Today’s historic signing of health reform into law by President Obama has overshadowed something else that happened today: Treasury Secretary Tim Geithner testified before the House Financial Services Committee about the future of housing finance, and the fate of Fannie Mae and Freddie Mac—the two government entities that guarantee $5t and 50% of our residential mortgage market. Here’s the link to the full testimony, and below are the excerpts that are most critical, starting with how Fannie and Freddie were taken over by the government in September 2008, and what Geithner proposes as a structure for the future of housing finance.
This is the basic framework for less reliance on Fannie and Freddie in the future, and Geithner points out next steps as follows: Treasury and HUD will submit a list of questions by April 15, 2010 for public comment and will seek responses from a wide variety of constituents, market participants, academic experts, and consumer and community organizations. Then the administration would use that feedback to provide a proposal for housing finance reform to Congress. So it appears this will happen closer to summer but well before the 2010 election.
The Collapse of Freddie Mac and Fannie Mae and Conservatorship
By the time the housing market began its collapse, extreme leverage was pervasive throughout the housing finance system – at the banks, at the GSEs, and with the homeowner. Almost every actor along the housing finance chain was overextended.
As long as housing prices continued to rise, the GSEs’ exposure to risky non-prime loans remained manageable. With the bursting of the bubble, however, the underlying weaknesses and flaws of Fannie Mae and Freddie Mac emerged with force. In 2007, the GSEs reported combined losses of over $5 billion, the first full-year loss for Fannie Mae since 1985 and the first ever for Freddie Mac. The companies’ share prices plummeted by 60 percent between July 2007 and July 2008. The GSEs ultimately reported combined 2008 losses in excess of $108 billion.
A collapse of Fannie Mae or Freddie Mac would have had devastating consequences for the housing finance system and the broader economy. These two entities are deeply interconnected with the broader global financial system, and the potential of their collapse would define the notion of systemic risk. Between the two entities, the GSEs guaranteed over $5 trillion of residential mortgage-backed securities, which represented nearly 50 percent of the overall residential mortgage market. They had over $1.7 trillion of debt securities outstanding, held equally among foreign and domestic investors. At a time when the foundations of the financial system were being deeply shaken by the broadening financial crisis, a collapse of either of these institutions would have caused a breakdown in the mortgage securities market, a significant worsening of the breakdown of confidence across the markets and a likely pull-back of foreign investment. In the end, as confidence eroded, the government was left with few viable policy alternatives.
As a result of the substantial deterioration in the housing markets, and Fannie Mae’s and Freddie Mac’s rapidly rising credit expenses and their growing inability to raise new capital and access debt markets, FHFA placed the GSEs into conservatorship on September 6, 2008 under the authority provided by HERA. In conjunction with that action, Treasury agreed to provide financial support to the GSEs through the establishment of Preferred Stock Purchase Agreements (PSPAs). While this action was undesirable, it was necessary and required. Both companies were severely undercapitalized and would not have been able to meet their obligations without the intervention and financial support of the government.
Prior to the actions taken in September 2008, investors in the GSEs had relied on the perception of backing by the government. Through the establishment of the PSPAs, the perception of government backing became explicit capital support, and as a result, the entities were stabilized sufficiently to play their current role in supporting recovery.
To continue the necessary support of the GSEs as the financial markets and economy recover, Treasury announced several changes in advance of HERA’s expiration in December 2009. Treasury agreed to amend the cap on Treasury’s funding commitment to each GSE, replacing the fixed $200 billion cap with a formulaic cap that increases above $200 billion by the amount of any losses, and reduces by any gains (but not below $200 billion), over the next three years. The cap will become fixed at the end of three years and will represent the maximum Treasury exposure to either GSE going forward from that point. Fannie Mae and Freddie Mac were also provided some modest additional flexibility as they reduced their retained mortgage portfolios. Treasury also announced that it would end its program to purchase mortgage-backed securities (MBS) at the end of the 2009 and terminate a liquidity facility that had not been utilized.
