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The Future of Housing FinanceRestructuring the U.S. Residential Mortgage Market
BROOKINGS INSTITUTION PRESSCopyright © 2011 THE BROOKINGS INSTITUTION
All right reserved.
Chapter OneThe Federal Role in Housing Finance: Principal Issues and Policy Proposals
DOUGLAS J. ELLIOTT
Fannie Mae and Freddie Mac dominate the American housing market, backing more than 62 percent of recent new mortgages and holding more than $5 trillion in accumulated mortgage risk. Unfortunately, their traditional structure as government-sponsored enterprises (GSEs for short) is clearly broken. The GSEs are a kind of public-private partnership in which private capital, motivated by the pursuit of profits, is channeled toward the accomplishment of government objectives for housing. For a while, the GSEs generated very high earnings while meeting increasingly challenging public goals with no cost registering on the federal budget. However, the structures came crashing down in 2008, requiring a rescue that has effectively given the federal government ownership of the two GSEs in exchange for a projected $224 billion in capital injections and the promise of more, if needed.
Fannie Mae and Freddie Mac are coming to a crossroads where the government will have to make key choices about their structure and, indeed, their very existence. This volume is an outgrowth of a conference held by Brookings to better inform these decisions. To begin, this chapter provides some background on the GSEs and the federal role in supporting the U.S. housing market and then summarizes and compares key proposals offered by the remaining chapters. The good news is that these chapters reflect what appears to be a growing consensus on several public policy issues critical to the design of a restructured housing finance system. This is particularly good news since the authors were chosen to represent a fairly wide range of views and analytical perspectives.
At the same time, important areas of disagreement remain. In addition, it is not clear that the emerging public policy consensus will be that of the politicians who will ultimately determine the fate of the GSEs and the housing market.
The key elements of consensus among the researchers, and with a Treasury white paper outlined at the conference, appear to be the following:
The federal government has an appropriate role in stabilizing housing finance markets and assisting low- and middle-income home buyers.
However, the government has been doing too much in this area and doing it too expensively. It should step back and let the private markets do more.
Mixing credit guarantee and affordability efforts so intimately in the GSEs was a mistake. Going forward, the housing affordability mission should lie with the Federal Housing Administration (FHA), the Department of Housing and Urban Development (HUD), and similar entities.
Any government credit guarantees, apart from the affordability mission, should be priced explicitly at "actuarially fair" rates and not be provided implicitly at zero cost, as before, or even explicitly but at a low cost.
Any private credit guarantors with government backing should be severely limited in their ability to own substantial portfolios of mortgages or related securities. This becomes even more important to the extent that such entities have a structural ability to earn arbitrage profits by borrowing at rates close to Treasury rates.
Any government housing subsidies should be calculated accurately and recorded in the federal budget.
A multiyear period is needed to transition from the current housing finance regime to any of the proposed ones. Housing finance is too troubled and the GSEs are too important to move immediately, although that does not need to hold back the decisionmaking, just full implementation.
Despite these areas of agreement, the authors disagree about the right structure for the housing finance system, including differences of opinion about the extent of the federal role. Before addressing these areas of disagreement, this chapter offers some background on housing finance in the United States.
Overview of the Federal Role in Housing Finance
The federal government has played an important role in the U.S. housing market since the early 1930s, when a number of programs were set up in response to the Great Depression. The recent housing and financial crisis caused the government role to expand still further, to the point where it clearly dominates the mortgage market, at least temporarily. As Dynan and Gayer note in chapter 4 of this volume, 88 percent of new mortgages were backed in some manner by the federal government in the first three quarters of 2010, roughly double the average share from 2000 through 2007.
Tax subsidies may be the single strongest, and most expensive, support that the federal government provides. Individuals and couples who itemize their deductions for federal income tax purposes are allowed to deduct the cost of mortgage interest, within fairly wide constraints. The federal government forgoes approximately $100 billion a year in tax revenue as a result, and many states subsidize homeownership in the same way.
