Background
In September 2008, the Federal Housing Finance Agency placed government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which held half of all US mortgage debt, into conservatorship. In August 2012 the Department of the Treasury changed the terms of the conservatorship agreement to expedite the winding down of Fannie Mae and Freddie Mac. The GSEs are no longer required to make a minimum dividend payment to the Treasury each quarter. Instead, they must distribute all of their quarterly profits to the Treasury. In addition the GSEs must reduce the size of their retained portfolios by 15 percent each year, rather than the previous reduction of 10 percent.
The shareholders in the two GSEs have since been forced to take steep losses. A lawsuit brought by investors who believe the government unlawfully enacted a net worth sweep of GSE quarterly profits is still pending in court. US taxpayers have fared better. From 2008 through 2012, the two GSEs received a total of $188 billion in funds from the Treasury. Fannie Mae has not needed a Treasury draw since 2011; Freddie Mac, since 2012. As of second quarter 2016, the GSEs have paid $250 billion in dividend payments to the Treasury.
Since being placed in conservatorship, the GSEs have effectively performed the functions for which they were created in the wake of the Great Depression. They have provided housing market liquidity and stability and maintained a working mortgage system in an economic downturn. They also provided access to financing for new purchases and refinancing so that many struggling borrowers could remain in their homes. Roughly 60 percent of the mortgages originated in the US in 2015 were financed through either the GSEs, Ginnie Mae via the Federal Housing Administration (FHA), the Department of Veterans Affairs and the Department of Agriculture. Although the GSEs and Ginnie Mae were indispensable to sustaining the housing market in the aftermath of the financial crisis, an extended continuation of this role could present financial risks for federal taxpayers.
Dodd-Frank contained provisions, including ability-to-pay requirements and mortgage risk retention standards, which addressed some problems of the mortgage market. Risk retention rules exempt qualified residential mortgages (QRM). This exemption is designed to encourage the availability of mortgages with product features and underwriting standards proven to reduce default. These changes, along with enforcement authorities provided to the CFPB, should help ensure that mortgage borrowers are not sold products they cannot afford. They should also ensure that originators retain some risk when they originate risky loans (see this chapter’s section Home Mortgage).
Lawmakers, industry participants, and consumer advocates agree on the need to reform the housing finance system and to address the future of the GSEs. There is no agreement, however, on how to do so. In recent years, various bills have been introduced in the House and Senate, and several were reported out of their respective committees. Although none was brought to a floor vote, the consensus achieved, particularly in the Senate on number of key areas may serve as a starting point for renewed discussions and negotiations in a new administration and Congress.
A number of industry groups and coalitions have developed policy principles and outlines for a new housing finance system. There appear to be significant areas of agreement on several features of a new housing finance system. These include the need for some type of federal support, better definition of the market served by federal guarantees, closer alignment of the interests of lenders and borrowers, and restrictions on the growth of credit risk through better underwriting and capital standards. All of the proposals seek to retain core GSE functions such as maintaining market liquidity, stability, and access to credit.
However, there is less agreement over obligations of secondary market actors to serve the entire market, especially traditionally-underserved communities. Some also oppose any continuing role for the GSEs and instead support full privatization of the secondary market as quickly as possible. These voices argue that the government should play no role (or a very limited one, at most) in housing finance, assigning to a very resource-constrained federal government the hard work of lending for affordable housing. How these issues are resolved will determine the extent of access to quality housing for millions of families and older consumers for years to come.
As the administration and Congress consider legislative and regulatory proposals to reform the housing finance system, the debate will focus on several issues of importance to consumers and community advocates. These include the following:
Long-term fixed-rate mortgages—in order to sustain and expand homeownership, the housing finance system must continue to support the widespread availability of long-term, fixed-rate mortgages at a reasonable cost. Such financing without prepayment penalties is rare outside of the US and requires a robust secondary market system.
The ability of the GSEs to borrow advantageously, effectively manage risks of long-term fixed-rate mortgages, and do so on a scale sufficient to reduce costs is a major reason why this option is predominant in the US. Home equity continues to be the largest financial asset of most families and is a bulwark for savings and a secure retirement.
