March 28, 2024

Economix Blog: Progress on Housing Finance Reform

Phillip Swagel is a professor at the School of Public Policy at the University of Maryland, and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.

Taxpayers received $66 billion of good news last Monday in the form of dividends to the Treasury from Fannie Mae and Freddie Mac as part of the compensation for the bailout of the two government-sponsored enterprises (G.S.E.’s). The bad news is that these payments reflect the fact that the two firms remain in government hands nearly five years after being taken into conservatorship in September 2008, putting taxpayers at risk in the event of another housing downturn.

A fundamental change in this situation requires Congressional action, which is always difficult in our divided political system. Even so, legislation introduced recently by a bipartisan group of eight senators led by Bob Corker, a Tennessee Republican, and Mark Warner, a Virginia Democrat, has focused renewed attention on housing finance reform.

Today’s Economist

Perspectives from expert contributors.

I was among the many people providing technical advice to the group working on the Corker-Warner proposal and think there is much to like in it.  The legislation includes the essential elements of housing finance reform: a dominant role for private capital; considerable protection for taxpayers against future bailouts; a secondary government backstop to ensure stability; competition and entry by new firms into housing finance so that no future entity is too big to fail; a clear delineation of the roles of private firms and the government; an empowered regulator to ensure that loan quality remains high for guaranteed mortgages; and support for activities related to affordable housing.

A paper I wrote with Ellen Seidman, Sarah Rosen Wartell, and Mark Zandi has a proposal similar in many respects to the Corker-Warner bill. Clicking through to the biographies of my co-authors quickly reveals that the four of us come at this issue from quite different political perspectives.  The common ground we reached in a sense mirrors that of the bipartisan group of senators in looking to move forward with reform rather than allowing Fannie and Freddie to remain effectively part of the government, which is the outcome that will obtain if no action is taken.

A key feature of the Corker-Warner proposal is the requirement that private investors must put up capital equal to 10 percent of the loans that will be guaranteed by a new government agency set up along the lines of the Federal Deposit Insurance Corporation. This provision alone goes a long way toward restoring the dominant role of private incentives and protecting taxpayers against the possibility of another costly housing bailout.  Indeed, Fannie and Freddie would have easily made it through the crisis had this been in place. The legislation further allows new firms to enter the mortgage securitization business now dominated by the two G.S.E.’s.  With enough competition, no firm in the future housing finance system will be too big to fail.

At the same time, a secondary government guarantee behind the private capital would ensure that mortgage financing is available across economic conditions, with taxpayers compensated for taking on residual housing credit risk.  This contrasts with the failed system of the past in which the government backstop was implicit but free.

The U.S. Mortgage Market

Some background might be useful for readers unfamiliar with the workings of our convoluted housing finance system. 

Originators such as banks make loans, which Fannie and Freddie then buy and bundle into mortgage-backed securities with a guarantee against losses from homeowner defaults.  The two firms then sell these securities to investors, now including the Federal Reserve as part of its quantitative easing program.  Banks and other lenders like the arrangement because they can readily sell loans to Fannie and Freddie and get cash to lend to yet again. The setup benefits home buyers through the greater availability of financing and lower interest rates as American families effectively tap into global financial markets for their mortgages.

There is a cost, however, borne by taxpayers. When the government took over the two firms in 2008, the Treasury Department promised to provide cash as needed to keep Fannie and Freddie afloat, effectively ensuring that the two firms’ $5 trillion in obligations will be honored (in addition to guarantees, that huge sum includes debt issued by the G.S.E.’s to finance their own purchases of mortgage-backed securities). Investors had long believed that the government would support the firms in a pinch, a belief that gave the G.S.E.’s an advantage over other financial firms.

Actions taken during the crisis turned the previously implicit government guarantee into an explicit one, at a cost to taxpayers that peaked at $189 billion at the end of 2012. American families at least got something from the bailout of Fannie and Freddie, as mortgages were available throughout the crisis even as other parts of credit markets experienced strains. The firms have paid some $132 billion in dividends to the government, but these funds do not get credited as paying down the taxpayer assistance. Moreover, the firms are not allowed to build up reserves with which to cover any potential future losses. Instead, the firms’ profits are swept to the Treasury, where they provide a temptation to Congress and the president as a means by which to pay for new government spending.

Fannie and Freddie today are linchpins of the nation’s housing finance system, providing guarantees on two-thirds of the mortgages originated in 2012.  Together with agencies like the Federal Housing Administration, the government stands behind nearly 90 percent of new mortgages. Taxpayers are thus extraordinarily exposed to future housing-related losses.

