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.
Mohnish Pabrai: 6.5x Return On Deep Value Turkish Stock [2020 Letter]
In his year-end letter to investors, Mohnish Pabrai, the Managing Partner of Pabrai Investment Funds, explained that 2020 had more impact on his way of thinking about the market than any other year since 1999. Q4 2020 hedge fund letters, conferences and more Following last year's lessons, Pabrai explained he has decided to move away Read More
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, albeit slowly. And we are writing about these issues because it seems that meaningful policy debate in Washington may begin anew in 2017.
The Secondary Mortgage Market and Its Collapse
While the Bailey Brothers’ Building and Loan from the classic movie It’s a Wonderful Life renders a heartwarming picture of local housing finance, only remnants of that system remain today. At least since the savings and loan debacle in the 1980s, the U.S. housing finance system has been dominated by the secondary mortgage market, that is, the marketplace where lenders, bond investors, and the infrastructure of securitization meet.
In simple terms, the secondary market is where individual mortgages made across the country are bundled into large groups of mortgages, called pools, and sold to global investors in a structure called a mortgage-backed security. The process of pooling mortgages and issuing MBS is called securitization. This system can be very powerful and beneficial. Rather than relying on the availability and stability of local deposits at a savings (or building) and loan, the secondary market draws asset managers across the globe to invest in pools of hundreds or thousands of mortgages.
In this way, pension funds, college endowment funds, insurance companies, mutual funds, retirement savings plans, foreign central banks, foreign wealth funds, and other institutional money managers responsible for investing the savings of individuals and institutions provide the money a family needs to buy a house anywhere in America. Interestingly, these widely dispersed investors know very little about the risk characteristics of any individual borrower in their pool, nor do they know much about the condition of a particular house, the neighborhood in which it’s located and the local economy. So why are they willing to fund these mortgages?
The answer lies in the structure and reliability of the secondary mortgage market and the institutions and legal arrangements at its center. In the run-up to the financial crisis, and still today, there are three
distinct components that compose most of the secondary mortgage market and make this financial ecosystem possible.
First, in the government segment of the housing finance system, the Government National Mortgage Association, or Ginnie Mae, oversees the pooling of mortgages guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and a few smaller federal housing programs. The Ginnie Mae label on a mortgage-backed security tells investors that the full faith and credit of the United States government guarantees that they will receive timely payment of principal and interest each month and that investors will not lose any principal as a result of borrower defaults on the underlying mortgages.
In this case, the risk is largely borne by the federal government through its FHA, VA, and other mortgage insurance programs. Loan originators and loan servicers retain some risk as well, and Ginnie Mae bears the ultimate risk if these private-sector entities fail to fulfill their responsibilities. Ginnie charges the homebuyer six basis points per year (or typically less than $1 per month) for this backstop guarantee. Today, Ginnie Mae MBS account for $1.5 trillion of the roughly $7 trillion in outstanding MBS, or more than 20 percent, which is a historic high.
Second, on the other end of the spectrum, in the purely private-label segment of the housing finance system, banks and other financial institutions (call them Wall Street firms if you must, although many are not located anywhere near New York) put together mortgage pools and sell the MBS to private investors. In this market segment, the nongovernment investors bear all the credit risk; that is, if borrowers default on their payments, investors suffer the loss. As a result, private-label MBS are broken into multiple subgroups, called tranches, which create a predetermined order for bearing credit losses. More subordinate tranches bear all the credit losses until they are wiped out, and then losses proceed to holders of more senior tranches of the pool.
In the decade or so leading up to the financial crisis, the private-label market (often referred to as the private-label securitization market, or PLS) exploded in size, often backed by subprime mortgages, which were underwritten according to nonstandard guidelines. To name a few, documentation of income or assets was frequently not required, there were very few antifraud controls, and whether prospective borrowers could repay a loan was seen as a secondary question at best. The PLS market fanned the flames of these problems, but the government-sponsored enterprises, worried about losing market share, were quick to follow.
The private-label market is also where so-called “jumbo loans” are securitized.1 By 2006, private-label MBS accounted for about half of outstanding MBS, but today that portion is down to less than 10 percent. In fact, there has been almost no new issuance in this market since the crisis. The reason is that the crisis exposed several deep, structural flaws in the PLS market, including a lack of standardization in disclosures, opaque and nonstandard legal terms from one PLS to another, and no functioning mechanism to ensure that servicers who determined whether and how to modify loans and enforce contracts did so in the best interest of investors. The U.S. Treasury Department and other entities are working to address these flaws in an effort to build a more sustainable PLS market, but this market segment remains moribund.
Third, and the largest by far, is the GSE market segment, composed of loans bundled, securitized, and guaranteed by Fannie Mae and Freddie Mac.2 Chartered by Congress, endowed with unique benefits unavailable to any other private firm, and tasked with developing a liquid and stable market in which non-FHA mortgages could be bought and sold, Fannie Mae and Freddie Mac grew into behemoths in both their market power and political influence.
