A Blueprint for Mortgage Finance Reform: Q&A

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  1. What does economic theory tell us about government intervention in markets? Regulation is only necessary when there is a market failure. So the relevant question must be: What, exactly, is the market failure in mortgage finance that justifies government intervention? The purpose of such intervention should be to remedy a clearly identified market failure, or, in other words, fill in where markets do not exist or are unlikely to achieve socially efficient outcomes.
  2. Is government intervention necessary in mortgage markets? It is clearly untrue that mortgage finance necessarily requires heavy government involvement, in particular, guarantees of mortgage defaults. Looking at the cross-section of mortgage funding models across various developed countries, no country has any entities that resemble Fannie Mae or Freddie Mac. The majority of countries rely on a deposit-based system in which the mortgage lender retains the mortgage loans on their books. These institutions are subject to prudential regulation just like any other bank. And the argument cannot be that this has a major impact on homeownership rates. Of the 25 most developed countries, the U.S. lies 17th in ranking. Of particular importance, what is unique about U.S. mortgage finance is that almost 2/3 of all mortgages are securitized, whereas abroad, the next largest securitizers—Australia and Canada—are only around 20%.1
  3. What is the argument then in favor of mortgage-backed securitization? While the deposit-based system mentioned above leads to the lender retaining the risk of mortgages (“skin in the game”), there are reasonable economic grounds for preferring the U.S. mortgage finance system of securitization. Securitization truly can turn “lead into gold”: Securitization takes illiquid mortgage loans and pools them to form liquid mortgage-backed securities (MBS) that trade on the secondary market. Because illiquidity commands a risk premium, the more liquid mortgage assets from securitization command better prices and thus a reduced mortgage rate. An additional benefit is that the credit risk gets transferred out of the systemically risky banking sector to the capital market at large. Also, the 30-year fixed-rate mortgage is a difficult financial instrument for banks to hold, since their deposits and other liabilities are considerably shorter term; the securitization of these mortgages, however, allows their natural customers—life insurance companies and pension funds, which have long-lived liabilities—to invest in these long-lived assets. In other words, if securitization works the way it is supposed to, the banking sector can better share its mortgage risks with rest of the economy. Finally, MBS provide banks with access to investors worldwide, which diversifies their funding base. A successful return of securitization, though, will crucially depend on increased transparency and reduced complexity of the structures. We believe the reforms proposed by the Dodd-Frank Act, the SEC’s regulation AB, the FDIC’s new safe harbor rules for securitization, and the FASB regulations 166/167 go a long way towards ensuring that securitization will be safer and more transparent in the future.
  4. What was the market failure, if any, in this financial crisis that requires government regulation? The market failure of the financial crisis is by and large that financial institutions produce systemic risk but do not bear the costs of that risk—we call this a negative externality. Financial institutions take risks either on the asset or liability side that are aggregate in nature and can trigger loss of intermediation to households and corporations (a “credit crunch”) and potentially also trigger contagion through inter-connectedness, bank-like runs, and fire sales on assets leading to downward price spirals. Other financial institutions share the costs of such events, which can lead to a complete collapse of the financial system. The private markets cannot solve this problem efficiently because individual firms do not have incentives to deal adequately with the systemic risk they produce. If government intervention is required in U.S. mortgage finance, it therefore follows that the purpose of such intervention should be to reduce or manage the systemic risk that emerges from mortgage finance.
  5. On systemic risk grounds, isn’t securitization a better system for mortgage finance than a deposit-based system? The answer is generally yes—on the assumption that securitization works as intended. To understand why the U.S. mortgage finance system failed, one has to understand the source of this failure – the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac (see next several points).
  6. What was the role of the GSEs, specifically Fannie Mae and Freddie Mac? The GSEs have been performing two separate functions. Their first function—the guarantee function—is arguably the most important: guaranteeing the credit risk in conforming (prime non-jumbo) mortgages that the GSEs securitize. They charge a small fee (recently, around 20 cents per 100 dollars of unpaid mortgage principal) for this guarantee, and they hold 45 cents of capital for every 100 dollars of mortgage face value that they guarantee. The second is essentially the proprietary trading function: purchasing mortgages and both prime and non-prime (Alt-A and subprime) MBS. They financed these asset purchases almost entirely by issuing debt (so-called “agency” debt). Because of the implicit government guarantee (which has now become an explicit guarantee), the GSEs are able to borrow at below-market rates. The GSEs are required to hold 2.50 dollars of capital for every 100 dollars of mortgages and MBS that they hold.
  7. What was the problem with the GSEs? Given both the implicit guarantee of the U.S. government (resulting in a below market cost for debt financing) and favorable capital requirements, the GSEs grew unencumbered for decades. From the last major GSE legislation in 1992, for example, Fannie Mae and Freddie Mac combined went from holding $153 billion in mortgages and guaranteeing the credit risk of another $714 billion to holding $1.5 trillion and guaranteeing $3.5 trillion, respectively by the end of 2007.
  8. Were the GSEs systemically risky? Yes, due to their interconnectedness - $1.6 trillion derivative positions, $3.5 trillion mortgage guarantees (i.e., approximately 7 times that of the infamous A.I.G Financial Products Group), their widely held debt, the possibility of fire sales resulting from liquidation of their $1.5 trillion portfolio, mortgage finance being at the center of the economy’s financial plumbing, and their failure igniting a run on short-term liabilities of the banking sector and possibly sovereign U.S. debt.
  9. What are the major flaws of the GSE model? While a number of problems exist, three stand out:
  10. • The obvious one is that unpriced government guarantees destroy market discipline and lead to below-market borrowing rates. This in turn encourages excess leverage and risk taking. Private profit taking with socialized risk is simply unacceptable as a matter of public policy.

