Is Housing Finance Reform Coming at Last?

With the nation’s focus on the latest fiscal crisis in Washington, Congress has paid scant attention to necessary reforms to Fannie Mae and Freddie Mac. The Bipartisan Policy Center’s Housing Commission just released its report on housing finance reform, and it should help refocus attention to this crucial issue.

As we move to overhaul housing finance, let us remember how we got to this point. Private risk-taking led to a race to the bottom unconstrained by either market discipline or government oversight. Weak regulation was a recipe for a vicious cycle of deteriorating standards in practices on all levels of the mortgage market: lenders and brokers; Wall Street firms that packaged and securitized these mortgages; and the credit rating agencies that rated them.

Fannie Mae and Freddie Mac were eventually caught up in this destructive race.  They had lost market share as standards deteriorated around them, and they made poor strategic choices to try to gain some of that market share back. They took on too much risk in order to grow their retained portfolios, increase returns, and inflate bonuses. The market did not discipline management’s decisions because the market assumed Fannie and Freddie had a government backstop. And their regulator lacked standing and authority to substitute the discipline that was missing.  

Passage of the Dodd-Frank Act in 2010 now gives regulators the necessary tools to clean up bad practices in the origination, servicing and securitization of mortgage loans. The Act should help end races to the bottom. And Fannie Mae and Freddie Mac are now under strict conservatorship. But unfortunately, legislative reform of Fannie Mae and Freddie Mac has remained stalled since their collapse in Fall 2008.

Perhaps broad bipartisan agreement on a path forward can help to jumpstart the process. Here’s what the unanimous panel of leading Republicans and Democrats agreed:

  1. Fannie Mae and Freddie Mac, still under conservatorship, need to be gradually wound down and eliminated.
  2. We need to get the private sector, through first-loss securitization, private mortgage insurance, and other means, to bear all but the catastrophic losses in housing, not taxpayers.
  3. The 30-year fixed rate mortgage is an important option for American families. American homeowners are not the best bearers of interest-rate risk in our economy. To have a robust and liquid market for such mortgages for most households, there needs to be a government guarantee.
  4. Public insurance, in the form of an explicit, fully funded guarantee of mortgage-backed securities meeting safe guidelines, should be provided. No more unfunded “implicit” backstops for private, shareholder owned entities playing “head’s I win, tails you lose.” Public insurance would only step in if the mortgages defaulted and the private sector first-loss provider went broke.
  5. Access to affordable and sustainable mortgage credit and affordable rental housing is a critical value, and should be funded in part by guarantee fees. A balanced approach to housing requires not only ownership but also rental options. Affordable rental housing also requires governmental support, a government guarantee for certain financing, and tax incentives.

These are important areas of agreement on the path forward.

There are, to be sure, details to be worked out. The insurance entity or “public guarantor” would need to be strong and independent, like the Federal Reserve or FDIC, funded through a portion of the guarantee fee. It would need to have sufficient supervisory and regulatory powers to make sure that the private sector played by the rules—on origination, servicing, securitization, and modifications. Capital requirements on the private-sector first-loss providers would need to be robust and strictly supervised by the public guarantor. We need to be sure that the new system is set up to serve the entire market fairly and efficiently. And the system needs to work well in times of stress, unlike the system we have had.

In the meanwhile, there are a number of steps that can and should be taken under existing law. Regulators need to put in place well-aligned rules for risk retention in securitization, ability-to-pay requirements for originations, and standards for loans to be guaranteed by Fannie Mae, Freddie Mac, and the Federal Housing Administration. New servicing standards, including rules regarding loan modifications, need to be strongly enforced, with careful attention paid to incentives in the system. The size limits for loans guaranteed by these entities need to be gradually reduced, so that fully private securitization predominates in a broader “jumbo” mortgage market. Guarantee fees need to match risks and costs, and not be siphoned off by the Congress for other purposes. The retained portfolios of Fannie Mae and Freddie Mac need to continue to be reduced.

The Senate also needs to confirm permanent Directors for the Federal Housing Finance Administration (the regulator of Fannie Mae and Freddie Mac) and for the Consumer Financial Protection Bureau (responsible for overseeing consumer protection in the mortgage markets).

Now Congress needs to come together around long-needed housing finance reform.