Rental housing development and preservation—to develop a more balanced national housing policy, it is critical to have a secondary market and housing finance system that supports rental housing development and preservation. The GSEs’ retained portfolios have been a major financing source for affordable housing.
Further, through the Low Income Housing Tax Credit (LIHTC) program, the GSEs were the largest equity investors in affordable rental housing. Some 30 percent of LIHTC properties are built primarily for older people. In 2008, Congress mandated that a portion of GSE earnings be placed in an affordable housing trust fund and these contributions are now being made. Any new system will need to provide continued support to this important sector of the housing market. Support must include borrowing credit for smaller affordable multifamily projects.
Equal access to the secondary market for financial institutions and communities—the GSEs’ willingness to purchase and securitize mortgages from any lender who meets their underwriting requirements prevents larger financial institutions from dominating the mortgage market. This is especially important to smaller community banks and credit unions that may not be serviced by larger institutions. It helps ensure communities of all sizes have access to securitization.
Innovation—because of their large volume of business, the GSEs brought innovations in mortgage products, such as alternative methods of evaluating creditworthiness, to scale quickly and efficiently. These innovations became standard industry practices. They benefitted consumers all over the country.
Innovation is especially important for the development of new residential care options and reverse mortgage products that are safe and affordable and that can meet a wide range of needs for people seeking to age in place. Federal mortgage insurance through FHA, and GSE funding through Fannie Mae, for example, were critical to the establishment of the reverse mortgage market through the home equity conversion mortgage program (see this chapter’s section on Reverse Mortgages).
Reform of Government-Sponsored Enterprises: Policy
Reform of government sponsored enterprises (GSEs)
In evaluating proposals to rebuild the nation’s housing finance system, the federal government should be guided by the following:
- Access to credit and liquidity—the housing finance system should provide sufficient credit for the development and purchase of single-family and multifamily units adequate to meet the housing needs of the nation, including lower-income households. Consistent and adequate liquidity is essential to the availability of quality credit. Achieving this goal requires:
- a strong network of primary lending facilities;
- well-functioning and robust secondary markets;
- careful but creative innovations balanced with the goal of consumer protection; and
- adequate access to credit for all appropriate forms of housing to meet the needs of all consumers, regardless of income or location.
- Counter cyclicality—measures to ensure consistent access to credit & liquidity. A successful housing finance system should ensure a consistent flow of credit, appropriately priced for market risks, in both good and bad times.
- Risk management and oversight—a vital component of a stable and successful mortgage finance system is ensuring that credit risk is appropriately measured, priced, distributed, and overseen. Regulation of credit risk should be comprehensive and robust, covering all aspects of the mortgage market, including secondary markets. A commitment to improving credit risk oversight will help craft a fairer system that will see fewer homeowners default on their mortgage obligations. Key steps to ensure that this happens are:
- a level playing field, with robust and comprehensive regulation;
- strong underwriting standards, which should ultimately result in more careful allocation of credit, not a deprivation of credit to underserved communities; and
- better risk assessment and capital adequacy, including changes in how the markets assess risk (currently through the rating agencies), as well as how risk-based capital requirements are determined.
- Standardization—standardization provides benefits to consumers and investors, helps ensure the safety and soundness of financial institutions, and improves the transparency and liquidity of housing finance. The benefits of standardization, however, must be balanced against the benefits of innovation and meeting unique needs, especially of underserved borrowers.
- Transparency and accountability—reforms of the housing finance system must be cognizant of aligning incentives that promote accountability and ensure transparency.
- Systemic stability—a reformed housing finance system must be able to lessen the possibility of future shocks through the entire financial system. It is important to ensure that risk is appropriately understood and allocated, so that those holding the ultimate risk can afford to bear it. Better measures of gauging counterparty and systemic risk must be adopted, and consideration must be given to other mechanisms for containing and minimizing risk. Design of a renewed mortgage finance system should also recognize the global nature of today’s financial markets.
- Enhanced consumer protection—to address unequal information in mortgage transactions, the system should have a built-in bias toward the long-term best interests of the borrower. Reforms should not only protect borrowers against bad actors but also set up a system of default options such as “qualified residential mortgages” as defined under the Dodd-Frank Act to ensure better outcomes.
