Destination Unknown: The Future of GSEs In America

The Future of GSEs In America

Anthony B. SandersSenior Scholar

Mercatus Center at George Mason University

Whither Fannie Mae, Freddie Mac, and FHA?

• Best analogy is a taxi cab medallion• License to operate with government guarantee• Only FHA, Fannie Mae and Freddie Mac have them

• Cost of the medallion?• NY City Taxi Cab Medallion recently sold for $1 million• The cost of the government guarantee medallion is far

more expensive (affordable housing goals)• All three medallion holders are chasing affordable

housing goals (aka, risky lending)• Are Government subsidized mortgage rates the “other”

entitlement along with mortgage rate deductions?

Should There Be A Medallion?

• No, the private market should price risk rather than government

• Policy since Clinton (National Homeownership Strategy) has so devastated the housing finance system (low down payment mortgages, streamlined underwriting, aggressive marketing, councilors, etc.) that we have government capture of mortgage markets:– >90% government control of residential

securitization– Add HECM and student loan capture …– Need to avoid creating a 100% FHA market!

The Result of Crowding Out By Government

“There’s simply no such thing as a nonguaranteed housing finance market, other than in ideological fantasies.” Adam Levitin, Georgetown University, Sept, 2011

•This sentiment is echoed by many in the finance industry– That is, no one will buy our MBS without a government guarantee– If this is correct, then SOMEONE has to hold the medallion– The question is WHO and HOW MANY?

•Spreads between GSE 30 yr MBS and 10 yr Treasuries reveal that Fannie/Freddie MBS are just Treasury substitutes.

– Private label MBS could attract more investors with higher yields

Their Talking Points• Product Availability Lower

– 30 Year, fixed rate, callable mortgage will not exist FALSE • Banks continue to originate and hold 30 year FRM

– Homeowners will have to take more risk, will not be able to match duration of their largest asset GOOD

• LESS TEMPTATION TO SPECULATE AND GO FOR THE MAX– 3-5 year ARMS with prepayment penalties will be the norm, putting more

risk upon households GOOD• ARMS FORCE BORROWERS TO CONSIDER HIGHER PAYMENTS IN FUTURE,

WILL CONSUME LESS HOUSING (DON’T CONFUSE THE ARM BEHAVIOR IN THE BUBBLE WITH NORMAL BEHAVIOR)

– Much larger TBTF banking system will be needed, with government support in another form BIGGER THAN FANNIE AND FREDDIE?

• NOT TRUE. THERE IS NO REASON TO BELIEVE THIS ARGUMENT.

Their Talking Points

• Level of Rates Higher– Level of mortgage rates will be 100 to 250bp higher

PROBABLY TRUE• Historically, the jumbo-conforming spreads has been

30 basis points, back to Clinton Spread history shows that private RMBS market had more volatile rates SO?

• Why should taxpayers subsidize lowering rate volatility, particularly when The Fed is already doing

Their Talking Points• Costs to Society will be higher

– Taxpayer bailouts will be more expensive AS OPPOSED TO THIS MELTDOWN?• NO REASON TO BELIEVE THIS IS TRUE

– Homeownership will be lower, fewer good borrowers will qualify PROBABLY• CLINTON PUSHED HOMEOWERNSHIP SO HARD WE BROKE THE SYSTEM.

WHAT’S WRONG WITH RENTING?– Labor mobility will be lower UNLIKE PEOPLE TRAPPED TODAY?

• MANY PEOPLE ARE TRAPPED IN THEIR HOMES THANKS TO GOVERNMENT HOUSING POLCIIES ALREADY

– Main monetary policy transmission mechanism will be diminished NOT TRUE• MORTGAGE REFIS ARE FASTER ON PRIVATE LABEL MBS, SLOWEST ON

GINNNIE MBS

Back To The Pre-Securitization Days

• No securitization, bank balance-sheet lending only– Regulators feel banks are already too exposed to real estate– But banks have staggering amounts of reserves available (although

“sterilized” by Fed– Regulatory knot (Fed, FDIC, OCC) – too much regulation

• But Dodd-Frank restricts bank lending– QRM definition is restrictive and only applies to originators, not to

medallion holders (Fannie Mae, Freddie Mac, FHA– Even if something is done with the GSEs, Dodd-Frank represents a

significant hurdle to repairing the mortgage market

• Perhaps 50% of $10 trillion mortgage market– If you want the mortgage market to shrink, stop securitization (Warning:

unintended consequences alert!)

