WORD ON THE STREET: The decision to place the government-sponsored enterprises (GSEs) into conservatorship proved to be appropriate, accomplishing the federal government's primary objective of supporting the ongoing availability of mortgage financing during a period of severe market contraction.
The actions of placing the enterprises into conservatorship, along with the financial support provided by the Treasury Department, were designed to maintain stability while providing policymakers time to consider the appropriate course for housing finance reform and the transition from the current enterprise structure. Despite the benefits derived from the Treasury support for enterprises activities, conservatorship is not a long-term solution.
We just passed the three-year anniversary of placing the enterprises into conservatorship. We all knew it was going to be difficult to develop a housing finance reform solution, but we must move forward on this process. As the conservatorships lengthen, the Federal Housing Finance Agency (FHFA) must not only direct the enterprises' activities on various programs consistent with our conservatorship mandates, but also consider how the enterprises should be structured and make investments in business platforms and human capital in the face of an uncertain future.
In thinking about the goals of a future housing finance system, I would start by reiterating the objectives that I shared with the House Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises last year. Our main purpose in addressing housing finance reform should be to promote the efficient provision of credit to finance mortgages for single-family and multifamily housing. I believe that an efficient system of credit allocation should have certain core characteristics: allowing innovation, providing consumer choice, providing consumer protection and facilitating transparency.
While these characteristics provide a set of goals for the future of the housing finance system, there are a number of specific areas related to the current activities of the enterprises that deserve special attention:
- ensuring that the mortgage market has adequate sources of liquidity;
- having the ability to avoid and, if necessary, absorb credit risk; and
- promoting the availability of mortgage credit.
To state the obvious, the key question in the debate on housing finance reform is the future role of the government in achieving these objectives.
We should be clear about this question at the outset. It seems safe to say that there will always be some portion of the housing or mortgage market that will be assisted by government programs, either through direct funding or through guarantees. In the future design of our housing finance system, careful consideration should be given to targeting subsidies to specific groups that lawmakers determine warrant that benefit.
For example, the explicit government guarantees that the Federal Housing Administration (FHA) and Department of Veterans Affairs provide reflect policymakers' judgment as to the public benefits from targeting certain borrowers with those programs. This is also the case with other programs provided by the Department of Housing and Urban Development.
Gven that there will be a role for the government in the aforementioned areas, a further refinement of the key question regarding the government's role in housing finance is what type of structure is necessary to replace the activities that are currently undertaken by the enterprises.
There seems to be relatively broad agreement that the GSE model of the past, where private-sector companies were provided certain benefits and charged with achieving certain public policy goals, did not work. That model relied on investors providing funding for housing at preferential rates based on a perception of government support, which ultimately turned out to be correct and has resulted in the GSEs' drawing $169 billion in funds from the Treasury as of Sept. 30.
Several proposals have been put forth on developing a housing finance system with some type of government guarantee. Clearly, if the securities offered in a reformed housing finance market have a government guarantee, those securities will be priced favorably and will have a high degree of liquidity to reflect that guarantee.
However, those securities would not have the benefit of market pricing for credit risk of the underlying mortgages. In these structures, much like the banking system and deposit insurance, private-sector capital through equity investment would stand in a first-loss position, with a government guarantee that was funded through an insurance premium being available to cover other losses. This type of structure requires a significant amount of regulatory safety and soundness oversight to protect against the moral hazard associated with providing a government guarantee.
While such an outcome has certain merit and some attractive features, the potential costs and risks associated with such a framework should be fully explored. To put it simply, replacing the enterprises' implicit guarantee with an explicit one does not resolve all the shortcomings and inherent conflicts in that model, and it may produce its own problems. Last year before this subcommittee, I offered three observations in that regard for your consideration.
First, the presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default, at least at any price that most would consider reasonable – or cannot manage that amount of mortgage credit risk on its own. But we might ask whether there is reason to believe that the government will do better. If the government backstop is underpriced, taxpayers eventually may foot the bill again.
Second, if the government provides explicit credit support for the vast majority of mortgages in this country, it would likely want a say with regard to the allocation or pricing of mortgage credit for particular groups or geographic areas. The potential distortion of the pricing of credit risk from such government involvement risks further taxpayer involvement if things do not work out as hoped.
Third, regardless of any particular government allocation or pricing initiatives, explicit credit support for all but a small portion of mortgages, on top of the existing tax deductibility of mortgage interest, would further direct our nation's investment dollars toward housing. A task for lawmakers is to weigh such incentives against the alternative uses of such funds.
The Private Mortgage Market Investment Act discussion draft
Another approach, as set forth in the discussion draft of the Private Mortgage Market Investment Act is to establish a functioning mortgage-backed securities market through replacing some of the standard-setting that the enterprises undertake today with a regulatory regime that sets those standards. This model would not rely on a government guarantee to attract funding to the mortgage market, but rather would look to standardization and rules for enforcing contracts to provide a degree of certainty to investors.
While we have not had time to fully evaluate the discussion draft, the focus is on setting standards around key features that investors need to know to be willing to price credit risk in the mortgage market. These include standards associated with underwriting, pooling and servicing, and disclosures. The model proposed in the discussion draft also tries to preserve some of the liquidity in today's mortgage-backed securities market by establishing buckets of securities that have similar credit characteristics and loan terms.
Clearly, the framework envisioned in the discussion draft is much different than a framework that has a government guarantee. Investors would be required to price the credit risk of mortgages. They also would be responsible for enforcing their rights under the standard contracts developed under this framework. Those requirements are consistent with the way that a private market functions.
We look forward to further considering the framework set forth in the discussion draft. Some areas that deserve further consideration include the following:
- Standardization will help to develop a private mortgage-backed securities market. Are there other areas in terms of monitoring or compliance that could potentially broaden the investor base while still achieving the primary function of having private markets price credit risk?
- Preserving the availability of credit in times of stress is an important function. Is there a role for the government, perhaps for the FHA to take on this role if necessary?
- Preserving liquidity in the market and the financial system in this framework would be an important function. Is there a need for a backstop source of funding when financial markets become temporarily illiquid? For example, could the Treasury Department, the Federal Reserve or the Federal Home Loan Banks play a role in a market that had this type of standardized structure?
These are just some of the issues that will have to be thought through as the process moves forward on building out this framework.
The process of undertaking housing finance reform is difficult. The discussion draft is a thoughtful approach to a framework that does not rely on a government guarantee. The final decision that policymakers must make involves determining what structure will provide a functioning housing finance market and does not place taxpayers at risk.
Edward DeMarco is the acting director of the Federal Housing Finance Agency. This article was adapted that DeMarco gave before the House Financial Services Committee on Nov. 3. To read his complete testimony, click here.