The federal government also provides mortgage guarantees to a wide swath of Americans through the FHA, the Veterans Administration (VA), the Rural Housing Service of the Department of Agriculture, and other bodies. In addition, the Government National Mortgage Association (Ginnie Mae) guarantees mortgage-backed securities containing mortgages with federal guarantees. These entities were set up to assist either groups who are viewed as particularly worthy of government aid, such as veterans, or low- and middle-income borrowers who are believed to have the financial ability to carry a mortgage, but need help in buying a first home or trading up to a larger home. Critics argue that the latter role has been stretched considerably to include aid for many Americans who could afford homes without the help. In addition, the government sponsored the two GSEs that are described next.
Background on Fannie Mae and Freddie Mac
For decades the government used an unusual form of public-private partnership with the two huge GSEs to achieve key goals in the housing market. Originally, Fannie Mae and Freddie Mac were both wholly owned government corporations. However, the government's stakes were sold to the public over time, starting under President Lyndon Johnson, apparently primarily for budgetary reasons. In addition, there were policy arguments that the hybrid form could bring the benefits of a private sector, profit-focused approach while still achieving the broader housing goals. These arguments are similar to those advanced in regard to federal credit programs, such as student loans or FHA mortgages, for guaranteeing private sector lending rather than making direct federal loans.
Each GSE was given a special federal charter, created by an act of Congress, which was intended to provide an element of continuing government control, such as through presidential appointment of a certain number of members of the board of directors, and special privileges that would allow the GSEs to function more effectively and profitably than purely private competitors. Both the government control and the special privileges in the charters were enhanced by additional regulatory actions. These charter provisions and regulations evolved over time. By 2001 the key elements in the balance of government control and special privileges were as follows:
The board of directors was now completely chosen by the shareholders, with no presidential appointees.
The Office of Federal Housing Enterprise Oversight, later restructured as the Federal Housing Finance Agency (FHFA), acted as the primary regulator. The agency set capital standards, within congressional rules that locked in fairly light requirements, enforced safety and soundness regulation, and determined whether the GSEs could introduce new products. The FHFA worked in concert with HUD on new product introductions and some other issues.
Each GSE was given "affordable housing" goals intended to ensure that a stated percentage of the mortgages that it owned or guaranteed were for low-and moderate-income, central city, or rural households. These goals generally rose over time.
The GSEs were only allowed to purchase mortgage-related assets where the underlying mortgages were for principal amounts below specific limits set by law. In addition, the GSEs imposed additional requirements regarding the form of the mortgage and the underwriting process. Those mortgages that met the legal and other requirements were referred to as "conforming" mortgages.
GSE debt was treated in a privileged manner that gave the firms a strong advantage in raising funds in large volume at low costs. Most important, banks and some other regulated entities were allowed to treat GSE debt as if it were U.S. government debt for the purposes of calculating risk-based capital requirements. This meant that banks generally needed to hold little or no capital against these instruments, a preference that could be worth 30 basis points annually to a bank. Further, GSE debt was not subject to credit concentration limits at these regulated entities, which could otherwise have constrained their GSE exposure. GSE debt was also settled through the same systems as U.S. Treasury securities.
The specific debt privileges, combined with the GSEs' important public policy roles, their special charters, and their origins as government agencies, left investors with the strong impression of an implicit government guarantee of the debt. This, of course, proved to be true in practice. That implicit guarantee further reduced the GSEs' funding costs.
GSE capital requirements were calculated differently than the requirements for banks, their closest competitors. Congress clearly sent the message to the regulators, both explicitly and implicitly, that they should calculate the capital needs in ways that gave the GSEs a significant market advantage by letting them put up less capital for each dollar of principal.
The GSEs grew strongly in recent years, until the housing crash, as shown in figure 1-1. The GSEs' mortgage exposure grew an average of 9.8 percent annually during this period. Part of this growth reflected what was happening in the mortgage market as a whole, and part of it was due to a pickup in market share. The biggest part of that gain in market share arose from the purchase of pools of mortgages that were held as investments, rather than securitized. The GSEs found their capital levels growing nicely as they profited each year from a combination of their powerful advantages and a benign mortgage market. They, and their investors, came to realize that the most effective way to employ the capital was to hold on to the mortgages. This employed the excess capital while still producing significantly higher returns on equity than investors could expect to earn elsewhere, due to the GSEs' funding and capital cost advantages. Securitization was also profitable per unit of capital, but it put little capital to use.