Securitization• The devastation caused by well-intended national housing policies

may have left us with no choice: a medallion is required• But WHO gets to hold the medallion if that is the path that we

choose?– All banks (originators) hold limited medallion (risk sharing with

government)– Convert Fannie/Freddie to reinsurance companies with NO retained

portfolios (Do we need two?)– FHA? Difficult to control and massively inefficient. Shut them down.

• To prevent a repeat of history, I suggest a cooperative form of ownership among originators – Even a mutual approach to ownership could work, but less cooperative

(utility) would remove the “hog trough” problem

Risk Sharing Approach Between Government And Originators

Level 1: Quality Mortgage Loans Minimum Down Payment, no second liens Strict UW Standards and Appraisal Requirements Full Recourse to borrower (State laws?)

Level 2: Separately Capitalized Originator Insurance Subordination based on extreme stress scenarios Standardized structures capitalized by valuable assets Non-rescindable insurance contract or subordinate bonds Originator earns profits over time instead of booking it all

upfront. Capital in SPV accrues in tax advantaged way. Reps and Warranties hit this first , no debate, no delay

Level 3: Government Medallion Wrap Bond holder looks to Federal government for full faith and

credit guaranty DANGER: Potential problem with Administration and Congress easing

the wrap rules (such as 3.5% down payment, 5% first loss to originator and 95% to taxpayers (aka, government). And this is a SECOND BEST SOLUTION, not the best solution (no government medallion).

First loss to OriginatorInitially 5%

(going to 30%)

Down payment 20%

Reinsurance from Gov’t

Initially 95%

(going to 70%)

Value of the loan

Cooperative Structure: More Detail

Preferred Futures of GSEsPreferred Solution•Bank portfolio lending •Securitization with no medallion (government guarantee)•No affordable housing mission*Second Best Solution (most likely)•Partial medallion to all originators (risk sharing with government)•Cooperative or mutual ownership structure•Fannie/Freddie as reinsurance companies•No affordable housing mission*Third Best Solution•Keep Fannie/Freddie in place, but with strict oversight (Warning: danger!)

– No retained portfolio, transparency on loan purchases, no affordable housing mandates, etc.

Multifamily?

•Spin off from Fannie/Freddie, use cooperative structure, no medallion– Already have FHA/GNMA programs

*Note: HUD still retains rental programs, so affordable housing mission is on balance sheet.

10 Year Phase In

•Whether we go with a cooperative or mutual ownership structure with Fannie/Freddie as reinsurance companies, or some other future, I suggest TAKING IT SLOW and PHASING IN CHANGES.•The last time we accelerated housing policy (1992-1999) we moved too fast and created a monster.

– Federal Housing Enterprises Financial Safety and Soundness Act of 1992• Act also established HUD-imposed housing goals for the financing of “affordable housing,”

housing in central cities, and housing in rural and “other underserved” areas. HUD has periodically raised the goals.

– National Homeownership Strategy: Partners in the American Dream” – 1995– Removal of Capital Gains Taxation on Housing – 1997– Financial Services Modernization Act of 1999

•Taken together, these well-intended policies had horrible consequences– Let’s provide STABILITY and take our time rather than rushing for the lifeboats on

a sinking ship

10 Year Phase In Non-Agency MBS Issuance Has Disappeared

But Private Label MBS Are Still Issued

U.S. Homeownership Rate—The Great Leap Forward

Home Price History

Fed Policy and Home Prices

Growing Bank Holdings of Agency MBS

MBA 30 vs FNMA Current Coupon – Spread Widened in Dec 2008

Different View of Bank Rates vs Fannie CC Rate

Jumbo-Bank Rate 30 FRM SpreadPre and Post Crisis

Fannie 30 CC vs 10 yr Treasury CMT 90 Basis Point Spread

TBA Shows Fannie 30s Barely Above 10 yr Treasuries

Example of Fannie Multifamily Deal

Sterilized Bank Reserves

Clinton-era Mortgage Rates

References/Additional Reading• FHA’s Instant Undertow Mortgage

– http://confoundedinterest.wordpress.com/2012/04/27/fhas-instant-undertow-mortgages-3-5-down-in-a-declining-home-price-environment/

