consternation to that Commission, an unintended consequence was to encourage the GSEs to take on riskier portfolios in order to preserve their market share from the private-sector LCFIs. For example, as Figure 3 shows, Fannie and Freddie’s share of the mortgage market rose sharply starting in 2005, in contrast to the steep decline of the preceding years when they lost market share to private-sector MBS.
Prior to 2003, as a fraction of their total MBS portfolio, each year the GSEs made approximately 10 percent of their total purchases in lower-quality loans. From 2004 to 2007, however, this fraction averaged 50 percent. While there is little doubt that, starting in the mid 1990s, government-mandated affordability housing goals played a role in shifting Fannie and Freddie’s profile to riskier mortgage loans, an interesting question is how much of the GSEs’ steeper dive into lower-quality mortgages was driven by those mandates and how much by their desire to maintain and expand their market shares.
Their former regulator, James Lockhart, testified that both Fannie and Freddie “had serious deficiencies in systems, risk management and internal controls.” Furthermore, “there was no mission related reason why the Enterprises needed portfolios that totaled $1.5 trillion.” He held “the Enterprises’ drive for market share and short-term profitability” responsible.8 Similar lan- guage can be found in Fannie Mae’s own strategic plan document, “Fannie Mae Strategic Plan, 2007–2011, Deepen Segments – Develop Breadth,” which outlines its strategy for 2007 onward: “Our business model—investing in and guaranteeing home mortgages—is a good one, so good that others want to ‘take us out.’...Under our new strategy, we will take and manage more credit risk, moving deeper into the credit pool to serve a large and growing part of the mortgage market.”9 Indeed, the data in Table 2 confirm that the GSE share of overall high-risk activity in mortgages (defined as mortgages with LTVs greater than 90 percent and borrower FICO scores of less than 620) declined from 43 percent in 2003 to 15 percent by 2006, but these risky mortgages regained their market share, to 31 percent, in 2007.
Ultimately, it is not possible to fix the US housing finance system for the long term without dismantling the GSEs in a phased manner and eliminating their imprint on housing markets, lest another race to the bottom emerge once benign conditions return and capital and credit become more readily available. However, it is unrealistic to believe that systemic risk will not exist in the mortgage finance market once the GSEs are removed: it is inevitable that too-big-to-fail LCFIs will gradually build up this risk on their balance sheets. Therefore it is crucial that the external costs of systemic risk be internalized by each of these LCFIs, or we will end up with an alternative group of private GSE financial firms in the mortgage finance area. The Dodd-Frank Act, even if imperfect, serves as a useful step in the direction of focusing regulatory attention on systemic risk contributions of the private financial firms.10
1. For a summary of the Dodd-Frank Act, see https://banking.senate. gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_com- prehensive_summary_Final.pdf.
2. Bush 1992.
3. Housing and Community Development Act of 1992, Title XIII, “Government Sponsored Enterprises”, Sec. 1354 “Review of Underwriting Guidelines.”
4. See Ambrose and Temkin 2002.
5. As mentioned above, the GSEs generally required loans with LTVs of greater than 80 percent to have private mortgage insurance. An important point, however, is that while private mortgage insurance helps insulate some of the GSE losses from a defaulted mortgage, the high LTVs also make default more likely. As is well documented, mortgage defaults usually create deadweight losses that are associated with spillover effects in the neighborhood, disinvestment in the property, and so on.
6. S&P/Case-Shiller Home Price Indices are available at https://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff--p-us----
7. Financial Crisis Inquiry Commission 2011.
8. James B. Lockhart, Acting Director of the Office of Federal Housing Enterprise Oversight (OFHEO), released its Report of the Special Examination of Fannie Mae on May 23, 2006. See https:// www.fhfa.gov/webfiles/2095/52306fnmserelease.pdf.
9. Fannie Mae Strategic Plan, 2007–2011.
10. See a discussion of the Dodd-Frank Act in Acharya et al. 2010.