Both the Bush administration and the Federal Reserve under Chairman Greenspan were quite concerned about the potential risk the GSEs posed to the taxpayers and the financial system if they ran into trouble. Their high growth rates, particularly in their investment portfolios, were viewed as a dangerous response to distortions produced by their excessively favorable structural benefits.
The administration therefore pushed for a stronger regulator, higher capital requirements, and limits on the size of the GSEs' investment portfolios. Congress, however, blocked most of the serious reforms in these areas, although some steps were taken.
Ironically, the major fear of critics was that the mismanagement of interest rate risk would bring these giants down, when in fact the basic business of taking credit risk on mortgages was the proximate cause of their failure. The fear about interest rate risk management was considerably heightened when it became clear that there were significant accounting failures at both of the GSEs with regard to how they calculated their exposure to losses on their massive books of interest rate derivatives. In 2003 Freddie Mac had to acknowledge that investors should not rely on their financial statements, and Fannie Mae followed in 2004. It took approximately three years to create acceptable accounting systems that allowed newly issued financial statements to be certified as accurate. Thus critics may well have been correct about the dangers on the interest rate side, but they largely missed what turned out to be the bigger issue.
The bursting of the housing bubble and the ensuing severe financial crisis put the GSEs in an untenable position. Impending large credit losses started to raise some doubt in investors' minds as to the seemingly risk-free nature of their debt, forcing the GSEs to pay higher and higher spreads and raising the prospect that a day might come when they would not be able to roll over their debt at a reasonable interest rate. This had become particularly critical since the GSEs borrowed most of their funds on a relatively short-term basis, certainly much shorter than the long-term mortgage assets they held as investments. In the end, the federal government, primarily through the Treasury Department, had to step in to recapitalize the two mortgage giants, effectively making the implicit debt guarantee explicit going forward.
Current Status of the GSEs
The financial state of the GSEs, and the associated concerns in the financial markets about their solvency, reached a critical point in September 2008 that forced the federal government to intervene directly. A law had been passed in July 2008 establishing a mechanism that would allow the FHFA to take over a GSE under a "conservatorship." The conservatorship would allow the GSE to continue operating, but under close government control. It would also give the FHFA the ability to determine which classes of investors would suffer financial losses, if any, much as the Federal Deposit Insurance Corporation is empowered to do for banks.
The FHFA used this authority on September 7, 2008, to put both GSEs into conservatorships. The Treasury stepped in the next day with an initial purchase of $1 billion of senior preferred stock in the two firms and a pledge to invest as much as $100 billion more, per firm, if needed to maintain positive net worth. (This cap was removed at the end of 2009 for capital needs through 2012.) This aid came with a high cost to the shareholders, since the Treasury received the right to buy 79.9 percent of the common shares of each of the firms for a few dollars.
The FHFA's conservatorship effectively gave it the powers normally belonging to shareholders and the board of directors, in addition to its standard regulatory authority. The agency used those powers to remove some of the key managers and board members who were in charge when the GSEs failed.
Today, the federal government effectively owns the GSEs and exerts strategic control. In conjunction with this, the GSEs are being used more explicitly than ever as an arm of federal housing policy, although they are still theoretically nongovernmental entities. For example, the GSEs are required to participate in two sets of foreclosure mitigation programs established under the Making Homes Affordable Program. Of one of these programs, Fannie Mae's Form 10Q filing for the third quarter of 2009 stated that the program would "likely have a material adverse impact on our business, results of operations, and financial conditions, including our net worth." The GSEs presumably would not have chosen to participate if they had been privately owned and operated entities.
The federal government's conservatorship and overall regulatory powers, combined with its effective ownership of 80 percent of the common and all of the senior preferred stock, give it the ability to direct the actions of the firms now and to determine their future shape and course. In practice, the government is allowing existing management to operate the firms as private sector companies, except where regulators or the Treasury deem there to be significant public policy considerations or concerns about the effects on the safety and soundness of the GSEs. For example, the GSEs have been required to participate in fairly generous mortgage foreclosure mitigation efforts.
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