February 12, 2011
Reforming
ng the GSEs: Where’s the Beef?
The much anticipated joint report from Treasury and HUD last week on reforming mortgage
markets in the end was short on specific recommendations but had a central theme of laying out
options that would sharply limit government involvement in housing going forward
forw
in the shortand long-term.
term. The report also offered some introspection into the causes of the GSEs’ demise
including a lack of credit discipline, particularly late in the housing bubble
bubble. Unfortunately, the
administration lost a prime opportunity for laying out a comprehensive strategy for getting the
housing market back on track.
If we step back before 2007 and reflect on what part of the housing system was most responsible
for the crisis,
risis, it can offer clues to which course to follow for reforming mortgage markets. In
the end, even an imperfect model such as existed for the GSEs leading up to their
conservatorship held up remarkably well from a credit perspective. As will be described
descri
below,
the key to any reform is ensuring asset quality. Without effective oversight of credit
underwriting standards, any model for mortgage markets will eventually fall victim to another
credit crisis.
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In looking back at the credit performance of the GSEs before the crisis, the two agencies
performed very well over an extended period of time as shown in the figure below. It is clear
that the agency model at least up until about 2001, held up well in terms of asset quality.
Thereafter, as competition from private-label securities heated up due to material increases in
risk-layered products coming into their own as Alt-A and subprime mortgages, the GSEs relaxed
their credit standards which allowed them to compete more effectively with this business. The
Figure 1 – Serious Delinquency Rates on Single-Family Mortgages: Freddie
Mac and Fannie Mae
two agencies had for many years adhered to strict underwriting criteria that limited the
combinations of risk attributes for a mortgage.1
As the agencies began to see erosion in their
market shares by the 2003-2006 period, the die was cast for excessive risk-taking. The
combination of weak corporate governance and regulatory oversight lies squarely at the center of
the credit meltdown for both agencies. This parallels a similar set of governance and regulatory
1
For several years the author managed the Single Family Mortgage Credit Policy Department at Freddie Mac and
was responsible for establishing all residential credit underwriting and collateral standards for the agency.
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deficiencies apparent at many large mortgage-originating depositories during the period as well.
With no effective regulatory counterbalance to poor governance practices by the GSEs, the
relaxation of underwriting standards and proliferation of risk-layered products such as Fannie
Mae’s Expanded Approve program was relatively easy to execute. The advent of automated
underwriting systems also facilitated greater product underwriting expansion as the statistical
merit of these systems such as Loan Prospector and Desktop Underwriter to evaluate multiple
risk attributes at once became apparent.
In effect, the agencies were allowed to “dump” product in the mortgage secondary market with
government support and a blind eye from safety and soundness regulators. Had this lapse in
oversight and governance occurred in the electric power industry, it would have created a
monumental environmental catastrophe. But the difference between the two industries is that
strict regulations apply to the power generation industry. Given the importance of the housing
market to the US economy, any option for reforming mortgage markets must include a strong
form of regulation similar to that found in public utilities. Any of the three options proposed by
the administration would eventually suffer at some later point another credit crisis for the reasons
provided above.
In an earlier briefing, I laid out the basic principles of a market that featured a significantly
reduced level of involvement by the federal government and a strong regulator.2 The mortgage
market would be segmented into three parts; a much smaller FHA market; fully supported by the
federal government for affordable borrowers needing a helping hand; a plain vanilla mortgage
secondary market privately capitalized with a federal backstop only required during periods of
financial distress; and a heavily regulated private-label market for nonstandard products with no
federal backstop.
2
Toward Comprehensive GSE and Housing Finance Reform, Center for Financial Policy Briefing, November 18,
2010.
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The product characteristics of the plain vanilla market would essentially define a Qualified
Residential Mortgage (QRM) for risk retention assessment. Such a product set would allow for
mortgages up to 90% loan-to-value (LTV) ratio with appropriate mortgage insurance. All loans
in this market would include standard 1st lien fixed-rate loans and amortizing adjustable-rate
mortgages (ARMs). Allowable ARMs would qualify the borrower at the fully-indexed mortgage
rate rather than at some teaser level. Minimum credit standards would be imposed across various
LTV and product combinations with full verification of income, employment and assets required.
The characteristics reflected then in the QRM provisions for this market would limit any further
take-out for FHA mortgages while providing broad standardization for an effective and liquid
secondary market.
Among the major features of the proposed structure was the creation of a number of privately
capitalized mortgage security issuers that would provide credit guarantees on the mortgage
security instrument. This model featured a public utility-style of regulator charged with
approving new products, fees and credit guarantee pricing. Multiple issuers would exist to
mitigate systemic risk exposure and a consolidated mortgage servicing unit would be maintained
to support the issuing entities. This new structure, combined with the elimination of the Federal
Home Loan Bank System and cultivation of a robust covered bond market would allow for a
housing finance market capable of sustained performance for the next generation of
homeowners.
The administration’s recommendations for extricating the federal government from its dominant
position in housing markets today has merit only if it establishes a comprehensive framework for
addressing disequilibrium in housing demand and supply. Recommendations lowering loan
limits and increasing guarantee fees are procyclical in nature, leading to higher borrowing costs
and restricting availability to credit for potential borrowers. With home prices still falling and
foreclosures up 12% last month, the administration must get more creative in resolving the
housing crisis. In another briefing on this subject, I laid out a set of potential mortgage product
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innovations targeted to specific segments of housing demand and supply.3 Adapted from
successful products in such countries as Australia, a shared equity mortgage allowing downside
protection for a borrower with shared upside for the lender combined with a job loss protection
component could spark additional housing demand by overcoming deeply rooted pessimism
regarding short-term improvement in housing and employment. Further, other products
including a Negative Equity Certificate (NEC) providing lenders incentives to promote principal
modifications could be fashioned to reduce foreclosures and improve the fate of delinquent
borrowers. A number of companies today have worked out many of the details of such products,
however, a policy vacuum has stifled experimentation and testing of these products on any scale
thus far.
In the time it has taken the administration to craft its housing finance reform report, home prices
have fallen further, foreclosures have accelerated and government support of mortgage markets
has continued unabated. What is newsworthy about the report is not so much the
recommendations, but the great lack of clarity in attacking the housing problem through a
comprehensive set of regulatory, innovative products, and capital markets solutions.
Clifford V. Rossi, PhD, Executive-in-Residence and Tyser Teaching Fellow
Center for Financial Policy
Robert H. Smith School of Business
University of Maryland
Contact Information: crossi@rhsmith.umd.edu
The views of this article are those of the author solely and do not represent those of the
Center for Financial Policy or the University of Maryland.
3
A Way Forward on the Housing Crisis, Center for Financial Policy Briefing, November 4, 2010.
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