Neither company was near the previous $200 billion per institution limit in December and neither is likely to exceed those caps even under a range of very conservative assumptions. These actions, however, were intended to provide greater certainty to the market going forward that, even in conditions that seem unlikely based on current trends, the GSEs in conservatorship will be able to continue to meet their obligations and play the vital role they are continuing to play during this current crisis. The change also ensures that each firm will have a more appropriate cap given their specific facts and circumstances at the end of 2012. By providing certainty to market participants for these extreme conditions, these actions are designed to improve market stability today, making such adverse conditions even less likely.
Additional flexibility was also provided in meeting the requirement that the companies reduce their retained mortgage portfolios over time. Fannie Mae and Freddie Mac are not expected to be active buyers of securities to increase the size of their retained mortgage portfolios in this period, but neither is it expected that active selling will be necessary to meet the required targets. Treasury remains firmly committed to ensuring that the GSE’s retained portfolios are substantially reduced.
Taken together, these actions represent the most effective way to protect financial stability and enable these institutions to continue to play a vital role in the housing market during this crisis, including by securing the benefits of historically low mortgage rates on economic recovery, while limiting the long-term cost of the housing market collapse to the taxpayer. Indeed, the economy and the taxpayers would be far worse off if Treasury had not taken action during the Bush Administration in 2008 or if it did not continue that support going forward under this Administration.
The need for this level of intervention is both unfortunate and undesirable. However, without the decisive actions taken by the government and the specific support for the GSEs, the mortgage market would have halted, making it nearly impossible for Americans to buy or sell their homes or to refinance the mortgage on their existing home. The result would have been a much more wrenching decline in housing prices, a more severe foreclosure crisis and a deeper economic downturn.
The GSEs’ securitization and guarantee activities continue to play an important role in housing finance today, and they have helped to stabilize the housing market during this crisis. As a result of the near complete absence of private capital in the mortgage origination market, the GSEs financed or guaranteed over 70 percent of new single-family mortgage originations in 2009, as compared to just under 40 percent in 2006. The FHA, the Department of Veterans Affairs (VA), and the Department of Agriculture (USDA) accounted for another 25 percent of originations in 2009.
Treasury and the Federal Reserve have also supported the secondary market through direct purchases of agency MBS (with approximately $200 billion and $1.2 trillion of purchases, respectively, in 2009).
Supporting the GSEs’ ability to support the funding of new home purchases and the refinancing of existing mortgages will provide an important and valuable bridge that should allow necessary reforms to be executed in a time of greater housing market stability, something the Administration believes is essential to a successful transition.
Clear Need for Reform of Housing Finance System and the Role of Government
The housing finance system cannot continue to operate as it has in the past. The Administration has already put forth important proposals for the broader financial system as part of financial regulatory reform, which will help address many of the problems in the private residential mortgage credit markets. These proposals substantially enhance supervision, establish an agency dedicated to ensuring clear rules of the road for consumer financial markets and create new rules for the securitization market including a requirement that all originators retain some risk in the mortgages they underwrite. These are necessary reforms that will make the financial system safer for all Americans.
More, however, must be done to address the specific flaws of the housing finance system. Action is needed to ensure that markets are more stable, consumers are protected, credit is widely accessible and important housing policy objectives, such as affordable housing for low and moderate income families, are administered effectively and efficiently.
Government has a key role to play in that new system, but its role, and the role of the GSEs in particular, will be fundamentally different from the role played in the past. Private gains can no longer be supported by the umbrella of public protection, capital standards must be higher and excessive risk-taking must be appropriately restrained.
When considering the future role of government in housing finance and its organizational design, it is important to remember that Fannie Mae and Freddie Mac are only one part of a whole set of institutions that support housing finance, which also includes FHA, VA, USDA and GNMA, the Federal Home Loan Banks, commercial banks, thrifts, community banks, community development financial institutions, credit unions, private issuers of mortgage-backed securities, mortgage brokers, and a wide range of other stakeholders and market participants. Any restructuring of Fannie Mae and Freddie Mac must be done as part of a reform of the wider housing finance system and placed within the context of broader housing policy objectives to ensure that the functioning of the whole system is advanced.