The market interpreted this package of benefits, including the GSEs’ federal charter and exemption from certain securities laws, as giving the two companies an implied government guarantee. In turn, these benefits and the associated implied guarantee allowed Fannie Mae and Freddie Mac to join Ginnie Mae in selling mortgage-backed securities in a forward market, called the “To Be Announced,” or TBA, market. Being able to trade MBS in the TBA market allows for easy trading and hedging of mortgages around the globe as well as the standardization of underwriting. But in 2008, our reliance on these entities as a public/private duopoly was exposed as a Faustian bargain.
A hybrid between public mission and private ownership, Fannie Mae and Freddie Mac often reaped the best of both worlds. Operating with numerous public benefits, the companies and their shareholders operated with lower costs, much lower capital requirements, and far weaker regulation than any bank or savings and loan.3 In the end, their unique structure of private shareholders, private-sector salaries and benefits, and an implicit public guarantee came to symbolize “Heads we win, tails the taxpayers lose.”
In this market segment, Fannie Mae and Freddie Mac bought mortgages, packaged them into MBS, and guaranteed the MBS holders payment of principal and interest if any borrower defaulted on a loan. They charged borrowers a guarantee fee embedded in the interest rate—effectively an insurance premium—for bearing this risk. With nearly $5 trillion in MBS outstanding at the time of the crisis—50 percent of all U.S. mortgage debt—we can see in hindsight that this concentrated credit risk exposure was a systemic threat.
It was widely discussed before the crisis that this setup, combined with the two companies’ importance to housing finance and their government support, meant that taxpayers, in all likelihood, “implicitly guaranteed” Fannie Mae and Freddie Mac MBS investors should the GSEs fail. While Congress routinely insisted that there was no government guarantee behind Fannie Mae and Freddie Mac, the market thought otherwise—and when the enterprises failed, that implicit guarantee was honored and became explicit. In the summer of 2008, Congress gave the Treasury Department unlimited authority to purchase Fannie Mae and Freddie Mac securities. The subsequent appointment of the FHFA as conservator backed by direct financial support from the Treasury protected the holders of Fannie and Freddie MBS.
Since the crisis, the private-label market mostly vanished, and Ginnie Mae, Fannie Mae and Freddie Mac have expanded their market shares. Despite Fannie Mae and Freddie Mac being on government life support, the conservatorship design supported by Treasury backstop financing enabled investors to continue buying their MBS, thereby ensuring ongoing liquidity in the U.S. mortgage market. Absent this life support, the country would have been without a viable secondary market to provide liquidity for new mortgages not backed by a government agency such as the FHA.
While there are other important considerations to the workings of this secondary market, two more background points—clear lessons from the financial crisis—are worth making here. First, to reap the benefits of a market like the one we have come to know, the mortgages in an MBS must be homogenous. That is, they need to share certain characteristics such as repayment term and whether the loan has a fixed or adjustable interest rate. Similar loans allow investors to analyze and estimate prepayment speeds, which affect MBS pricing. This is a critical component of how investors manage the interest rate risk of a long-term security with variable prepayment.
Second, Ginnie Mae, Fannie Mae, and Freddie Mac play an important role overseeing and enforcing certain contracts critical to the market’s operations. Key among these are overseeing mortgage servicers on behalf of investors and taking appropriate remedial steps, including transferring mortgage servicing, in the event of problems. The private-label world, as we came to see in the crisis, lacks an effective mechanism for such oversight, which the Treasury Department and industry groups have wrestled with in recent years.
This brief review reminds us that the objective of strengthening the secondary market while avoiding future government bailouts means replacing what is broken in the Fannie/Freddie model. That includes the systemic risk caused by concentrating credit risk on two balance sheets. We also need to eliminate the features of their charters that concentrated risk and political power in two quasi-private companies. Not to be lost is the challenge and opportunity of strengthening the other two component parts of the secondary mortgage market—the government segment and the purely private segment—and modernizing critical infrastructures that support housing finance.
At the same time, we need to preserve the liquidity and capacity of an active, globally financed MBS market because it ensures lower mortgage rates and stable access to credit. And we need to better define the role of each segment of the housing market. The purely private, purely public, and hybrid parts of the system must operate as one ecosystem, not competitors in a race to the bottom.
What Has Transpired So Far?
From a public policy perspective, it makes sense to begin policy analysis by examining the purely governmental programs and institutions involved in housing finance, especially the Federal Housing Administration. Nonetheless, the Fannie/Freddie space of the secondary mortgage market is by far the largest component of the housing market. So we address its flaws here, and we will return to the FHA and other government programs in a later paper.