Many who follow Fannie and Freddie had long warned that their problems posed a risk to the financial system. The imperative of housing finance reform is to devise a new system that protects taxpayers against another costly bailout while ensuring that American families have access to mortgages on reasonable terms.

Challenges With Reform

A key challenge in moving forward with reform is that bringing in private investors who take losses ahead of taxpayers will translate into higher mortgage interest rates, reflecting the compensation demanded by private investors to take on housing credit risk. Indeed, in the past, proponents of reform were sometimes derided as being “anti-housing” for supposedly wishing for higher interest rates.  The crisis has mostly silenced this criticism, with broad agreement that reform must involve greater private capital to take losses ahead of any potential government backstop.

The Corker-Warner proposal requires investors to put at risk funds equal to 10 percent of the value of the mortgages included in mortgage-backed securities to be guaranteed by the government. The total losses of Fannie and Freddie during the crisis were equal to about 4 percent of the firms’ combined assets. The firms were shielded by homeowner down payments and by private mortgage insurance before they had to make good on their guaranteed securities, but the housing price collapse of more than 30 percent combined with concentrations of Fannie and Freddie’s risk in key bubble states such as Nevada combined to generate losses that wiped out the firms’ thin capital cushions of less than 1 percent of their assets. 

With a 10 percent capital requirement, the firms would easily have made it through the worst housing cycle in recent memory.  To be sure, a 10 percent capital requirement is not the same as the 100 percent in a fully private system.  But a fully private system is neither feasible nor stable. By the standards of the recent housing debacle, the Corker-Warner legislation provides considerable protection for taxpayers.

Still, any government guarantee gives rise to moral hazard, since investors will naturally seek to obtain government backing on risky mortgages that provide a high private upside if the loan works out, and a loss for taxpayers if it does not. The Corker-Warner legislation creates an empowered regulator with a mandate to ensure that underwriting standards remain high. This is helpful, but not enough by itself — after all, regulators failed to prevent the previous bout of poor lending behavior.

An important insight, however, is that requiring substantial private capital to take losses ahead of the government guarantee helps to mitigate the moral hazard.  This is because the investors with their funds at stake have a powerful incentive to enforce prudent underwriting.  The presence of first-loss private capital thus brings market discipline to bear by aligning private interests with those of the government. This is exactly the point made by the Federal Reserve chairman, Ben S. Bernanke, in an April 2007 speech on financial regulation. The Corker-Warner proposal involves sufficient private capital to generate a meaningful incentive for prudence.

A further critique of the Corker-Warner approach is that the government inevitably will charge too little for its guarantee. Indeed, this would be in keeping with other government insurance offerings, such as the federal flood insurance program.  In the first place, setting a price for the guarantee will be better than leaving it implicit and unpriced, as in a system that is notionally private until the crisis actually hits. Moreover, as reform brings in private capital and the government share of the housing market recedes from its current 90 percent, market-based mechanisms like auctions can be used to set the price of the government backstop.

Moving Forward

The policy debate over housing finance reform is a microcosm of the larger debate about the role of the government in society.   A government guarantee lends stability and ensures that taxpayers can get mortgages across economic conditions, but puts taxpayers at risk in the event of the next housing downturn. The Corker-Warner proposal seeks a balance by ensuring that considerable private capital is at risk ahead of the guarantee.

Other possible outcomes for housing finance reform are to maintain the status quo in which Fannie and Freddie are controlled by the government and there is no private capital, or to move to a private system in which government involvement is limited to the small share of loans made with the involvement of agencies such as the Federal Housing Administration that work with targeted groups of borrowers.

Both of these alternatives are flawed. The current government-dominated system exposes taxpayers to needless risk and stifles the possibility of beneficial competition and innovation.  Not moving forward with reform would lock in this unfortunate situation.

A move to a fully private system seems desirable, but it is difficult to see this as a stable outcome or one that actually protects taxpayers in the event of an inevitable future crisis.  This is because the government will feel compelled to intervene in the face of any future housing market collapse, regardless of promises that the system was private. To do otherwise would be to countenance an economic catastrophe.  A housing finance system that is notionally private would inadvertently recreate the key flaw of the past with an implicit, and uncompensated, guarantee.

Moreover, it is a political reality that legislation for a fully private system has scant chances.  Delay in moving forward with a pragmatic reform maintains the current system in which there is a dominant government role with a full guarantee and no private capital. Holding out for the unattainable but theoretically perfect housing finance system thus cements in place the nationalized outcome least favored by proponents of a market-based approach.