Furthermore, as part of any broad review of government’s role in the housing finance system, one must consider how other government programs and policies support housing. A reformed housing finance system should reflect a consideration of how these different policies and institutions are balanced to achieve overall housing policy objectives.
The Administration has defined a framework of objectives for reform of the mortgage finance system. A reformed housing finance system should deliver stability and efficiency to the housing market, while minimizing the risks and costs borne by the American taxpayer.
Objectives of Reform
In considering reform, the Administration will be guided by the view that a stable and well-functioning housing finance market should achieve the following objectives:
Widely available mortgage credit. Mortgage credit should be available and distributed on an efficient basis to a wide range of borrowers, including those with low and moderate incomes, to support the purchase of homes they can afford. This credit should be available even when markets may be under stress, at rates that are not excessively volatile.
Housing affordability. A well-functioning housing market should provide affordable housing options, both ownership and rental, for low- and moderate-income households. The government has a role in promoting the development and occupancy of affordable single- and multi-family residences for these families.
Consumer protection. Consumers should have access to mortgage products that are easily understood, such as the 30-year fixed rate mortgage and conventional variable rate mortgages with straightforward terms and pricing. Effective consumer financial protection should keep unfair, abusive or deceptive practices out of the marketplace and help to ensure that consumers have the information they need about the costs, terms, and conditions of their mortgages.
Financial stability. The housing finance system should distribute the credit and interest rate risk that results from mortgage lending in an efficient and transparent manner that minimizes risk to the broader financial and economic system and does not generate excess volatility. The mortgage finance system should not contribute to systemic risk or overly increase interconnectedness from the failure of any one institution.
The housing finance system could be redesigned in a variety of ways to meet these objectives. However, the Administration believes that any system that achieves these goals should be characterized by:
Alignment of incentives. A well functioning mortgage finance system should align incentives for all actors – issuers, originators, brokers, ratings agencies and insurers – so that mortgages are originated and securitized with the goal of long-term viability rather than short term gains.
Avoidance of privatized gains funded by public losses. If there is government support provided, such as a guarantee, it should earn an appropriate return for taxpayers and ensure that private sector gains and profits do not come at the expense of public losses. Moreover, if government support is provided, the role and risks assumed must be clear and transparent to all market participants and the American people.
Strong regulation. A strong regulatory regime should (i) ensure capital adequacy throughout the mortgage finance chain, (ii) enforce strict underwriting standards and (iii) protect borrowers from unfair, abusive or deceptive practices. Regulators should have the ability and incentive to identify and proactively respond to problems that may develop in the mortgage finance system.
Standardization. Standardization of mortgage products improves transparency and efficiency and should provide a sound basis in a reformed system for securitization that increases liquidity, helps to reduce rates for borrowers and promotes financial stability. The market should also have room for innovations to develop new products which can bring benefits for both lenders and borrowers.
Support for affordable single- and multifamily-housing. Government support for multifamily housing is important and should continue in a future housing finance system to ensure that consumers have access to affordable rental options. The housing finance system must also support affordable and sustainable ownership options.
Diversified investor base and sources of funding. Through securitization and other forms of intermediation, a well functioning mortgage finance system should be able to draw efficiently upon a wide variety of sources of capital and investment both to lower costs and to diversify risk.
Accurate and transparent pricing. If government guarantees are provided, they should be priced appropriately to reflect risks across the instruments guaranteed. If there is cross-subsidization in the housing finance system, care must be exercised to insure that it is transparent and fully consistent with the appropriate pricing of the guarantee and at a minimal cost to the American taxpayer.