    • Less discussed, but equally important, is the fact that the mortgage finance system essentially ordained the GSEs as the dominant mortgage player. Under capital rules, if a bank makes a portfolio of loans, the bank must hold 8% capital. If these loans, even of identical risk, were mortgages, the bank would need to hold only 4% capital. If these same mortgage loans were then sold to the GSEs and bought back as mortgage-backed securities, the bank would need to hold only 1.6% capital. Since the GSEs had to hold only 0.45% capital to support their guarantees on these MBS, the lower overall 2.05% capital requirement basically assured GSE involvement. In fact, over 37% of MBS were held within the banking sector, which is contrary to the “originate-to-distribute” prediction of the desired risk-sharing purpose of securitization business model described above.

    • Starting in the 1990s, and increasing over time, partly due to government mandates and partly due to risk taking decisions by the GSEs, the GSEs took on mortgages with high credit risk, such as loan-to-value ratios greater than 80% (i.e., down payments less than 20%), borrowers with FICO scores less than 660, and Alt-A loans (i.e., those with lower documentation levels). The light regulatory capital requirements - 2.5% for portfolio holdings and 0.45% for their MBS default guarantees – may have seemed reasonable when set back in 1992, but the mortgage-backed assets of the GSEs of 2007 had a quite different credit risk profile than those of 15 years earlier.

  11. Why did mortgage securitization fail? Securitization failed in mortgage markets because the risk transfer it promises did not (sufficiently) take place, largely because of regulatory arbitrage of capital requirements, and because the credit rating agencies massively mis-rated private-label mortgage-backed securities. The GSEs, as private companies, were essentially mandated to be front and center of mortgage securitization markets. The mortgages that they guaranteed saw unprecedented default rates during the crisis of 2007-2009. The GSEs had underestimated and underpriced that default risk, which combined with the losses on their investment portfolio, resulted in their insolvency. But non-conforming mortgages securitized in “private-label” MBS fared even worse. They saw default rates 3-5 times as high as those on conforming mortgages.
  12. • The credit rating agencies massively mis-rated these private-label MBS securities, as witnessed by the fact that in January 2010 less than 10% of subprime MBS were still rated AAA compared to 80% in January 2008. The ratings problems were even worse for collateralized debt obligations (CDOs) that had tranches of mortgage-backed securities as collateral.

    • Other too-big-to-fail financial institutions exploited loopholes in regulatory capital requirements through private-label securitization to concentrate risky tail bets with little or no capital. They either directly held MBS on balance sheet or provided guarantees to MBS that they transferred to off-balance sheet special purpose vehicles (conduits and SIVs). The future U.S. mortgage finance system needs to prevent such buildups in systemic risk by tightening the regulatory capital treatment of (tranches of) MBS and guarantees written to special purpose vehicles. The new FASB 166/167 rules concerning consolidation of assets in special purpose vehicles for the purpose of regulatory capital calculations, the SEC’s Regulation AB, and the FDIC’s new safe harbor rules for securitizations are all steps in the right direction.

