Further Progress on Housing Finance

By PHILLIP SWAGEL

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.

The House Financial on Services Committee will hold a hearing on Thursday to consider draft legislation for housing finance reform put forward by its chairman, Jeb Hensarling, Republican of Texas, that would end the taxpayer backstop on mortgages now provided through Fannie Mae and Freddie Mac and wind down the two companies over five years. Under the proposal, private investors rather than taxpayers would fund mortgages and take on the risks and rewards of housing investments.  

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New rules would foster increased use of covered bonds, under which a pool of private assets rather than a government guarantee protects investors against losses. The legislation further seeks to ensure that smaller banks continue to play a role in housing finance. The Hensarling approach thus has the desirable features of moving to a housing finance system driven by private incentives while protecting taxpayers and ensuring the participation of banks of all sizes.

The government role in the new system would be sharply defined, with regulators focused on oversight and setting standards rather than providing insurance. The Federal Housing Administration would continue to guarantee mortgages under the Hensarling proposal but would focus on first-time home buyers with moderate incomes.

Currently, the Federal Housing Administration is involved with loans of up to $729,750, which is difficult to square with the agency’s mission to expand sustainable homeownership. As documented by Joseph Gyourko, a professor of at the Wharton School of the University of Pennsylvania, the agency has financial troubles of its own. (I testified about the need for its reform at a hearing in February of the Senate Banking committee). The Hensarling bill includes changes that would address this situation.

Mortgage interest rates will rise with any overhaul that brings in private capital, but this reflects that the system is now undercapitalized with taxpayers at risk. Before the financial crisis, private-label mortgages bundled into securities without a then-implicit guarantee provided by Fannie and Freddie had interest rates from 0.5 to 1 percentage point higher than loans backed by the two government-sponsored enterprises.

It is hard to know quite how much rates would rise without a government backstop, but the housing market is in an upswing and affordability remains high, so it seems likely that the housing sector would continue to recover even with higher rates from both changes in housing finance and the Federal Reserve’s eventual normalization of monetary policy.

The proposal for a fully private system contrasts with the bipartisan legislation introduced a few weeks ago by Senators Bob Corker, Republican of Tennessee, and Mark Warner, Democrat of Virginia, in which a government guarantee would kick in on covered mortgage-backed securities after private investors have first taken losses equal to 10 percent of the value of mortgages receiving the guarantee.

The Corker-Warner approach involves charging insurance premiums for the government guarantee, so the interest rate difference between the two systems ultimately depends on the insurance pricing. In general, though, a fully private system would be expected to involve greater changes in interest rates and the availability of mortgages with long-term fixed interest rates.

Note that the Corker-Warner proposal’s 10 percent first-loss private capital is much closer to the House bill than it would seem just from comparing the required private capital shares of zero (the situation now) to 10 percent (Corker-Warner) and 100 percent (Hensarling). The total losses of Fannie and Freddie in the financial crisis were about 4 percent of their assets, so the 10 percent capital level in the Corker-Warner proposal makes the government guarantee very far back; this is an immense amount protecting taxpayers. The proposals are different, but they share the common ground of seeking to put substantial private capital ahead of taxpayers.

One might expect considerable pressure for Congressional action in the event of a future housing crisis in which private investors hesitate to take on housing risk and American families find it costly to obtain financing. In the Hensarling approach, Congress could always enact legislation that provides a guarantee on new mortgages but not on old ones.

This would be along the lines of a proposal by Harvard professors David S. Scharfstein and Adi Sunderam (though they would have the government offer insurance on a modest share of mortgages even in normal times, to maintain the capacity to scale up when needed). This implies that the proposed new housing system would not be resilient to future crises; the Corker-Warner approach explicitly takes into account the inevitability of future financial market convulsions.

A further challenge for the House approach to housing finance reform is to avoid inadvertently recreating the implicit guarantee of the previous system, under which policy makers provided a retroactive guarantee when the crisis hit. Securities backed by Fannie and Freddie were about $7.5 trillion of the $57 trillion in total credit market debt in the United States in early 2013, with another $2.5 trillion in home mortgages not tied to government enterprises.

The Treasury and the Federal Reserve both intervened to stabilize money market mutual funds in fall 2008, when those funds were less than $4 trillion of the then $51.8 trillion in credit market debt. Policy makers judged that a lockup of this aspect of United States financial markets would have an untenable negative impact on the economy. Given the considerably larger size of the mortgage market, one might reasonably expect a similar intervention in a future housing crisis. In this case, government intervention could be seen as latent and unpriced.

Even with these challenges, the draft legislation from the House Financial Services Committee represents an important step toward an eventual reform of housing finance that better protects taxpayers and the economy from the misguided incentives and risks of the previous system. The Hensarling bill provides a comprehensive and thoughtful proposal for a fully private system that serves as a benchmark in the policy debate. 

The Obama administration has not yet weighed in with its preferences for reform. Engagement from the administration would be the natural next step.