In the aftermath of the greatest housing crisis since the Great Depression, a fundamental debate is under way about the architecture of U.S. mortgage markets. At the heart of this debate is the future of Fannie Mae and Freddie Mac, the so-called government-sponsored enterprises (GSEs) that support the retail mortgage market. The eventual decision will have major implications for households and communities for generations to come.
The dominant proposals being offered rely heavily on private securitization of mortgages and minimize the role of the federal government in housing finance. For those who observed with alarm the house of cards built by Wall Street's speculative mortgage products since the late 1990s, relying on private securitization and minimizing federal involvement to remedy the ensuing crisis may seem more than a bit odd.
In the late 1990s, subprime securitization engineered by investment bankers fueled the stripping of home equity from vulnerable homeowners and littered central-city neighborhoods with vacant properties. This "private label" securitization -- so called because its sponsors did not go through Fannie or Freddie -- fueled the largest housing boom and bust that the nation has ever seen. If reforms are dominated by private-label securitization, they are unlikely to restore a system that will provide loans that are both affordable and sound.
FROM PUBLIC AGENCY TO PRIVATE SPECULATION
Some history is in order to provide context. From its creation in 1938 until the late 1960s -- a period of growing middle-class homeownership and stable mortgage markets -- the Federal National Mortgage Association -- or FNMA, nicknamed Fannie Mae -- was not a "government sponsored" private enterprise. It was first a government agency -- and later a government-owned corporation -- created to purchase Federal Housing Administration (FHA)-insured loans from lenders in order to provide them with the liquidity they needed to make more loans. This government invention became known as the secondary mortgage market. Fannie financed its own operations by selling bonds.
Then, during the Vietnam War era, Fannie Mae was privatized. Thus began its status as a GSE, a private corporation with a public mission (providing housing credit) and a tacit government guarantee of its bonds. Soon thereafter, in 1970, a second GSE was created, the Federal Home Loan Mortgage Corporation, nicknamed Freddie Mac. In the 1970s, the two GSEs began pooling and securitizing conventional mortgages, leaving FHA loans to be securitized via the still public Government National Mortgage Association, inevitably nicknamed Ginnie Mae. (Ginnie and its partner, the FHA, incidentally, came through the recent crisis relatively unscathed.)
In the 1980s and 1990s, Fannie Mae and Freddie Mac expanded. They became a bigger risk to the U.S. economy because they were lightly regulated and increasingly behaved more like their purely private competitors. Then, in the 1990s and 2000s, Wall Street firms began issuing risky private-label mortgage-backed securities, whose lower standards did not require approval of the GSEs, to provide funding to subprime lenders. As subprime lending and its close cousin, "Alt-A" mortgages, boomed in the 2000s, the GSEs lost market share in the secondary market. To please their shareholders and regain market share, the GSEs began to enter higher-risk, higher-return segments of the mortgage market, first by investing in private-label securities. Later, in the mid-2000s, they began purchasing some riskier loans themselves, especially Alt-A loans, which typically required little or no borrower income documentation. Fannie and Freddie also beat back legislative efforts to increase regulatory oversight and the amount of equity capital they would need to hold in the event of financial problems.
By the eve of the collapse, the GSEs were engaged in purchasing individual mortgages from lenders and securitizing large pools of these mortgages by selling bonds to investors. They were also providing bond insurance on their securitizations and investing their own capital in both individual mortgages and private-label securities.
The subprime collapse took down Fannie and Freddie, which were deeply invested in subprime securities. The federal government put Fannie and Freddie into receivership in order to stabilize mortgage markets. Since the collapse of subprime and related mortgage-backed securities in 2007, the private-label market for mortgage-backed bonds has all but dried up, and the GSEs have funded almost all home loans other than those insured by the FHA.