Since Fannie Mae and Freddie Mac were put on government life support in 2008, the question, “What do we do with them and the housing finance system next?” remains unanswered. But to be entirely pessimistic about policymakers’ capacity to solve complex problems misses important points. Some helpful steps have been taken, and they are worth quickly reviewing.
The first of these policy initiatives occurred in 2012 with the introduction of the FHFA Strategic Plan for Enterprise Conservatorships4 and its associated “annual scorecards.” The scorecards set the FHFA’s priority objectives for Fannie Mae and Freddie Mac to achieve over the subsequent calendar year.5 The strategic plan and annual scorecards defined initiatives for Fannie Mae and Freddie Mac to modernize their operations and business practices while preparing the groundwork for a post-conservatorship secondary mortgage market. The two most significant results of these efforts are the development of credit risk-sharing, or credit-risk transfer (CRT) products that have helped shift risk away from Fannie Mae and Freddie Mac (and therefore taxpayers); and a common platform to replace each company’s outdated, proprietary securitization infrastructure and technology.
Beginning here with CRT, credit-risk transfer transactions began small in 2013—the scorecard goal was just $30 billion in unpaid principal balance—but they have since become a substantive risk-shifting mechanism for the enterprises and, with a bit more work, can become a market asset class of their own. Credit-risk transfer accomplishes a number of key tasks on the reform agenda. CRT brings in market signals, ushers in private risk takers ahead of taxpayers, and focuses market practitioners on the development of models for continued improvement in mortgage credit risk management. In short, credit-risk transfer has helped form a foundation for a new mortgage credit market structure.6 Importantly, we also now know that the plumbing for credit-risk transfer works well—both “front end,” in which terms are arranged before loans are sold to a GSE, and “back end,” in which a GSE determines how and when to shed risk.
There is no doubt that the mortgage credit markets are slowly coming back to life. We should continue to foster this development by expanding the scope and depth of risk transfer and developing a legal and regulatory infrastructure that ensures transparency and investor protection. These steps are needed for credit risk investors to have confidence in this sector for the long haul and for the market to remain liquid during periods of economic difficulty. With a properly modernized architecture, these credit markets can be harnessed to measure and price credit risk, allocate credit, and insulate taxpayers in a targeted and effective way.
In 2012, the FHFA announced that work would begin on a common securitization platform, that is, the systems technology that governs payments from borrowers to MBS investors. The agency had determined that neither Fannie Mae nor Freddie Mac had a securitization platform capable of being built on for the future. Moving from the outdated, proprietary securitization infrastructure each company used to a shared utility provides numerous benefits. Among them, it creates the opportunity to standardize disclosures, data terms, and even bond administration functions between the two entities.
We now know that many of the functions that underpin MBS securitization can be managed as a common utility, which is being called the CSP or CSS.7 If done properly, a common platform for securitization could remove a significant barrier to entry for potential competitors. Unfortunately, thus far the focus of the CSP project has been the adoption of a single security for use by only the GSEs, and not as a means to allow new entrants into the market. However, despite this unfortunate dynamic, in the end we now know that the plumbing of the CSP could operate as a standalone market utility or, more promisingly, it could be folded into a government agency that provides the catastrophic guarantee for MBS (such as a Federal Mortgage Insurance Corp., a National Mortgage Reinsurance Corp., or simply Ginnie Mae). Either way, both of these initiatives—the CRT and the CSP—are meaningful undertakings that faced skepticism in the beginning but are now largely recognized as worthwhile endeavors. These changes alone, so long as they are continued, help ensure that the post-conservatorship secondary market segment traditionally served by Fannie Mae and Freddie Mac will not look the same as it did before the crisis.
Congress, for its part, has done more than immediately meets the eye as well. It is true that we have not had a Rose Garden signing ceremony for a major reform law. But progress has occurred. Consider that both the House and Senate committees of jurisdiction passed reform bills in 2013 and 2014. Alternative bills were also crafted in both chambers, and all were done with a great deal of thought applied to a highly complex topic. Passions sometimes flared as various approaches were offered. But such is to be expected when discussing legislation that will forever impact the market structure that enables Americans to purchase homes. It’s clear, though, that both sides of the aisle and both chambers of Congress—with administration input—have nudged their way forward. In the end, we do not think political consensus is as far away as some would suggest.
To many Americans, owning a home is a quintessential element of the American dream. How the housing market should serve families is a question to be answered by our elected officials. Congress and the White House must and, in our view will, set the four corners of how the future secondary mortgage market will operate. After all, an act of law chartered the enterprises, and an act of law injected nearly $200 billion of taxpayer money into them to keep them solvent since 2008. An act of law will ultimately resolve the conservatorships and decide the secondary mortgage market’s future structure and participants. To think that something of this magnitude should be done simply via regulatory action is, to us, an insult to Congress and the American democratic process.
See full PDF below.