Bringing Housing Finance Reform over the Finish Line

photo by LarryWeisenberg

Mike Milkin at Milkin Institute Global Conference

The Milkin Institute have released Bringing Housing Finance Reform over the Finish Line. It opens,

The housing finance reform debate has once again gained momentum with the goal of those involved to move forward with bipartisan legislation in 2018 that results in a safe, sound, and enduring housing finance system.

While there is no shortage of content on the topic, two different conceptual approaches to reforming the secondary mortgage market structure are motivating legislative discussions. The first is a model in which multiple guarantor firms purchase mortgages from originators and aggregators and then bundle them into mortgage-backed securities (MBS) backed by a secondary federal guarantee that pays out only after private capital arranged by each guarantor takes considerable losses (the multiple-guarantor model). This approach incorporates several elements from the 2014 Johnson-Crapo Bill and a subsequent plan developed by the Mortgage Bankers Association. Fannie Mae and Freddie Mac—the government-sponsored enterprises (GSEs)—would continue as guarantors, but would face new competition and would no longer enjoy a government guarantee of their corporate debt or other government privileges and protections.

The second housing finance reform plan is based on a multiple-issuer, insurance-based model originally proposed by Ed DeMarco and Michael Bright at the Milken Institute, and builds on the existing Ginnie Mae system (the DeMarco/Bright model). In this model, Ginnie Mae would provide a full faith and credit wrap on MBS issued by approved issuers and backed by loan pools that are credit-enhanced either by (i) a government program such as the Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA), or (ii) Federal Housing Finance Agency (FHFA)- approved private credit enhancers that arrange for the required amounts of private capital to take on housing credit risk ahead of the government guarantee. Fannie Mae and Freddie Mac would be passed through receivership and reconstituted as credit enhancement entities mutually owned by their seller/servicers.

While the multiple guarantor and DeMarco/Bright models differ in many ways, they share important common features; both address key elements of housing finance reform that any effective legislation must embrace. In the remainder of this paper, we first identify these key reform elements. We then assess some common features of the two models that satisfy or advance these elements. The final section delves more deeply into the operational challenges of translating into legislative language specific reform elements that are shared by or unique to one of the two models. Getting housing finance reform right requires staying true to high-level critical reform elements while ensuring that technical legislative requirements make economic and operational sense.  (2-3, footnotes omitted)

The report does a good job of outlining areas of broad (not universal, just broad) agreement on housing finance reform, including

  • The private sector must be the primary source of mortgage credit and bear the primary burden for credit losses.
  • There must be an explicit federal backstop after private capital.
  • Credit must remain available in times of market stress.
  • Private firms benefiting from access to a government backstop must be subject to strong oversight. (4-5)

We are still far from having a legislative fix to the housing finance system, but it is helpful to have reports like this to focus us on where there is broad agreement so that legislators can tackle the areas where the differences remain.

Taking up Housing Finance Reform

photo by Elliot P.

I am going to be a regular contributor to The Hill, the political website.  Here is my first column, It’s Time to Take Housing Finance Reform Through The 21st Century:

Fannie Mae and Freddie Mac, the two mortgage giants under the control of the federal government, have more than 45 percent of the share of the $10 trillion of mortgage debt outstanding. Ginnie Mae, a government agency that securitizes Federal Housing Administration (FHA) and Veterans Affairs (VA) mortgages, has another 16 percent.

These three entities together have a 98 percent share of the market for new residential mortgage-backed securities. This government domination of the mortgage market is not tenable and is, in fact, dangerous to the long-term health of the housing market, not to mention the federal budget.

No one ever intended for the federal government to be the primary supplier of mortgage credit. This places a lot of credit risk in the government’s lap. If things go south, taxpayers will be on the hook for another big bailout.

It is time to implement a housing finance reform plan that will last through the 21st century, one that appropriately allocates risk away from taxpayers, ensures liquidity during crises, and provides access to the housing markets to those who can consistently make their monthly mortgage payments.

