A Blueprint for Mortgage Finance Reform: The Administration's Plan


From a level of 30,000 feet, it is hard to argue against the fundamental premise of the administration’s plan for mortgage finance, and, in particular, for the GSEs. Their various plans all call for effectively winding down and eventually shuttering Fannie and Freddie and, as a replacement, for a privatized system of housing finance with little government involvement:

“Under our plan, private markets—subject to strong oversight and standards for consumer and investor protection—will be the primary source of mortgage credit and bear the burden for losses. Banks and other financial institutions will be required to hold more capital to withstand future recessions or significant declines in home prices, and adhere to more conservative underwriting standards that require homeowners to hold more equity in their homes. Securitization, alongside credit from the banking system, should continue to play a major role in housing finance subject to greater risk retention, disclosure, and other key reforms. Our plan is also designed to eliminate unfair capital, oversight, and accounting advantages and promote a level playing field for all participants in the housing market. The Administration will work with the Federal Housing Finance Agency (“FHFA”) to develop a plan to responsibly reduce the role of the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”) in the mortgage market and, ultimately, wind down both institutions.”  

Reforming America’s Housing Finance Market,
Administration Report to Congress

That said, there is plenty to quibble about in the report itself and, in particular, with respect to the implementation of the administration’s proposals. We separate our remarks into four areas:

1. The causes of the crisis and the GSE’s role

We agree with the basic notion that we want to look forward and not back. But the role and subsequent failure of the GSEs within the U.S. mortgage finance system provide valuable lessons for how to reform the system.

There is little doubt that the financial crisis was not brought about just by the reckless profit-seeking incentives of then-private-but-always-implicitly-guaranteed Fannie and Freddie. Private-label securitization of sub-prime and Alt-A mortgages, which were destined to fail when house prices fell and which were not guaranteed by Fannie and Freddie, left much to be desired as well. There were poor underwriting practices and standards; the capitalization of originators and securitizers was woefully inadequate and many of these also enjoyed explicit or implicit government guarantees; the private-label MBS were massively mis-rated by the credit rating agencies, whose ratings many investors took on blind faith; and the dispersed owners of sliced-and-diced tranches of risk had little incentive to pursue efficient renegotiation of defaulted or near-default mortgages. In the end, many private players became too big to fail, just like Fannie and Freddie.

But the data do not support the idea that the GSE’s mortgage portfolio and credit guarantees followed safe and sound practices prior to the 2005 period. While the quality of the 2005-2007 vintages were certainly below those of the earlier period, the main determinant of defaults was the collapse in home prices. If such a collapse had occurred prior to the 2005 period, then the GSEs would have failed then too, perhaps not as spectacularly, but failed nonetheless. The data from the FHFA (via Fannie Mae and Freddie Mac) show significant increases in the riskiness of their mortgages starting in the 1990s. It is not rocket science to understand that high loan-to-value (LTV) ratios and lower FICO scores increase risk exposure. The fact that national house prices, according to the Case-Shiller index, increased 132 straight months from 1995 to 2005 is the primary reason mortgage defaults were low in this period. The GSEs, or future variations of the GSEs, need to therefore go back to sound underwriting. We think the 90% LTV cited in the Administration’s report is too high and favor an 80% LTV ratio for first and second liens combined. That is, a household with 20% equity in its house would not be allowed to take on a second mortgage or a home equity line of credit, while a household with 30% equity could take on a second mortgage no larger than 10% of the value of its house.

Also missing from the report, and perhaps most important, is the key problem that the mortgage finance system placed the GSEs as the heads of U.S. mortgage finance. They received implicit government guarantees that enabled them to borrow at near-government rates with little or no capital. If banks involved Fannie or Freddie in the mortgage underwriting and securitization process, the system allowed for twice the leverage even though the underlying risk was the same. It should not be surprising that the U.S. banking sector, including Fannie and Freddie, held 37% of GSE MBS in 2007. This is the opposite implication of the originate-to-distribute model of securitization: risks remained on the financial sector’s balance sheet rather than being dispersed to capital-market investors and other intermediaries.


It is important to understand the consequences of this regulatory capital arbitrage. A pool of mortgages, no matter how these mortgages are sliced and diced in securitization or guaranteed by one counterparty or another, has the same overall risk. If regulators believe a certain amount of capital needs to be held against these mortgages, then sound economics suggests this should be similar at the beginning and end of the securitization process. Moreover, if systemically important financial institutions hold these mortgages or securitized versions, then the capital requirements should actually go up to reflect the external costs of systemic risk. In equilibrium, one might expect therefore that the less systemic institutions would hold these securities, in contrast to what was observed in the period leading up to 2007.

