Returning Private Capital to Mortgage Markets: A Fundamental for Housing Finance Reform

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May 152013

Swagel-Phillip-HRThis is an excerpt from CFP Academic Fellow Phillip L. Swagel’s testimony before the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs on May 14, 2013.  Click here for the full transcript.

Bringing private capital back to fund mortgages and take on credit risk is an essential element of housing finance reform, particularly with respect to reform of the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac. Housing finance reform should ensure that mortgages are available across economic conditions, while shielding taxpayers from taking on uncompensated risk and protecting the broader economy from the systemic risks that arose in the previous system. Bringing about increased private capital as part of housing finance reform will help protect taxpayers and improve incentives for prudent mortgage origination by lenders and investors with their own resources at risk.

The situation in housing finance today is that taxpayers fund or guarantee more than 90 percent of new mortgages through the GSEs and through government agencies such as the Federal Housing administration (FHA). Fannie Mae and Freddie Mac stand behind virtually all new conforming mortgages through the two firms’ guarantees on the mortgage-backed securities (MBS) into which the two firms bundle the home loans they purchase from originators. There is loan-level capital to absorb losses in the form of homeowner down payments and private mortgage insurance (PMI), but no private capital at the level of the mortgage-backed security (MBS) ahead of the financial resources of Fannie and Freddie. With the U.S. Treasury committed to ensuring that Fannie and Freddie remain solvent, the U.S. government effectively backstops conforming loans, leaving taxpayers exposed to considerable losses in the event of another housing downturn—and this risk remains even while the two firms are now profitable. Taxpayers further take on credit risk in housing through the government backstop on the Federal Home Loan Bank (FHLB) system, and through guaranteed mortgages supported by the Federal Housing Administration (FHA) and other federal agencies. I have previously testified on reforms to the FHA that would better protect taxpayers while focusing the agency on its mission to expand access to mortgage financing for low- and moderate income families who have the financial wherewithal to become homeowners.¹ I thus focus here on GSE reform.

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Election Aftermath: Financial Policy, Legislation and Regulation

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Nov 142012

by Bill Longbrake, Executive-in-Residence, Center for Financial Policy

This is an excerpt of the November 2012 Longbrake Letter. To read the letter in its entirety, click here.

Congress will focus on tax and spending issues over much of the coming year. This will crowd out consideration of most other legislative issues. However, there is unfinished business in dealing with mortgage finance issues and the future of the housing government sponsored enterprises – Fannie Mae and Freddie Mac.

In spite of calls from several quarters to revamp provisions of the Dodd-Frank Act, the most Congress is likely to do in the coming year is hold hearings. It will leave it to regulators to continue the slow tedious process of writing and adopting implementing regulations, although hearings will be used to try to exert some influence on the direction and content of certain regulations.

Increased bank size and complexity and greater concentration of financial resources in fewer institutions have lead to concern about “too big to fail” and adverse competitive impacts on smaller banking organizations. This is a bipartisan issue. Both Democrats and Republicans are troubled. Hearings will be held and legislation will be introduced, although passage of anything in the coming year appears to be unlikely.

Implementation of Basel III capital and liquidity rules was supposed to occur in 2013. However, the final rules have not yet been adopted. There has been a firestorm of protest, especially from smaller financial institutions, that implementation could have extremely harmful effects. Banks have lobbied for implementation to be delayed until a thorough economic impact analysis is completed. Congress appears to be sympathetic to this complaint. Regulators recently announced a delay in implementation but did not indicate they would conduct the requested economic impact analysis.

1.    Congressional Leadership

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The Housing Market and Government Intervention

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Oct 022011

by Phillip Swagel
CFP Academic Fellow and Professor of International Economics at the
Maryland School of Public Policy

In a recent essay, Peter Wallison asserts that it is “completely frivolous” to believe that the government is incapable of resisting the urge to bail out the housing market. But history is not so kind to this assertion.  Congress has taken many steps to foster homeownership and it seems far from frivolous to envision that Congress would act again in the future if mortgage credit dried up for American families. One can similarly imagine an intervention taking place if the secondary market in mortgage-backed securities locked up, since this in turn would likely lead to a lack of credit for new mortgages.  After all, the Federal Reserve and Treasury Departments intervened in the fall of 2008 to stabilize money market mutual funds, which then consisted of not quite $4 trillion of assets.  Housing-related securities are $10 trillion out of around $53 trillion in U.S. debt. While one can hope that a future administration and Congress in the midst of a financial crisis would avoid particular interventions, Wallison rests on just this—hope.