Secondary market liquidity. Today, the US housing finance market is one of the most liquid markets in the world, and benefits from certain innovations like the “to be announced” (or TBA) market. This liquidity has provided a variety of benefits to both borrowers and lenders, including lower borrowing costs, the ability to “lock in” a mortgage rate prior to completing the purchase of a home, flexibility in refinancing, the ability to pre-pay a mortgage at the borrowers’ discretion and risk mitigation. This liquidity also further supports the goal of having well diversified sources of mortgage funding.
Clear mandates. Institutions that have government support, charters or mandates should have clear goals and objectives. Affordable housing mandates and specific policy directives should be pursued directly and avoid commingling in general mandates, which are susceptible to distortion.
Key Policy Choices for a New Housing Finance System
Since the 1930s, the U.S. government has played an important role in housing finance. Today, significant support for housing and homeownership is now common across many different countries. Intervention in this market has been generally defended on two grounds:
(i) some government support, particularly through the provision of guarantees or insurance, can contribute to financial stability and help reduce booms and busts in home prices and
(ii) direct subsidies can support the social benefits of home ownership and the availability of affordable housing to low and moderate income families.
Federal support for housing finance in the current system has at times conflated these two objectives. As part of any reform, it is important to ensure that the objectives and goals of government support are clear and well defined. Financial stability arguments have two components.
First, stable access to mortgage credit is important for households and the economy. The largest financial asset for many households is the equity in their home. The housing sector also plays an important role in the overall economy. Residential construction is more volatile than other parts of the economy and consequently plays an important role in economic cycles. Changes in the value of real estate are an important source of variance for household wealth and consumption.
Second, housing finance can be severely affected when the financial system is disrupted. Mortgage loans are relatively small idiosyncratic credits. Underwriting mortgage loans responsibly, and investing in them, involves collecting and evaluating a substantial amount of information. A well functioning mortgage market requires institutions that develop and maintain the capacity to carry out this sort of analysis. When financial stress undermines existing financial institutions engaged in mortgage finance it can be difficult and take time to recreate that capacity.
The case for providing direct government support to stabilize mortgage credit would thus rest on the judgment that mortgage credit is particularly important to households and the economy overall. Moreover, the relative size of the housing market and high correlation of losses it can experience in times of financial distress means that government may be best suited to serve as a source of stability in a responsible manner. In the current crisis, mortgage credit that was not supported by either the GSEs or government programs collapsed highlighting the vulnerability of mortgage credit to financial stress. It is noteworthy that other forms of financial intermediation have fared much better (for example, the corporate bond market has recovered strongly over the past year). As the recent crisis has shown all too painfully, fluctuations in the supply of mortgages over boom and bust credit cycles can have a major impact on the economy. By supporting the availability of and access to mortgage credit, the government can ease the adverse effects of stress in the financial system on the broader economy.
Assuming government continues to play a meaningful role in the housing market for any of the reasons described above, there are a variety of mechanisms which could be employed to promote stability or convey a subsidy if desired.
In considering the various systems around the world, it is apparent that one of the key choices is whether or not government should provide explicit support or guarantees for the issuance individual mortgages or mortgage-backed securities to provide such stability. Government’s involvement provides certainty in the value of the guarantee and can promote a stable supply of mortgage credit. Guarantees, together with appropriate regulation, can also form the foundation for promoting good underwriting standards, consumer protections, and the management of broad macroeconomic credit risk.
If some form of guarantee is to be explicitly provided or supported, a series of important questions would need to be answered about how best to achieve these objectives. First, what should be the appropriate scale and scope of those guarantees and which borrowers and mortgage products should be eligible? Guarantees on mortgage-backed securities could be provided on a full or partial basis and there are a variety of criteria such as loan size, loan-to-value ratio, credit score and income-to-debt service ratio which could be used to set eligibility and provide benchmarks for standardization. Second, how should any guarantees that are to be provided be priced? In order to protect taxpayers, guarantees should be priced in a way that appropriately reflects the underlying risk assumed by the government. Third, where support or a guarantee are not available or are purposefully limited, how will the risk which is retained in the mortgage finance chain be managed and supervised?