The importance of this observation cannot be understated. The new and improved mortgage finance system must be a level playing field or systemic risk will once again be built up within a few financial institutions: those who can hold the risk at the lowest cost and whose costs are artificially cheap because of explicit or implicit government guarantees.

2. The unwinding of the GSEs

The report makes four suggestions for unwinding the GSEs. While each of the four recommendations is reasonable, each lacks specifics:

A. Increasing guarantee fees to bring in more private capital.

“We support ending the unfair capital advantages that Fannie Mae and Freddie Mac previously enjoyed and recommend FHFA require that they price their guarantees as if they were held to the same capital standards as private banks or financial institutions.”  

Reforming America’s Housing Finance Market,
Administration Report to Congress

There is no recognition that the government, no matter how well intended, cannot accurately price default risk. Without accountability, and subject to no market discipline, it is difficult to see how the pricing will improve under the watchful eye of the FHFA. Without market pricing, it is not clear how private markets will emerge.

B. Increasing private capital ahead of Fannie Mae and Freddie Mac guarantees.

“In addition to increasing guarantee pricing, we will encourage Fannie Mae and Freddie Mac to pursue additional credit-loss protection from private insurers and other capital providers. We also support increasing the level of private capital ahead of Fannie Mae and Freddie Mac’s guarantees by requiring larger down payments by borrowers. Going forward, we support gradually increasing the level of required down payment so that any mortgages insured by Fannie Mae or Freddie Mac eventually have at least a ten percent down payment.”  

Reforming America’s Housing Finance Market,
Administration Report to Congress

Fannie Mae and Freddie Mac were statutorily required to hold mortgages with at least 20% down payment. The way the GSEs got around this restriction was to have private mortgage insurance (PMI) on the mortgages. While PMI provides protection to Fannie and Freddie, it does not change the fact that mortgages with high LTVs are more likely to default. These defaults lead to deadweight costs that push the value of the property down. To lower the mortgage risk, 10% down payment is not sufficient. Encouraging additional credit-loss protection is not a bad idea per se as long as it is structured in a way that does not reduce the overall capital in the system. Mortgage insurers, by their very nature, are systemically risky. For example, leading up to the financial crisis, $960 billion of PMI had been written with 80% of the insurance performed by just 6 companies. In 2007 alone, these companies lost 60% of their market value, effectively causing them to suffer a capital shortfall. The key goal should be to prevent a systemic risk buildup anywhere in the financial sector, whether public or private.

C. Reducing conforming loan limits.

“In order to further scale back the enterprises’ share of the mortgage market, the Administration recommends that Congress allow the temporary increase in conforming loan limits that was approved in 2008 to expire as scheduled on October 1, 2011 and revert to the limits established under HERA. We will work with Congress to determine appropriate conforming loan limits in the future, taking into account cost-of-living differences across the country.”

Reforming America’s Housing Finance Market,
Administration Report to Congress

While reverting to a loan limit of $625,000 is a necessary action, it is by no means sufficient. The implication of the above paragraph is that these limits would remain in place, otherwise why mention the cost-of-living differences nationwide. A conforming loan limit of $625,000 keeps the government firmly entrenched in the jumbo segment of the housing market. For the private sector to emerge, and as long as the GSEs are “alive”, there has to be a formal way to eventually choke the life out of these GSEs. Gradual loan limit reductions all the way down to zero and according to a clear timeline would seem like a straightforward way to do this.

D. Winding down Fannie Mae and Freddie Mac’s investment portfolio.

“The PSPAs require a reduction in this risk-taking by winding down their investment portfolios at an annual pace of no less than 10 percent.”

Reforming America’s Housing Finance Market,
Administration Report to Congress

While we prefer a more immediate closing of the GSEs, lest they still crowd out the private sector, and for their portfolio to go into an RTC-like entity, the 10% reduction should be quite manageable given the normal pay-down rate of the mortgage portfolios. We advocate a faster paydown rate if market conditions permit, and we advocate legislation to that end so that future administrations cannot renege on this plan.

3. The Public Mission

“[W]e should make sure that all Americans who have the credit history, financial capacity, and desire to own a home have the opportunity to take that step. At the same time, we should ensure that there are a range of affordable options for the 100 million Americans who rent, whether they do so by choice or necessity.”

Reforming America’s Housing Finance Market,
Administration Report to Congress

As one path to the above goal, the report calls for a reformed and strengthened Federal Housing Administration (FHA), which includes (i) a commitment to affordable rental housing, (ii) measures to ensure that capital is available to creditworthy borrowers in all communities, including rural areas, economically distressed regions, and low-income communities, and (iii) a flexible and transparent funding source to support targeted access and affordability initiatives.