  13. If a mortgage finance system has securitization as its anchor, does it require heavy-handed government involvement, e.g., government guarantees of mortgage defaults? The answer is NO. There are many securities markets that expose investors to credit risk, which function as intended. It is certainly true that government guarantees of mortgage defaults remove credit risk from the pools of mortgages underlying the mortgage-backed securities. This helps standardize these mortgage pools, allowing for greater liquidity and secondary market trading. But as we have argued above, these government guarantees come at great cost, not least the distortions that these guarantees produce in the mortgage market and the crowding out of private markets. The role of the government in securitization should be limited to set regulations that improve data disclosure, increase standardization, and reduce complexity of securitized products so that these markets can flourish again.
  14. Your proposed solution for mortgage finance system does, however, involve some form of government guarantees. Why? The executive summary termed this the “genie in the bottle” problem. Capital market investors have relied on government guarantees for 25-plus years, focusing on the valuation and trading of MBS securities that carry only interest rate and prepayment risk. There needs to be a transition that allows the private market to develop. In reality, private markets do not spring up out of thin air. As has been demonstrated through past financial innovations, such as the emergence of mortgage-backed securities, high-yield bonds, and leveraged loans, it takes years to develop the investor base and institutional knowledge of the markets. One of the failures of the current crisis was that, like previous mortgage market failures (e.g., collateralized mortgage obligations in the early 1990s), the market for subprime securitization products arose so quickly that when the financial crisis started, there wasn’t really the market or expertise for standby private capital to step in.
  15. So how will your proposal work? Since mortgage default guarantees were an essential element of the development and liquidity of the mortgage market, to the extent possible, mortgage default insurance should be preserved in the short term as we transition to a fully private market. The problem is that the private sector cannot be the sole provider, as this insurance is systemic due to its dependence on macroeconomic events. The negative externalities caused by such aggregate risk exposure are not fully reflected in the price of insurance. Yet because there is not the right incentive structure and no accountability (let alone political considerations), the public sector cannot step into the breach. We argue for a public-private partnership in which the private sector determines which mortgages to guarantee and at what price to guarantee them, insuring only a 25% fraction, while the government is a silent partner, insuring the majority 75% of the remainder and receiving the corresponding market-based premiums. It is important that the public sector involvement be limited to conforming, safe mortgages. And to help the transition along its way, the loan limit for conforming mortgages would be gradually reduced over time. Market pricing of the guarantees will ensure that a competing private sector mortgage market (without guarantees) will not be crowded out. Precedence for such partnerships exists, such as the private-public program given by the Terrorism Risk Insurance Act (TRIA) of 2007. Most important, and described in prior pages, the private sector firm/subsidiary would be “well-capitalized” and subject to an irrefutable resolution authority.
  16. Are there any concerns? Most notably, once the GSEs are effectively shuttered, it is hard to believe that systemic risk in the mortgage finance market will not persist. One can imagine that this risk will be gradually built up by private sector financial institutions that garner favorable capital requirements and government guarantees. It is crucial therefore that the external costs of systemic risk are internalized by each financial institution to prevent private sector “GSEs” from forming.
  17. What about the affordability of housing? Affordability issues have bedeviled housing policy and were partly responsible for the demise of the GSEs. In the apparent pursuit of affordability, the U.S. has had policies (such as the deductibility of mortgage interest against income tax) that are extremely costly to the federal budget (as much as $300 billion/year), yet mostly favor higher income households. These policies ultimately made housing less affordable because they pumped up housing prices by making mortgage debt artificially cheap.
  18. What about encouraging home ownership? Many of those same policies have also been supposed to encourage home ownership. But they mostly encourage upper-income households, who would buy their homes anyway, to buy larger houses on larger lots, and to take on excessive debt in doing so. An important consequence is that the U.S. has invested too much in housing and not enough in other forms of productive capital (including business investment, social infrastructure, and human capital), so that U.S. GDP is lower than it otherwise could be.

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–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.


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