BACK TO THE FUTURE
The reform of the secondary mortgage market is now the subject of a fierce debate that has ideological, political, and interest-group dimensions. Free-market purists want government out of the business of financing or insuring mortgage loans. The premise is that this activity is better handled by the free market, and if the result is more barriers to home-ownership, this is just the correct and necessary verdict of the market.
Most of the housing industry -- realtors, homebuilders, mortgage bankers, and affordable-housing advocates -- wants to retain some government involvement, for fear of an even steeper housing-market collapse. However, there is little support for continuing Fannie and Freddie in their present form. The large investment banks that invented private-label securities would like to provide many of the functions now served by Fannie and Freddie, though they want a government backstop to protect them against catastrophic failure and to help draw in critical investment capital.
In February, the Obama administration laid out three broad policy options for the long-term restructuring of the GSEs: 1) full privatization of secondary mortgage markets; 2) privatization with an "emergency" federal guarantee that would kick in only in crisis situations; and 3) a system of insuring mortgage-backed securities through a number of federally chartered, private mortgage-bond insurance firms, or "private mortgage guarantors." These firms would put private capital at risk before a federal reinsurance backstop would kick in. In option 3, Wall Street sees yet another new profit center, with government protecting against losses.
The options proposed by the administration seem to have been chosen based primarily on their ability to draw global capital back into the U.S. housing market relatively quickly, with less attention given to whether they will provide for a sound, fair, and affordable mortgage market. Moreover, some of the options are unlikely to reduce the mortgage market's systemic risks to taxpayers.
THE PERILS OF PRIVATIZATION
Options 1 and 2 -- those effectively calling for privatization -- are the simplest to understand and are popular with Tea Party-wooing politicians who have latched onto "the GSEs did it" narrative of the mortgage crisis -- one that seems to persist no matter the evidence to the contrary. Fans of privatization are frequently also in favor of repealing the Dodd-Frank Act. They would reinvent the same elements of the system that generated the subprime debacle. Some privatization proponents cling to the myth that government involvement in mortgage markets was a primary cause of the subprime crisis. In fact, it was too little, not too much, federal involvement -- especially in terms of regulation -- that was the main culprit. The crisis stemmed from under -- regulated mortgage markets that had become fragile, overly leveraged, and highly susceptible to changes in home values.
None of this is to argue that the GSEs were sufficiently regulated. And the GSEs certainly participated in the subprime and Alt-A lending booms, especially by investing in private-label securities. However, they played a subordinate and trailing role. The core activity of the GSEs is to directly purchase loans. In the run-up to the crash, these loans were predominantly prime mortgages. Despite housing-price declines of at least 30 percent, they have held up far better than mortgages funded by private-label securities. It was the loss of GSE market share that led Fannie and Freddie to invest in private-label bonds and purchase Alt-A mortgages. Weak regulation and pursuit of profit for their shareholders -- not carrying out their public mission -- led Fannie and Freddie to invest in riskier assets.
Privatization proponents argue that, by removing explicit guarantees from the housing-finance system, they will protect taxpayers. This is a fatal mistake. The mortgage market will always be a large part of the economy and is increasingly dominated by a few large and potentially systemically important banks. As a result, implicit "too big to fail" guarantees will not be eliminated under a privatization scheme. On the contrary, without limited and explicit guarantees and associated oversight, the problem of implicit guarantees and their probability of being used actually increases. Moreover, as large banks are liable for poorly underwritten loans, other explicit federal guarantees -- in the form of deposit insurance -- come into play. The U.S. mortgage market is simply too large and systemically intertwined to be isolated from federal guarantees.
"Housing-finance risk is inherently socialized because of the centrality of housing to society and as an investment," says Adam Levitin, a Georgetown University law professor and widely recognized expert on mortgage markets. "The only question is whether the risk is socialized implicitly or explicitly." What is referred to as "privatization" ignores the reality that these plans would almost certainly result in large and systemically important firms dominating the market, firms that will benefit from both explicit and implicit federal guarantees. As Janneke Ratcliffe, executive director of the Center for Community Capital at the University of North Carolina, recently told members of the Senate Banking Committee, "History has shown us that a housing-finance system left to private markets will be subject to a level of volatility that is not systemically tolerable."