The stakes for housing finance reform today are as high as they were in the 1930s when the housing market was in its greatest distress. It seems, however, that there was a greater clarity of purpose back then as to how the housing markets should function. There was a broadly held view that the government should encourage sustainable homeownership for a broad swath of households and the FHA and other government entities did just that.

But the Obama Administration and Congress have not been able to find a path through their fundamental policy disputes about the appropriate role of Fannie and Freddie in the housing market. The center of gravity of that debate has shifted, however, since the election. While President-elect Donald Trump has not made his views on housing finance reform broadly known, it is likely that meaningful reform will have a chance in 2017.

Even if reform is more likely now, just about everything is contested when it comes to Fannie and Freddie. Coming to a compromise on responses to three types of market failures could, however, lead the way to a reform plan that could actually get enacted.

Even way before the financial crisis, housing policy analysts bemoaned the fact that Fannie and Freddie’s business model “privatizing gains and socialized losses.” The financial crisis confirmed that judgment. Some, including House Financial Services Committee Chairman Jeb Hensarling (R-Texas), have concluded that the only way to address this failing is to completely remove the federal government from housing finance (allowing, however, a limited role for the FHA).

The virtue of Hensarling’s Protecting American Taxpayers and Homeowners Act (PATH) Act of 2013 is that it allocates credit risk to the private sector, where it belongs. Generally, government should not intervene in the mortgage markets unless there is a market failure, some inefficient allocation of credit.

But the PATH Act fails to grapple with the fact that the private sector does not appear to have the capacity to handle all of that risk, particularly on the terms that Americans have come to expect. This lack of capacity is a form of market failure. The ever-popular 30-year fixed-rate mortgage, for instance, would almost certainly become an expensive niche product without government involvement in the mortgage market.

The bipartisan Housing Finance Reform and Taxpayer Protection Act of 2014, or the Johnson-Crapo bill, reflects a more realistic view of how the secondary mortgage market functions. It would phase out Fannie and Freddie and replace it with a government-owned company that would provide the infrastructure for securitization. This alternative would also leave credit risk in the hands of the private sector, but just to the extent that it could be appropriately absorbed.

Whether we admit it or not, we all know that the federal government will step in if a crisis in the mortgage market gets bad enough. This makes sense because frozen credit markets are a type of market failure. It is best to set up the appropriate infrastructure now to deal with such a possibility, instead of relying on the gun-to-the-head approach that led to the Fannie and Freddie bailout legislation in 2008.

Republicans and Democrats alike have placed homeownership at the center of their housing policy platforms for a long time. Homeownership represents stability, independence and engagement with community. It is also a path to financial security and wealth accumulation for many.

In the past, housing policy has overemphasized the importance of access to credit. This has led to poor mortgage underwriting. When the private sector also engaged in loose underwriting, we got into really big trouble. Federal housing policy should emphasize access to sustainable credit.

A reform plan should ensure that those who are likely to make their mortgage payment month-in, month-out can access the mortgage markets. If such borrowers are not able to access the mortgage market, it is appropriate for the federal government to correct that market failure as well. The FHA is the natural candidate to take the lead on this.

Housing finance reform went nowhere over the last eight years, so we should not assume it will have an easy time of it in 2017. But if we develop a reform agenda that is designed to correct predictable market failures, we can build a housing finance system that supports a healthy housing market for the rest of the century, and perhaps beyond.