Wallison criticizes my proposal for housing finance reform that includes an explicit secondary government backstop on conforming mortgage-backed securities. He points out that the government will charge too little for providing the insurance.  Oddly, Wallison writes as if my proposal does not recognize this.  But a key facet of my proposal is to allow entry by new firms that securitize conforming MBS precisely because the government will inevitably underprice the guarantee.  The competition from these entrants will help ensure that the implicit subsidy of underpriced insurance goes to homebuyers in the form of lower interest rates rather than being kept by GSE shareholders and management as in the previous system.   Wallison does not have to agree with this proposed response to the inevitable government underpricing of insurance, but his criticism has a disingenuous flavor in pretending that it was not made.

My view is that the government will intervene in housing in the future and will underprice insurance today.  As the saying goes, these are not problems to be solved, but instead facts of life that must be dealt with.  My proposal for housing finance reform does so by ensuring that there is considerable private capital ahead of a secondary guarantee, taxpayers are compensated for taking on risk, and private market competition directs the benefits of the inevitable government subsidy to homeowners.  Moreover, allowing for entry by new firms will eventually result in a housing finance system in which firms are no longer too big to fail.

The alternative espoused by Wallison would involve a system that is notionally private but in which the government guarantee is latent and uncompensated.  Moreover, given that there is little prospect for the fully private alternative to ever come into being, holding out for it in fact leaves Fannie and Freddie in government hands—and the longer this persists, the more likely they will stay there forever.  Waiting for a supposedly perfect but unattainable housing finance reform could instead leave us permanently with the worse alternative of a government-run housing finance system in which there is no private capital other than downpayments and none of the benefits of private sector competition and innovation.

This article was first published on, the Journal of the American Enterprise Institute, on September 26, 2011.

Jul 212011

by Phillip L. Swagel

Academic Fellow, Center for Financial Policy

This post was originally featured in Bloomberg on July 18, 2011.

Here is one clear lesson from the economic meltdown of 2008: Any future U.S. administration will intervene directly and heavily if faced with a potentially devastating economic crisis. Market purists might not like it, but it is a fact I witnessed firsthand at the Treasury Department during the George W. Bush administration.

As a corollary, it is also true that the government will be compelled to step in if it becomes concerned that American families cannot obtain mortgages at reasonable interest rates. Indeed, it is inevitable that the government will also intervene if secondary mortgage markets — that is, the trade in securities and bonds made up of bundled mortgages — lock up.

The math is simple: Home mortgages represent $10 trillion out of $53 trillion in total U.S. credit market debt; remember that the Treasury and Federal Reserve felt compelled to stabilize money-market mutual funds in the fall of 2008 when they held just under $4 trillion.

Acknowledging these facts is central to solving a problem Congress is finally taking seriously: deciding the future of the government-sponsored enterprises at the center of the housing collapse, Fannie Mae and Freddie Mac.

Members of Congress, who began debating several bills to reform Fannie and Freddie last week, must start from this implicit promise of government intervention. Thus it makes little sense for Republicans to push for an ideal, purely market-based system. That head-in-the-sand approach will only help those like Representative George Miller, Democrat of California, who call for increasing government involvement.

Instead of holding out for an unattainable goal, conservatives would be wise to move forward with housing reform that specifies an explicit, but limited, government role.

The centerpiece of any proposal should be protecting taxpayers. The best way to make that happen is to bring private capital back into the market and ensure that it would take losses ahead of any government guarantee on mortgages and securities composed of them.

Fortunately, Congress already has a good model to follow: a bipartisan proposal now before the House sponsored by John Campbell, a California Republican, and Gary Peters, Democrat of Michigan. Under the plan, at least five private firms would be set up to finance and securitize high-quality conventional mortgages. The government would guarantee the resulting financial instruments, but the companies would have to pay insurance premiums for that backstop. The firms themselves would not be guaranteed — only the mortgage-backed securities they created would be protected.

Such a program would create a competitive market in which Fannie and Freddie would become just two of many firms involved in securitization, and neither would be too important to fail. Over time they would probably be sold back into private hands or wound down.