Mortgages and housing values are susceptible to contagion effects that spread from home to home. Risky lending and higher foreclosures depress property values, leading to higher foreclosure rates among nearby homes, even among those with conservatively underwritten mortgages. Housing-finance systems should not fuel pricing booms that provide the basis for subsequent busts.
Because of these vicious cycles and interactions, mortgage markets are not like most other markets, where the harm from unwise transactions is mostly limited to the buyers and sellers. Moreover, contagion effects, and the size of the housing sector, mean that securitization and financial derivatives often spread -- and magnify -- risks that can trigger global financial problems. This means that it is important to develop mortgage-market systems that leave little room for reckless lending -- and that effectively crowd out irresponsible, high-risk lenders. One way to do this is to write and enforce strong regulations. However, the vigor of regulation will inevitably ebb and flow over time. Therefore, an important complement to regulation is to preclude irresponsible or unaffordable loans in the design of the system itself.
THE CAP PROPOSAL: IMPROVING ON OPTION 3
Several groups -- including the powerful Financial Services Roundtable representing the banking industry -- have offered plans similar to the administration's option 3. Among the stronger of these is a proposal prepared by the Mortgage Finance Working Group convened by the Center for American Progress.
The CAP proposal is similar to option 3 in that it relies primarily on federal reinsurance of federally chartered mortgage-bond insurers as the key vehicle for supporting the mainstream mortgage market. However, the CAP proposal includes several improvements and specifications. These include a duty-to-serve, or anti-creaming, provision that seeks to prevent bond insurers from creaming off more affluent market segments. It also provides funding measures and tools to support affordable homeownership and rental housing. The CAP proposal also calls for tight regulation of the bond insurers, explicitly favors long-term, "plain vanilla" fixed-rate mortgages, and calls for strong consumer-protection and financial regulations.
Despite such improvements, the CAP model relies too heavily on the assumption of a near flawless regulatory system. But recent history shows that purveyors of complex mortgage products tend to overwhelm regulators. It is preferable to design a simpler, more transparent, and more public system.
Even when Congress legislates strong rules, those measures are often weakened in later years or made obsolete by structural changes in financial markets. Regulatory agencies frequently fail to enforce the statutes adequately. A critical complementary strategy to stronger regulation is to constrain risk and irresponsible finance via the structure of the housing-finance system itself. The privatization proposals clearly fail in this respect. Option 3 and the CAP proposal are better than the others, but they are still overly dependent on regulators looking over the shoulders of the private securitization market, which is likely to seek opportunities to "innovate" around their regulators.
A key, underlying assumption of all three of the administration's policy options is that, as secondary markets are dominated -- and controlled -- by private capital, they will become more accountable and averse to risky lending. There is certainly an argument for developing systems where lenders, investors, and servicers have interests that are aligned with sound and fair lending. But it is not at all clear that minimizing government involvement in secondary markets or marginalizing it to an indirect role will be a successful approach for achieving these ends, especially in the long run. Over the last 60 to 70 years, the only period during which a large portion of the mortgage market was essentially "privately" funded was the subprime-dominated period of the mid-2000s. From the 1930s through the late 1960s, deposits at commercial banks and savings and loan associations used for funding mortgages were fundamentally enabled by federal deposit insurance, and the secondary mortgage market was fundamentally a public institution.
The subprime crisis revealed the myriad conflicts among the many parties involved in the mortgage-origination and securitization chain. By precluding a direct government role, option 3 and its variants would make it more difficult to ensure that the mortgage market limits risks and conflicts of interest. While the CAP proposal generally prohibits access to federal reinsurance for high-risk loans, the plan builds in a constituency that will seek to push the envelope -- and lobby for increasingly relaxed boundaries on what can be included in insured pools. In the face of weakened standards or regulations in the CAP or option 3 models, competition among bond insurers could result in a race to the bottom, where lax insurers would be able to gain market share, just as Wall Street issuers of private-label securities captured market share from the GSEs.