Finally, how should any organization that provides such guarantees be structured and how should guarantees be distributed? Clearly the governance structure of the GSEs in the past, in particular the unhealthy combination of private ownership and implicit government support, proved to be a mistake. Careful choices are needed about organizational design to ensure that those providing any guarantees have the appropriate incentives and expertise.
Many countries provide significant government support for housing finance, but they do so in a variety of ways. Several countries have GSE-like entities that guarantee and/or hold mortgages, but in no other country are they as large as they are in the United States. In a number of countries governments underwrite mortgage insurance. In some cases countries governments provide a regulatory framework and set standards that promote liquid mortgage markets. Securitization does not play a major role in housing finance in all other high-income countries, and where it does exist, it takes different forms. Many European countries use so-called covered bonds to channel credit to housing. This diversity of international practice in housing finance can provide useful insights and examples to consider.
Transition to a New System
Transition presents several important challenges. There is a large stock of investments on the balance sheets of the GSEs, and financial markets are depending on the ability of the GSEs, in their current form, to perform on their obligations. The GSEs and the federal government, through the FHA and GNMA, are playing a larger role in the housing finance market today than they have since the Great Depression. Conditions must be created so that private capital will return in a substantial manner to the housing market. There are important infrastructure, capabilities and human resources at the GSEs that have great value and should continue to serve the needs of the housing market as reform moves forward. Maintaining these capabilities and retaining these personnel through the transition is important.
In conjunction with the Treasury’s commitment to supporting the GSEs while in conservatorship, it should be clear that the government is committed to ensuring that the GSEs have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any of their debt obligations. The Administration will take care not to pursue policies or reforms in a way that would threaten to disrupt the function or liquidity of these securities or the ability of the GSEs to honor their obligations. The Administration recognizes the central importance the mortgage finance market plays in the broader capital markets and will ensure that this market is not allowed to be disrupted. Recent amendments to the Preferred Stock Purchase Agreements should leave no uncertainty about Treasury’s commitment to support Fannie Mae and Freddie Mac as they continue to play a vital role in the housing market during the current crisis. Maintaining the current securitization operational flow, TBA liquidity, secondary MBS market liquidity and the ability of the GSEs to issue debt during the transition will remain key priorities for the Administration.
Government’s role in the housing finance system and level of direct involvement will change, however, and the Administration is committed to encouraging private capital to return to the housing finance market. The substantial direct support for the housing markets that has been put in place will be allowed to fade as the market recovers and fully stabilizes. In addition, through regulatory reform and other supervisory actions, the Administration is committed to clarifying the framework for new securitizations to restart these important markets. These steps should create the room necessary for private markets to re-emerge.
An effective transition plan will seek to maintain the extensive infrastructure, knowledge, personnel and systems of Fannie Mae and Freddie Mac. Designing an effective transition plan that leverages these resources and minimizes market disruption will be a critical component of reform.
To achieve these goals, the Administration intends to develop a comprehensive reform proposal for delivery to Congress. To ensure that input is provided by all stakeholders, Treasury and HUD will submit a list of questions by April 15, 2010 for public comment and will seek responses from a wide variety of constituents, market participants, academic experts, and consumer and community organizations. These questions will ask participants to provide comment on their recommendations for, and comments on (i) the priorities for government housing policy, (ii) the role of government in the housing finance system, (iii) characteristics of mortgage products available to consumers, (iv) the best practices to ensure consumer protection, and (v) the most effective design of the housing finance system.
The Administration will seek to work closely with the Congress, on a bipartisan basis, prior to finalizing a comprehensive reform plan.
Given the importance of the long term stability of the housing market and the critical role the GSEs continue to play in the current financial circumstances, this approach to GSE reform, built upon significant input from various stakeholders, should form the basis for a strong bi-partisan solution, introduced, enacted and executed at a time of greater market stability.