Critics will no doubt make the case that Fannie and Freddie made housing possible for the less affluent, who would be left behind in a freer system. Under such a proposal, a portion of the insurance premiums could be earmarked for affordable-housing initiatives.

More important, an open market is also the best way to spur useful innovation in mortgages, as lenders would compete to find ways to help credit-worthy borrowers with modest incomes become owners. An irony is that the large banks so many Americans blame for the economic crisis are the companies most likely to compete effectively with Fannie and Freddie. (Disclosure: I have done consulting work for some large banks on reforming those enterprises.)

In order to give all competitors equal footing, regulators should require all firms involved to issue standardized mortgage-backed securities, as opposed to the current system in which Fannie’s and Freddie’s securities trade separately from other mortgage-backed instruments. This would have side- benefits: unifying the market would improve mortgage liquidity and thus probably lower interest rates for borrowers.

There are a few caveats. There is a risk in having the government price insurance — something that it has done a terrible job at with flood insurance, for example. But any price it charges will be better than zero, which was the de facto rate in the Fannie-Freddie system that was ostensibly private but had its implicit federal guarantee.

The larger concern is what would happen to interest rates as the government backstop receded. If private investors overwhelmingly balked at taking on housing risk, it could lead to a surge in interest rates and further depress home sales and construction. Thus the prudent path would be to go quickly to a competitive system but phase out the current federal role at a slower pace, namely by gradually bringing in private capital ahead of a secondary government guarantee.

The longer Fannie and Freddie stay in government hands, the more likely they will become permanent wards of the state. This would be the worst of possibilities, yet it becomes more likely as conservatives push for a supposedly private housing financing system that has no hope of enactment. The government will always be part of the housing market; let’s make sure we keep its role as small and contained as possible.

(Phillip L. Swagel is a professor at the University of Maryland School of Public Policy. He was assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.)

May 272011

by Phillip Swagel

Academic Fellow, Center for Financial Policy

This post was originally featured on the House Financial Services Committee’s Blog.

A reduction in the dividend payments that Fannie Mae and Freddie Mac make to the federal government would serve no policy purpose and amount to a gift from taxpayers to the investors who owned Fannie and Freddie when the firms required a $150 billion taxpayer bailout.  It is important to return Fannie and Freddie back to private hands in the future and have market participants rather than the government as the main provider of housing finance.  But there are ways to do this that do not involve a windfall for the old shareholders, who were appropriately wiped out when the two firms went bust.

The federal government now stands behind the financial obligations of Fannie Mae and Freddie Mac, the two government-sponsored enterprises involved with housing finance that were placed into conservatorship in September 2008. Taxpayers are on the hook for their losses, with some $150 billion committed so far to make good on the government backstop.

Taxpayers effectively own these two companies.  As part of the agreement with the firms when they were put into conservatorship, the U.S. government gained control of 79.9 percent of the common stock, and received preferred shares with a 10 percent dividend payment in exchange for capital injections to maintain a positive net worth for the two firms.  With $150 billion of taxpayer capital injected already, the 10 percent rate means that Fannie and Freddie make huge dividend payments each year.

The 79.9 percent figure for the common stock component was chosen because an 80 percent stake would have triggered government accounting rules that put the firms’ assets and liabilities onto the public balance sheet.  This is mainly a symbolic distinction, since the terms of the so-called “keepwell” agreements made between the firms and the Treasury mean that the government covers the firms’ net gains and losses even if their assets and liabilities are not formally on the public balance sheet.  Still, a concern in the fall of 2008 was that market participants and rating agencies might not understand the situation and respond poorly to $5 trillion of GSE obligations coming onto the federal balance sheet—even those these obligations were matched by nearly an equivalent value of assets and taxpayers had committed to cover the difference between assets and liabilities regardless of whether these were formally on the federal balance sheet.

In recent quarters, the large dividend payments on the government-owned preferred shares have given rise to the seemingly unusual situation in which Fannie and Freddie are now profitable in their operations but usually still make net losses because of the payments to the government.  As a result, the two firms take more government capital in order to turn around and pay some of the money back to the Treasury as dividends.  As discussed by Daniel Indiviglio of The Atlantic [LINK =], Freddie actually reported a profit in the first quarter even including its $1.6 billion quarterly payment to the Treasury, but the firm notes that this profit situation is not likely to continue into the future.  Fannie needed another $8.5 billion from the Treasury, including money to cover its $2.2 billion quarterly payment.  The dividend payments appear to be crushing the firms and preventing their return to profitability.