Housing Finance Reform at the AALS

The Financial Institutions and Consumer Financial Services Section and the Real Estate Transactions section of the American Association of Law Schools hosted a joint program at the AALS annual meeting on The Future of the Federal Housing Finance System. I moderated the session, along with Cornell’s Bob Hockett.
Former Representative Brad Miller (D-N.C.) keynoted.  Until recently he was a Senior Fellow, at the Center for American Progress and is now a Senior Fellow at the Roosevelt Institute. He was followed by four more great speakers:
The program overview was as follows:
The fate of Fannie Mae and Freddie Mac are subject to the vagaries of politics, regulation,public opinion, the economy, and not least of all the numerous cases that were filed in 2013 against various government entities arising from the placement of the two companies into conservatorship. All of these vagaries occur, moreover, against a backdrop of surprising public and political ignorance of the history and functions of the GSEs and their place in the broader American financial and housing economies. This panel will take the long view to identify how the American housing finance market should be structured, given all of these constraints. Invited speakers include academics, government officials and researchers affiliated to think tanks. They will discuss the various bills that have been proposed to reform that market including Corker-Warner and Johnson-Crapo. They will also address regulatory efforts by the Federal Housing Finance Agency to shape the federal housing finance system in the absence of Congressional reform.
During the presentations, I felt a bit of awe for the collective knowledge of the speakers.  The program also emphasized for me how much there always is to learn about a topic as complex as housing finance.
Laurie Goodman was kind enough to let me post her PowerPoint slides from the program. If you are looking for a good overview of the current state of housing finance reform, you will want to take a look at them.
I was a bit depressed by the slide titled, “Why GSE reform is unlikely before 2017:”
1. There is no sense of urgency: GSEs are profitable, current system is functioning.
2. Higher legislative priorities.
3. No easy answers as to what a new housing finance system should look like.
4. Bipartisan action requires compromise, and some believe they have more to lose than to gain by compromising in this arena.
While the slide depressed me, I think it offers a pretty realistic assessment of where we are. I hope Congress and the Obama Administration prove me wrong.

Reforming Fannie & Freddie’s Multifamily Business

Mark Willis & Andrew Neidhardt’s article, Reforming the National Housing Finance System: What’s at Risk for the Multifamily Rental Market if Fannie Mae and Freddie Mac Go Away?, was recently published in a special issue of the NYU Journal of Law & Business. Most of the ink spilled about the reform of Fannie and Freddie addresses their single-family lines of business. The single-family business is much bigger, but the multifamily business is also an important part of what they do.

The author’s conclude that

Reform of the nation’s housing finance system needs to be careful not to disrupt unnecessarily the existing multifamily housing market. The near collapse of Fannie and Freddie’s single-family business over five years ago resulted in conservatorship and has spawned calls for their termination. While a general consensus has since emerged that Fannie and Freddie should be phased out over time, no consensus exists as to which, if any, of their functions need to be replaced in order to preserve the affordability and availability of housing in general, and multifamily rentals in particular.

On the multifamily side, Fannie and Freddie have built specialized units using financing models that involve private sector risk-sharing (i.e., DUS lender capital at risk or investors holding subordinate tranches of K-series securities) and that have resulted in low default rates and limited credit losses. These units have benefited from an implicit government guarantee of their corporate debt, which has expanded their access to capital and lowered its cost. As a result of the implicit guarantee, Fannie and Freddie have been able to: 1) offer longer term mortgages than generally available from banks, 2) provide countercyclical support to the rental market by funding new mortgages throughout the recent housing and economic downturn, and 3) ensure that the vast majority of the mortgages they fund offer rents affordable to households earning less than even 80% of area median income.

The potential for moral hazard can be reduced without disrupting the multifamily housing market simply by separating out and nationalizing the government guarantee It would then be possible to: 1) spin off the multifamily businesses of Fannie and Freddie into self-contained entities and 2) create an explicit government guarantee, offered by a government entity, and paid for through premiums on the insured MBS. The first step could happen now with FHFA authorization. These new subsidiaries could also begin to pay their respective holding companies for providing the guarantee on their MBS. The second step requires Congressional legislation. Once the public guarantor is up and running, the guarantee would be purchased from it and these subsidiaries could then be sold to private investors. As for other reforms that would explicitly restrict market access to the government guarantee, the best approach would be to first test the private sector’s appetite for risk on higher-end deals. (539-40)

This article has a lot to offer in terms of analyzing how Fannie and Freddie’s multifamily business is distinct from their single-family business. But I do not think that it fully makes the case that the multifamily sector suffers from some sort of market failure that requires so much government intervention as it advocates. I suspect that private capital could be put into a first loss position for much more of the lending in this sector. The government could continue to support the low- and moderate-income rental market without being on the hook for the rest of the multifamily market.