Article source: http://economix.blogs.nytimes.com/2013/07/08/progress-on-housing-finance-reform/?partner=rss&emc=rss

Fair Game: 2011, a Year of Me-Firsts in Business — Fair Game

Some of this stuff we already knew. Like the fact that banks love the perks that come with being too big to fail. They will lobby shamelessly to hang on to their riskiest businesses and stay perilously large. No surprise, really. A heads-we-win, tails-the-taxpayers-lose model has a lot going for it, at least for executives atop these institutions.

Here’s another lesson we didn’t need to relearn: Penalties levied on corporate miscreants, and the legal bills they rack up defending themselves, never come out of their own pockets. Insurance policies and shareholders wind up paying. Another win for the me-firsters.

And what if you run a company so far into the ground that the federal government has to take it over? Not to worry: the taxpayers may even pay your legal bills. Consider Fannie Mae and Freddie Mac. Since the two companies collapsed into conservatorship in 2008, taxpayers have advanced about $73 million to pay the legal bills of former executives who are fighting fraud suits and investigations dating back to 2005.

Isn’t America great?

Another unfortunate lesson we keep learning over and over is that policy makers always put off tough decisions for another day. Kicking the can down the road is so much more fun and profitable, especially for politicians worried about re-election.

But last year also provided some truly illuminating moments. A favorite was the pronouncement that if Greece were to default on its debts, it wouldn’t really count as a default at all. That determination meant that investors who had bought insurance against a possible default would be out of luck. Their policies wouldn’t pay off as expected.

Who ginned up this nondefault default? A secret committee of bankers who call the shots in the world of credit default swaps. These people happen to work for big banks that probably sold the insurance and, as a result, would be on the losing end if a Greek default were actually called a default.

It sure is good to run the Wall Street branch of the Ministry of Truth.

Another eye-opener came courtesy of the folks at MF Global, the trading house and derivatives dealer overseen by Jon S. Corzine, the former New Jersey senator and governor and former chief executive of Goldman Sachs. Investors were shocked to learn that MF Global, a supposedly legitimate brokerage firm, was so lax about its affairs that hundreds of millions of customer dollars simply vanished. Months after MF Global failed, an army of investigators is still searching for the missing money.

Washington politicians can usually be relied upon to educate the citizenry — again and again. Last year was no exception. One telling moment came late in the year, when Democrats and Republicans agreed to extend an existing payroll tax cut for two months. Helping to defray the cost was $36 billion generated through an increase in mortgage guarantee fees charged by Fannie Mae and Freddie Mac.

That $36 billion will come out of borrowers’ hides, of course. But using Fannie and Freddie as a money spigot sent a powerful message: Never mind that losses at these mortgage giants have cost taxpayers $150 billion so far. Or that many Americans would prefer these toxic twins to go out of business sooner rather than later. As long as Fannie and Freddie are viewed as piggy banks, there is little chance that Congress will dissolve them. It looks as if these taxpayer-owned zombies, which did so much damage to our economy, are poised to live on and on.

Finally, it was in 2011 that the ugliest paradox of the financial crisis became clearer. That is, some of the very people our government had pushed to embrace the American dream of homeownership — minority groups, lower-income borrowers, immigrants and others previously shut out of the market — were the very people hurt the most by the foreclosure mess. Washington’s push to increase homeownership opened the door for companies to sell poisonous and tricky loans that have now imperiled many of the most vulnerable.

This became painfully evident in a discrimination suit filed by the Justice Department against Countrywide, once the country’s largest mortgage lender. The suit, filed in December, was based on investigators’ findings that more than 200,000 minority borrowers had been charged higher fees and rates by Countrywide than white borrowers of similar financial standing.

The Justice Department also said that Countrywide steered more than 10,000 minority borrowers into high-cost subprime mortgages even as white borrowers received standard, lower-cost loans. The company’s systems, investigators said, allowed loan officers and mortgage brokers to change the terms of mortgages without complying with fair-lending rules.

Bank of America, which bought Countrywide in 2008, agreed to pay $335 million to settle the suit. The events cited in the lawsuit occurred before its purchase of Countrywide.

But the facts assembled by the Justice Department certainly shed new light on Countrywide’s boasts of eliminating barriers to minority homeownership. Its House America program, which committed $600 billion in loans for low-income borrowers in 2003, won plaudits for Angelo R. Mozilo, Countrywide’s co-founder.

The next year, Mr. Mozilo was named Housing Person of the Year by the National Housing Council Conference. “We commend his leadership,” said G. Allan Kingston, the group’s chairman at the time, adding that it “led to the company becoming one of the top lenders to African-Americans and Hispanics, a direct result of his clear understanding that we must do more to ensure affordable homeownership opportunities throughout the nation.”

As I said: live and learn.

Article source: http://feeds.nytimes.com/click.phdo?i=9b0a501680e5cb6376ffad2ffd75c1ed