Fannie Mae – Why Housing Reform Still Matters by Michael Bright and Ed DeMarco

The 2008 financial crisis left a lot of challenges in its wake. The events of that year led to years of stagnant growth, a painful process of global deleveraging, and the emergence of new banking regulatory regimes across the globe.

But at the epicenter of the crisis was the American housing market. And while America’s housing finance system was fundamental to the financial crisis and the Great Recession, reform efforts have not altered America’s mortgage market structure or housing access paradigms in a material way.

This work must get done. Eventually, legislators will have to resolve their differences to chart a modernized course for housing in our country. Reflecting upon the progress made and the failures endured in this effort since 2008, we have set ourselves to the task of outlining a framework meant to advance the public debate and help lawmakers create an achievable plan. Through a series of upcoming papers, our goal will be to not just foster debate but to push that debate toward resolution.

Before setting forth solutions, however, it is important to frame the issues and state why we should do this in the first place. In light of the growing chorus urging surrender and going back to the failed model of the past, our objective in this paper is to remind policymakers why housing finance reform is needed and help distinguish aspects of the current system that are worth preserving from those that should be scrapped.

Why Housing Finance Reform Is Needed, and What It Must Accomplish

Structural housing finance reform was never going to be an easy undertaking. But it can’t be ignored. After years of debate, we understand that sensible reforms should seek to preserve the aspects of the old system that worked while ridding the system of its flaws. And we understand that transitioning to a new market infrastructure must be carried out without disruption—disruption that could upset mortgage availability in the near term or upset the processes and operations of the thousands of firms that make up the complex housing finance ecosystem.

So no, this was never going to be easy.

Still, nearly a decade after the financial crisis, housing finance is notable for its political and policy complexity as well as the passion that it stirs. Meaningful reform must be achieved, the vast majority of policymakers say, yet the decade anniversary of the conservatorships of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) looms.

A home is the largest purchase most Americans will make in their lives. By some estimates, housing is the engine that propels nearly one-fifth of the American economy. Access to decent housing is crucial to a vibrant middle class. On top of all that, the system is enormously intricate; this is not your grandfather’s housing market. No longer is the typical mortgage characterized by a 20 percent down payment and funded with community deposits from the local savings and loan. Today, the vast majority of America’s mortgages come into existence via a complex financial infrastructure, not via local banks that simply take in deposits and lend them out. Instead we have a web of bank and non-bank lenders, bank and non-bank mortgage servicers, mortgage insurers, guaranteed securities, derivatives, credit investors, rate investors, and more that together connect savers across the globe with families across the country who seek to buy a house. All of this has led to structurally lower and less volatile interest rates. But it has also created complex terrain to navigate.

So here we are eight years after the financial crisis, with the two government-sponsored enterprises (GSEs) that sit at the heart of America’s housing finance ecosystem-Fannie Mae and Freddie Mac-trapped in a state of legal limbo called conservatorship. The government life support given to them at the height of the financial crisis was meant to be temporary, followed by legislation replacing the toxic aspects of their activities and reforming our market structure. But a long-term decision about how to replace the life support with something better without disrupting the housing market requires political compromise and pragmatic thinking. Politically, members of Congress on both sides of the aisle will have to give on some issues to achieve an agreement. They will need to put ideology aside and ask, “Will this actually work?”

The challenge of finding sufficient political common ground to break the GSEs out of conservatorship has felt so daunting that it has led to doing nothing. But continued inaction is a de facto decision to stay with what we’ve got. Others have suggested we give up in a different way: return, hat in hand, to the old model that failed. These arguments are misguided and dangerous. Neither approach would address the failures of the past or the economic challenges of the present.

The former choice—remaining in conservatorship—would allow the entire housing system to rely almost entirely on the decisions of the Federal Housing Finance Agency (FHFA) director and the two CEOs he or she is meant to regulate. In the end, this “head in the sand” strategy is not a serious approach. Such a lack of legislative clarity turns market decisions, such as how to underwrite a loan or price its risk, into a bureaucratic exercise or worse. This is not the proper role for a regulatory agency. But until Congress acts, the FHFA is stuck in its role of regulator and conservator.

The latter idea—returning to the old model, in which the GSEs operate in a blessed state as government-sponsored enterprises that are tasked with a public mission but report to private shareholders, coupled with a management team incentivized to leverage all advantages not for the long-term health of the economy but instead for immediate financial gain—relies on the assumption that future congresses will also bail out Fannie Mae and Freddie Mac successor entities the next time there is a major market disruption. (And there will always be market disruptions.) This path, too, leaves the well-being of the housing market very much to chance.

As the events of 2008 demonstrated, the old model worked only because investors were confident that taxpayers stood behind the companies. If Fannie Mae and Freddie Mac were released from government control and, for all intents and purposes, returned to their pre-conservatorship quasi-private status, are we sure that a future Congress will inject emergency capital into them when they become insolvent or the mortgage-backed securities (MBS) market questions the strength of their guarantee?

Of course, the answer is no. Yet from Congress’ perspective, as much as it may never want to vote for taxpayer life support again, the pressure to keep two dominant players operating could very well lead to another vote to allocate emergency capital into successor entities.

All of this begs the question: Where, exactly, do we go from here?

There are notable, impressive successes inside America’s housing finance system. These must be preserved. Yet we must also reduce the likelihood that financial institutions will need emergency congressional action in the future. Additionally, incentives need to be properly structured and transparent, not comingled and opaque. Put another way, housing finance reform is about throwing out the dirty bathwater but keeping the baby. Fortunately, meaningful steps have already been taken,

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