A reasonable question to ask is why households that have the “credit history and financial capacity” cannot access the mortgage market. Where is the market failure that private markets cannot operate here but can elsewhere?

Is it not mildly worrying that the administration still emphasizes a role for government agencies to target creditworthy low and moderate income households, in effect, to continue the “American dream” of homeownership? It is taken as a given that these programs are socially optimal. The enormous subsidies thrown at housing - the mortgage interest rate tax deductibility, the tax exemption of implicit income from owned housing, the exemption from capital gains upon sale of a house, and the subsidies to Fannie and Freddie – have not served us well. Many low-income households ended up losing their little home equity and are left with little but a ruined credit history. As documented in numerous economic studies, most of these programs involve transfers of wealth to the well-to-do and not to the poor. More generally, there needs to be serious analysis and debate whether this is the best way to redistribute wealth to households in need.

4. The Administration’s three plans

The Administration offers three possibilities, all of which involve efforts to assure housing affordability for low- and moderate-income households—albeit explicit, on-budget, and primarily the domain of the Federal Housing Administration (FHA). Putting aside the above discussion on whether this is the socially optimal goal, returning to the past tighter standards of the FHA and making all of these programs transparent removes some of the major issues that arose with Fannie and Freddie.

Conditional on a government role through the FHA, the administration presents three plans: (i) a wholly private structure; (ii) a largely private structure, but with an agency that would provide guarantees to new MBS at times of general and severe stress in the MBS markets; or (iii) a largely private structure, with a government agency providing “tail risk” or catastrophic insurance in the event that a private guarantor defaulted on its obligations. As is clear, we believe that the first is the appropriate long-term goal; but we believe that our plan is a superior interim means of getting there. The other two plans offered by the administration allow for the government to slide into the mortgage market through the backdoor and remain permanent fixtures.

In one option, the government comes in like the Lone Ranger (or should we say “Loan Ranger”) and saves the day in a financial crisis. It is not atypical for government entities to act as a lender of last resort, but, to keep the mortgage system in check, it should be the case that whatever the government lends out in a crisis should be at exorbitant rates. In other words, it should really be THE last resort. Where to set the threshold for government intervention is difficult and determining the level of guarantee fees that will adequately compensate the government for the default risk of mortgages issued during a crisis is even more difficult. Also, isn’t this the function that we already expect the Federal Reserve to perform?

The final option offered by the administration looks a little like what we currently have in disguise. When mortgages start to default, private mortgage guarantors that sold protection would absorb the first losses. If defaults continue to mount, and private guarantors are wiped out, the government would step in and make the MBS holders whole. In this plan, the government assumes the so-called tail (or economic catastrophe) risk. While such a system brings back some market discipline and tries to address systemic risk, it nevertheless is a dangerous idea for four reasons.

First, can we think of any instance in which the government does a good job in pricing credit risk, whether it is deposit insurance for banks or hurricane insurance in Florida? The answer is a resounding no. Even if they had the very best people working for them, setting the correct price would be virtually impossible. Without the interaction and competition amongst market participants and resulting information revelation, the prices of the tail risk will be wrong. And, eventually, moral hazard will rear its ugly head. The problem of pricing the risk accurately is only aggravated by the fact that this is tail risk. By its nature, tail risk only materializes rarely. Lack of data thus plagues the pricing process.

Second, markets (and politicians) become impatient if they have to pay for tail risk insurance which (by its nature) may not materialize for many years. They will call for a reduction in catastrophic risk insurance fees, often at the very moment that more credit (tail) risk is taken on. This is what happened with FDIC insurance fees. Banks successfully lobbied to stop contributing to the fund during the quiet time. While its coffers appeared full at the time by standards of expected losses, the fund experienced a massive unexpected shortfall when the catastrophic risk materialized in 2008-2009.

Third, if there is one thing the current financial crisis has taught us, regulators are always one step behind well-paid financiers. The crisis was the poster child for financiers’ coming up with clever ways of pushing risk out into the tails and avoiding capital requirements. It doesn’t take much imagination to see how mortgage financiers will do the same here, given that they in effect control the quantity of tail risk borne by the government.

Fourth, if private mortgage insurers suffer first losses, and an event occurs that triggers a government payout, then by construction all the private mortgage insurers go bust. Next, the government takes over the mortgage market, crowding out private markets from then on. There is a certain “been there, done that” feel to this plan. And we will be back to solving the “genie in the bottle” problem that we face right now! ❚

–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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