- Equitable and fair access to credit for consumers and communities—the mortgage finance system should be designed to eliminate disparities in the allocation of credit and to ensure that communities that have historically suffered from denials of credit or credit on discriminatory or predatory terms have appropriate access to credit from all parts of the finance system.
Structure of a new housing finance system
To facilitate the transition from conservatorship of the GSEs to a new housing finance system, the following key goals are essential:
- preserving the availability of 30-year fixed-rate, penalty-free, prepayable mortgages at reasonable cost to creditworthy borrowers;
- assuring adequate support for decent, affordable rental housing;
- ensuring equal access to the secondary market for a broad array of financial institutions, including community banks, credit unions, and community development financial institutions, so that communities of all sizes can benefit from securitization; and
- fostering safe, affordable innovations in mortgage products, such as reverse mortgages and residential care options that can meet a wide variety of needs for older people seeking to age in place.
Congress should enact housing finance reform legislation that is guided by the following framework:
- Explicit and limited federal guarantee on mortgage-backed securities (MBS)—any federal guarantee offered in a new housing finance system should be explicit, transparently priced, and limited solely to the principal and interest of MBS products meeting rigorous federal standards.
- Catastrophic insurance fund—a federally run catastrophic insurance fund, similar to the Federal Deposit Insurance Fund, should be established to price and collect premiums that back guarantees on MBS in the event of financial failure. The fund should have the authority to:
- establish rigorous product and underwriting standards for mortgages placed into guaranteed securities,
- institute rigorous and transparent securitization standards governing the issuance of MBS, and
- enforce its rules and regulations.
MBS guarantee institutions—to incentivize the flow of private capital into the secondary market, federally chartered guarantee institutions should be authorized to provide investors in MBS with a guarantee of timely payment of principal and interest on securities that are backed by loans eligible for such support through the catastrophic insurance fund. Guarantee institutions should have features such as the following:
- ownership—a variety of ownership structures should be permitted and should preclude conflicts of interest and misalignment of incentives.
- capital requirements—the federal government should strictly regulate guarantee institutions for capital adequacy and compliance with consumer protection standards. Capital requirements should be significantly higher than those currently required of the GSEs.
- taxpayer liability—in the event a guarantee institution fails, its equity and corporate debt should be liquidated before the catastrophic insurance fund is exposed to any losses.
- use of portfolios—guarantee institutions should be permitted to have portfolios. However, their use should be restricted to financing difficult to securitize loans, such as some multifamily loans and loans designed to test new products. The size of portfolios should be limited by federal rules and their use subject to strict oversight by federal regulators. Any debt issued to finance portfolio lending must be for public purposes and not be covered by a federal guarantee.
- prohibitions on campaign contributions and political activities—as a condition of their federal charter, guarantee institutions should be strictly prohibited from making campaign contributions or engaging in partisan political activities of any type.
Innovation Fund—an innovation fund should be established to provide, on a competitive and shared risk basis, additional credit enhancement and research and development funds for promising mortgage finance products, such as reverse mortgages and residential care options, that could better meet the needs of underserved markets. The Innovation Fund should be financed by a fee on all MBS. This fee should also fund the National Housing Trust Fund and the Capital Magnet Fund, which finances states and community development financial institutions to support affordable rental housing.
Ensuring financing for underserved communities and populations
Equal access for all financial institutions and communities—guarantee institutions should be required to provide an equitable outlet for the securitization of all loans that meet the standards for the guarantee. They should be required to mirror the primary market in the amount and geography of single-family and moderate-income loans that are securitized and eligible for the federal guarantee.
Affordable rental housing—guarantee institutions should be required to guarantee multifamily loans and to demonstrate that at least 50 percent of the units supported by securitized multifamily loans during the preceding year were offered at rents that were affordable to households at 80 percent of the area median income or less.
Special housing needs—guarantee institutions should be required to provide guarantees to ensure funding for areas of specific concern (identified annually such as rural housing, small rental properties, and shortages created by special market conditions.