• National Homeownership Strategy and the Clinton Housing Trifecta– http://confoundedinterest.wordpress.com/2012/04/20/parsons-blames-glass-steagall-repeal-for-crisis-but-glass-steagall-was-

only-13rd-of-clintons-housing-trifecta/• Dangers of the Administration’s 14 Loan Modification Programs

– http://confoundedinterest.wordpress.com/2012/04/22/senate-proposal-for-expanding-harp-taking-off-the-safety-features/• FHFA and Principal Reductions

– http://confoundedinterest.wordpress.com/2012/04/10/fhfas-demarco-no-trial-principal-reduction-yet/• Krugman on Bush Creating the Housing Bubble

– http://confoundedinterest.wordpress.com/2012/01/26/krugmans-misleading-tale-of-two-bubbles-a-closer-look-at-the-data/• TBA for Private Label MBS?

– http://confoundedinterest.wordpress.com/2012/03/07/tba-or-not-tba-that-is-the-question-do-we-need-the-federal-government-guarantee/

• Reuter’s Mortgage Write Down Calculator– http://confoundedinterest.wordpress.com/2012/04/18/reuters-uber-cool-mortgage-write-down-calculator-loss-to-taxpayers-

of-128-billion/• Fannie/Freddie had 30%-40% share of “subprime” from 2001-2008

– http://confoundedinterest.wordpress.com/2011/12/19/sec-versus-fannies-mudd-and-freddies-syron-it-boils-down-to-the-definition-of-subprime/

• Do We Need the 30 year Fixed-rate Mortgage?– http://mercatus.org/publication/do-we-need-30-year-fixed-rate-mortgage

• Andrew Davidson, GSE Reform: Risk Sharing and Cooperatives, 2012. Paper at Federal Reserve of Atlanta.

Contact Information

• GMU Web: http://mason.gmu.edu/~asander7/• Mercatus Web: http://mercatus.org/anthony-b-sanders• Email: [email protected]• Phone: 703-993-1326

Destination Unknown: The Future of GSEs in America

Dr. Arnold KlingMercatus Center at George Mason [email protected]

Presentation in Washington, DCMay 2, 2012

The Way Forward: Mortgage Finance in a Post-GSE World

Lawrence J. WhiteStern School of BusinessNew York [email protected]

Presentation in Washington, DCMay 2, 2012

“The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.”

David Frum, National Post, July 11, 2008

“..the GSEs play an extraordinarily successful double game…[telling] Congress and the news media, ‘Don’t worry, the government is not on the hook’ – and then turn around and tell Wall Street, ‘Don’t worry, the government really is on the hook.”

Richard Carnell, Senate testimony, February 10, 2004

“It’s only when the tide goes out that you learn who’s been swimming naked.”

Warren Buffet

Deep Throat* (Hal Holbrook): “Follow the money.”

Bob Woodward (Robert Redford): “What do you mean? Where?” Deep Throat: “Oh, I can't tell you that.” Bob Woodward: “But you could tell me that.” Deep Throat: “No, I have to do this my way…”

“All the President’s Men” (1976)

*Now known to be Director: Alan J. Pakula

W. Mark Felt, Writer: William GoldmanDeputy FBI Director

Overview

•Housing and subsidies•The failures of Fannie and Freddie•How to avoid future bailouts of the housing finance system•What about “affordability” and “accessibility”?•What about the 30-year fixed-rate mortgage?•Where will mortgage finance come from?•How to get from here to there•Other needed long-run reforms•Conclusion

Housing is heavily subsidized

•Fannie & Freddie

•FHA, VA, USDA, Ginnie

•Income tax deductions for mortgage interest, state & local government taxes

•Capital gains exclusion

•Subsidies for builders

•Direct provision by government (“public housing”)

Consequences of heavy subsidy

•Households buy more house!– Larger, better appointed houses on larger lots

•Because of subsidies, U.S. housing stock is 30% larger; U.S. GDP is 10% smaller•Income tax deductions and exclusions mostly benefit upper income households•Effects on home ownership rates are modest (at best)

– Subsidies for purchase mostly encourage households that would have bought anyway to buy bigger

– Where is the social benefit in that?