Reiss on GSE Privatization

GlobeSt.com quoted me in Waiting to Say Goodbye to the GSEs. It reads in part,

US HUD Secretary Julian Castro added another “to do” item to the lame duck Congress’ list of things they should get done before they adjourn on Dec. 11: pass the bipartisan Johnson-Crapo Senate bill introduced earlier this year that would wind down the GSEs.

“This could be, I believe, a good victory in the lame duck session or next term of Congress for housing finance reform,” he said in an interview with Bloomberg Television earlier this week. The crux of the plan – doing away with Fannie Mae and Freddie Mac, creating a backstop for these loans and removing tax payer risk – are all supported by the Obama Administration, he said.

“Housing finance reform will continue to be a priority for the Obama Administration,” Castro said.

The multifamily finance industry has been expecting GSE reform for years now; certainly there have been calls for their dismantlement when they were placed in conservatorship in 2008 during the depth of the financial crisis. Many in the industry, in fact, would welcome their sunset, in the expectation that the private sector could fully and more efficiently and more cheaply provide the same level of funding.

That is not the unanimous sentiment though. In fact, opinions about the subject in commercial real estate range, widely, across the board from “it is about time” to “the politics are too strident for it to happen” to “maybe it will happen but it is difficult to believe the GSEs could entirely be replaced by the private sector.”

*     *     *

David Reiss, a professor of Law and Research Director, Center for Urban Business Entrepreneurship (CUBE) at Brooklyn Law School, has been calling for the privatization of Fannie and Freddie for some time and is dismissive of the “Chicken Little claims” that the sector will collapse if the government reduces its footprint in multifamily and single-family housing finance.

“With a carefully planned transition, it is eminently reasonable to believe that we can put private capital in a first loss position for multifamily housing so long as the government retains a role in subsidizing affordable housing and acting as a lender of last resort when necessary,” he tells GlobeSt.com.

Reiss on Privatization of Fannie and Freddie

BadCredit.org profiled an article of mine in Brooklaw Professor Pushes for Privatization of Fannie Mae/Freddie Mac. The profile opens,

Since the end of the Great Recession, policymakers, academics and economists have been struggling with a very difficult question — what should we do with Fannie Mae and Freddie Mac? Should the government continue its role in providing mortgage credit to millions of American?

Fordham University Associate Professor of Law and Ethics Brent J. Horton made a proposal in his forthcoming paper “For the Protection of Investors and the Public: Why Fannie Mae’s Mortgage-Backed Securities Should Be Subject to the Disclosure Requirements of the Securities Act of 1933“:

“The best way to reduce risk taking at Fannie Mae is to subject its MBS offerings to the disclosure requirements of the Securities Act of 1933,” Horton writes.

However, Brooklyn Law School Professor of Law David Reiss believes “the problems inherent in Fannie Mae’s structure are greater than those that increased disclosure can address.”

In his response, titled “Who Should Be Providing Mortgage Credit to American Households?” Reiss points to increased privatization as one way to address the question of what to do with Fannie Mae and Freddi Mac.

Reiss on Who Should Be Providing Mortgage Credit to American Households?

I have posted a short Response, Who Should Be Providing Mortgage Credit to American Households?, to SSRN (as well as to BePress).  The abstract reads,

Who should be providing mortgage credit to American households? Given that the residential mortgage market is a ten-trillion-dollar one, the answer we come up with had better be right, or we may suffer another brutal financial crisis sooner than we would like. Indeed, the stakes are as high as they were in the Great Depression when the foundation of our current system was first laid down. Unfortunately, the housing finance experts of the 1930s seemed to have a greater clarity of purpose when designing their housing finance system. Part of the problem today is that debates over the housing finance system have been muddled by broader ideological battles and entrenched special interests, as well as by plain old inertia and the fear of change. It is worth taking a step back to evaluate the full range of options available to us, as the course we decide upon will shape the housing market for generations to come. This is a Response to Brent Horton, For the Protection of Investors and the Public: Why Fannie Mae’s Mortgage-Backed Securities Should Be Subject to the Disclosure Requirements of the Securities Act of 1933, 89 Tulane L. Rev. __ (forthcoming 2014-2015).