A Blueprint for Mortgage Finance Reform: Timeline
Shutter Fannie Mae and Freddie Mac
- Create a Resolution Trust Corporation (RTC) for the GSEs to wind down their $1.7 trillion portfolio. The preferred structure would be equity partnerships along the lines of those created to resolve the Savings & Loans (S&L) crisis. Since the typical paydown rate for the GSEs in normal times is around 25%, this suggests almost 60% of the original portfolio could be sold off within the first three years.
- In terms of purchases of new loans, the government would effectively be out of this business. We see no need for the GSE RTC, or some other government entity, to be an active trader in these markets. There is a well-developed capital market that can play this role. That said, for purposes of market stabilization, the GSE RTC could purchase modest quantities of MBS that have been guaranteed by the GSEs in the first three years. This would delay slightly the winding down of the portfolio.
- Since the GSEs are to be shut down, the GSEs’ securitization and guarantor function for mortgages should similarly be phased out, by reducing the size of loans that they can securitize (the “conforming loan limit”) and raising their guarantee fees (the “g-fees”).
- After three years, the GSE RTC would sell the remaining portfolio over the next 7 years or sooner. The GSE RTC would be mandated to sell 1/7th of the remainder every year, but, depending on market conditions, might sell a greater amount.
For conforming mortgages (such as those with loan to value less than 80%, FICO scores above 660, and to borrowers with measurable income—from labor or asset holdings—that can cover the interest on mortgages), mortgage originators have three primary choices:
- Hold the mortgage loans on their balance sheet and be subject to a K% capital requirement.
- Securitize the mortgages, and sell these securities to the capital market at large. Under Dodd-Frank, banks will be required to retain a 5% interest and must hold at least K% capital against their 5% interest. Qualified residential mortgages, whose criteria remain to be determined, are exempt from this retention requirement. Prudentially regulated capital market investors must also hold at least K% capital on their holdings of these MBS. Of course, market participants that are considered systemically risky (the “systemically important financial institutions”, or SIFIs, determined by the Financial Stability Oversight Council, or FSOC, under the Dodd-Frank Act) would be subject to even higher capital requirements. If the securities are structured into various tranches, it must be recognized that the weighted-average capital requirement of the combined tranches must also be at least K%. The expectation is that a MBS market without guarantees will eventually dominate as capital markets develop savvy mortgage-credit investors, and as the transparency of structured products improves.
- Securitize the mortgage but purchase a guarantee. Private guarantors would offer insurance on 25% of the securitized mortgage pool at insurance rates determined in the market place. As a silent partner, a newly formed government mortgage insurance company (GMIC) would provide the remaining 75% insurance at those same rates, backed by the full faith and credit of the U.S. government. Initially, given their experience in focusing only on interest rate and prepayment risk and not credit risk, capital market investors might prefer these guaranteed MBS. The expectation, however, is that because this insurance is priced by the market and therefore costly, many investors would prefer to take the credit risk themselves and earn higher yields.
- The conforming mortgage limit for provision of guarantees by the GMIC would start at $625K in the first year (current GSE limits exceed $729K in some high-cost geographic areas), decline by $75k each year to $400k in the 4th year, and by $66k each year thereafter to $0 by the 10th year. The GMIC would cease to exist after a decade-long period.
- The private mortgage guarantors would be subject to rigorous prudential regulation and a credible resolution authority (see below).
For mortgages that are non-conforming, banks again have three primary choices:
- Hold the mortgage loans on their balance sheet and be subject to a K*% capital requirement (where K* exceeds K, K being the requirement for conforming mortgages).
- Securitize the mortgages, and sell these securities to the capital market at large. Under Dodd-Frank, banks would be required to hold a 5% interest, and, under this rule, they must hold at least K*% capital to support their 5% interest. Prudentially regulated capital market investors must also hold at least K*% capital on their MBS holdings with the proviso that systemically important financial institutions (SIFI’s) would be subject to greater capital requirements. And like above, if the securities are sliced and diced into various tranches, it must be recognized that the weighted-average capital requirement of the combined tranches must also be at least K*%.
- Private insurance could be offered on 100% of the securitized mortgage pool at insurance rates determined in the marketplace. There would be no role for the government other than fulfilling its regulatory function. These private mortgage guarantors would automatically be considered by the Financial Stability Oversight Council (FSOC) to be systemically important financial institutions (SIFI’s), which in effect means they would be subject to (i) higher capital requirements, i.e., K**% (where K** exceeds K*), (ii) other forms of enhanced prudential regulation, and (iii) a credible resolution authority (see below).
The private mortgage guarantors and their resolution authority would have the following properties:
- The private mortgage guarantors cannot be financed via short-term (systemically risky) liabilities as the risks they guarantee are long-term and systemic in nature.
- If the private guarantors are housed within a larger, complex financial institution, then the insurance unit must be ring-fenced and financed separately, again not using short-term liabilities for funding purposes.
- Upon the failure of one of these private insurers, any losses associated with unpaid mortgage guarantees to capital market investors would be pari passu with the senior unsecured debt of the guarantor. In other words, capital market investors would now receive payment on only a fraction of the mortgage balance. This is quite similar to how covered bonds in the mortgage market in other international jurisdictions are treated. The investors would, however, be assured of receiving the 75% from the GMIC.
The Bigger Picture
There is tremendous subsidization of homeownership in the United States. The Congressional Budget Office (CBO) estimated that the total cost of tax expenditures—such as 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, the subsidies to the GSEs, etc.—is alone close to a staggering $300 billion per year. This number needs to be substantially reduced to enable private markets to allocate capital more efficiently in the economy. In particular,
- There is over-consumption of housing which crowds out more productive economic investment, such as human capital, social infrastructure and business investment.
- The public mission of stimulating home ownership can be debated. While the GSEs may have had a little impact on increasing housing accessibility for the poor, the GSEs engaged in many activities that were completely unrelated to this mission. There are many more direct and effective ways to support housing initiatives at the federal, state or municipal level. Furthermore, the GSE subsidies applied equally to first and second homes, encouraged leverage, and benefited the rich substantially more than the poor. The latter is true of several of the other tax expenditures as well.
–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.