The Failures of Fannie & Freddie

•Too many high-risk mortgages were held and securitized– This began in the mid to late 1990s

•Not enough capital– Only 2½% capital for mortgages held in portfolio

• Supposed to cover credit risk and interest-rate risk

– Only 0.45% capital for securitized mortgages• Supposed to cover credit risk

– Banks and S&Ls are required to hold 4% capital just to cover the credit risk on mortgages!

•The U.S. Treasury’s capital contribution so far: more than $180 billion

How to avoid future bailouts of the housing finance system

•Require more capital for “systemically important financial institutions” (SIFIs)

•If size generates negative externalities, put a tax on size– Much better than the sledgehammer of a forced breakup

•Cut back on government guarantees– Limit guarantees to FHA, VA, USDA, Ginnie

– Be clear-eyed that the focus is to help (properly screened) low/moderate-income first-time home buyers

– Expect on-budget moderate losses

– Eventually replace with down payment assistance

How to avoid future bailouts of the housing finance system

•Require more capital for “systemically important financial institutions” (SIFIs)

•If size generates negative externalities, put a tax on size– Much better than the sledgehammer of a forced breakup

•Cut back on government guarantees– Limit guarantees to FHA, VA, USDA, Ginnie

– Be clear-eyed that the focus is to help (properly screened) low/moderate-income first-time home buyers

– Expect on-budget moderate losses

– Eventually replace with down payment assistance

What about “affordability” and “accessibility”?

•“Affordability” is a code word for widespread subsidy– Income redistribution is best done through income transfers, not

through subsidizing specific goods– The pre-2007 differential between conforming (F&F) loans and

jumbos was only approximately 25bp (0.25%)!

•“Accessibility” is a code word for mandates– Why does a profitable service need to be mandated?– And if it’s not profitable…– If the real issue is discrimination, then address that directly and

prosecute vigorously

What about the 30-year fixed-rate mortgage?

•Jumbo (unguaranteed) 30-year fixed-rate mortgages have been and continue to be available•The major issue with 30-year fixed-rate mortgages is interest rate risk; but government guarantees cover only credit risk•Insurance companies and pension funds are natural buyers for long-lived obligations

– But pre-payments are a problem•Pre-payment fees need to be part of the answer

– The “free” pre-payment option adds about 50bp to mortgage interest rates

Where will mortgage finance come from?

•Expanded depository lending– Depositories held 30% of mortgages in 2007 (not including

MBS)• Despite all of the subsidies/advantages for F&F

– Covered bonds may provide modest help•Simplified, clarified private-label securitizations

– Simple tranche structures– Insurance companies and pension funds are natural buyers

• Life and P/C insurance companies: $6.7 trillion in assets• Private, state, local, federal pension funds: $10.5 trillion in assets• Less than 6% of these assets are currently held in MBS

How to get from here to there

•Fannie & Freddie plus FHA/VA/USDA/Ginnie currently account for over 90% of mortgage originations

– They are crowding out private-sector involvement•Start winding down/selling off F&F’s mortgage portfolios•Reduce the F&F conforming loan limit by 10% per year

– Reduce FHA’s limit by 10% per year until it is 20% below median house prices

•Raise guarantee fees by 5bp per year

Other needed long-run reforms

•Cut back on housing subsidies generally– Start portraying a house as just another asset, not special– Replace lending subsidies with down payment assistance– Make renting respectable

•Reduce resource distortions that make housing more costly– Local land-use zoning– Restrictions on lumber imports from Canada

•Make recourse the norm in mortgage lendingWill reduce strategic defaultsWill discourage excessive leveraging

•Give the primary lender the power to approve a second lien– This is standard in commercial lending

Conclusion

•Housing and housing finance are important•Good policies can make a big difference

– So can bad policies•Sooner is better than later