A PUBLIC OPTION
A better alternative to all of these variants on privatization would be a model based on the advantages of government authority, centralization, standardization, and transparency. A government-owned corporation -- call it the Public Mortgage Corporation, or PMC -- with a public purpose would purchase mortgages and issue securities. This corporation would have no private shareholders and would return any excess earnings to the U.S. Treasury, much the way the Federal Reserve does.
The corporation would be prohibited from lobbying and be governed by a presidentially appointed governing body including members from the financial-services and housing industries as well as individuals with backgrounds in consumer protection, community development, and other areas. The PMC would not be a line agency of the government and would be given substantial autonomy to change guidelines and procedures for its operations, with only occasional review by Congress. However, there would be broad oversight of the PMC by Congress as well as an inspector general to ensure that the PMC was maintaining sound lending and securitization standards, that its fees were actuarially sound, and that it was not engaging in either disparate treatment or disparate impact discrimination of any sort. Moreover, the PMC would impose a fee on all securitization activity that would be used to provide support for affordable homeownership and rental-housing programs in safe and sound ways.
The PMC would provide only partial insurance for most of its mortgage-backed securities, with insurance levels dropping for bonds comprising larger loans and/or lower-risk borrowers. Moreover, it would be able to work in partnership with private bond insurers to blend private and public sources of insurance and leave private insurers to bear the first loss. The PMC proposal shares many of the goals of the CAP proposal. However, by centralizing the purchase, aggregation, and securitization processes, it will work to crowd out many issuers of dubious mortgage products.
The fundamental goal is to create a governance structure that provides public accountability to the primary mechanisms of the purchase, pooling, and securitization of mortgages. Providing a government-controlled, centralized, and standardized channel through which most mortgages flow will reduce housing-market and systemic risks compared to a privatized market where profit can be extracted by concealing rather than revealing underlying risks. It should also prove more efficient.
Some skeptics have expressed concern that a government-owned securitization firm would not be able to recruit the talent needed to maintain strong secondary markets. However, the PMC would not need to be subject to regular government salary caps and, like banking regulators, would be able to pay more to recruit staff with sufficient financial experience. At the same time, the goal should not be to use oversized salaries to recruit those normally attracted to high-risk Wall Street jobs. The goal, in fact, should be to limit the speculative nature of employment in mortgage securitization and motivate employees through generous but reasonable salaries and other career-building benefits. Organizations such as the Centers for Disease Control and Prevention, the National Institutes of Health, the government labs, and many other organizations have demonstrated that top-flight talent can be attracted and retained without mammoth salaries. The talents, skills, and knowledge needed in these organizations are at least as demanding as those needed in the secondary-mortgage -- market arena. After all, secondary markets are not rocket science, and if they begin to look like rocket science, we are setting ourselves up for more problems.
One of the key advantages of the GSEs loan circuit compared to the private-label securities circuit was the much greater degree of standardization in loan origination, securitization, and servicing. There was also far greater transparency. Some argue that the privatization and bond reinsurance models would provide more opportunities for "innovation." However, the financial collapse was partly caused by innovations intended to conceal and shift risks. And the potential for real innovations that benefit home-owners is more limited than private securitization proponents contend. If the collapse demonstrates anything, it shows that financial innovation should be carefully regulated. The PMC model would allow for careful and reasonable innovations that serve the interests of borrowers as well as lenders.
Whatever the final model, it should be judged on its ability to provide the public with some of the benefits from mortgage-market securitization, instead of solely having to absorb the downside of risks. Most important, the structure should complement and reinforce improved regulation in reducing the volatility of mortgage and housing markets by providing for a reliable governing mechanism on the flow of capital to finance affordable and secure homeownership.