This is by design.  The steep payments on the dividends make it so that the remaining 20.1 percent of GSE common shares and the pre-conservatorship preferred shares have no value because the GSEs will never earn high enough profits to redeem the government’s preferred shares.  This is both intentional and appropriate.  Fannie and Freddie were deeply insolvent in September 2008 when they required a bailout.  With the housing market weak and credit markets strained in the fall of 2008, Treasury did not want to put the two firms into receivership and wind them at that moment, but it also wanted to make sure that the equity holders of the firms received nothing.  The preferred shares accomplish this while not crossing the accounting threshold.  Fannie and Freddie shareholders have not been abused—they got exactly what happens to shareholders of insolvent firms:  a loss of their investment.

Some people want to reduce these payments or take other steps to the advantage of the owners of the common shares.  In an April 11 letter to Committee Chairman Bachus and others [LINK =], for example, Ralph Nader decries the treatment of common shareholders, including the delisting of the firms’ shares.   Others note that a lower dividend rate would allow Fannie and Freddie to build up retained earnings rather than relying on additional government capital to keep them solvent.

But reducing the dividend would simply transfer value from the government to pre-conservatorship shareholders.  This would be a pure gift from taxpayers to investors, without a public policy rationale.

There are better ways to restore Fannie and Freddie to private hands in the future that recoup as much of the bailout as possible without providing a windfall to investors.  One approach would be to split the firm into two companies each.  So-called “good companies” would have clean balance sheets with the valuable assets of Fannie and Freddie’s computer systems and networks through which to acquire mortgages from originators throughout the United States.  These would be profitable firms and perform the socially valuable tasks of securitizing and guaranteeing conforming mortgages.  The legacy mortgage-backed securities (MBS), guarantees, and debt would remain with the two “bad companies,” which would continue to have their net worth kept positive by the Treasury while their assets and liabilities run off.  The 79.9 percent share of common stock and the $150 billion of senior preferred shares held by the Treasury would likewise remain with the bad firms, which in turn would own the two new good firms.

The separation of Fannie and Freddie into “good” and “bad” firms would in effect leave the government providing a ring-fence around the legacy assets and liabilities.  The two good firms could then be sold back to private investors as profitable companies with clean balance sheets and functioning business systems.  Taxpayers would realize all of the proceeds of these two IPO’s, because these funds would go to the bad firms and thus to the government as dividends on the Treasury preferred shares as the old Fannie and Freddie are wound down.  Even so, it is unlikely that the proceeds of the public offerings of the two good firms would recoup all of the $150 billion in taxpayer money paid out to stabilize Fannie and Freddie.  The remaining net loss after the initial public offering and including any additional future capital needed to stabilize the firms would constitute the overall cost of the GSE bailout.

Since the government is not likely to recoup its investment in the firms, this means that pre-conservatorship common and preferred stockholders will realize no value from their holdings.  This is appropriate, since the two firms were deeply insolvent when they were put into conservatorship.   This differs from the situation with AIG, where AIG was illiquid but not insolvent and thus pre-crisis shareholders will come out with some value, even though for holders of common stock this value will be greatly diluted by the government stake acquired in the rescue of that company.  Again, this is an appropriate distinction to make between AIG on the one hand and Fannie and Freddie shareholders on the other.  The GSEs were insolvent while AIG was not.

It is vitally important to move forward with GSE reform to ensure that the U.S. housing market is supported by private capital rather and so that the securitization and guarantee functions performed by Fannie and Freddie benefit from private sector incentives and innovation.  While an eventual path for GSE reform is discussed, it is equally important to avoid taking steps that transfer value from taxpayers to private investors without appropriate compensation.  This would be the effect of proposals to reduce the dividend payments made by Fannie Mae and Freddie Mac on the capital invested in the two firms by the United States Treasury.

Phillip Swagel is a professor of international economic policy at the University of Maryland School of Public Policy.  He was formerly Assistant Secretary for Economic Policy at the Treasury Department from December 2006 to January 2009.  He testified before the committee on GSE reform on September 29, 2010.