The voices of Urban Institute's researchers and staff
April 21, 2014

Suggestions for housing finance reform

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A major step toward meaningful housing finance reform, the Johnson Crapo discussion draft (S.1217), is scheduled for markup on April 29. Two of the bill’s important features, however, are cause for concern: the dual structure for private capital and the mechanics of the affordable housing flexible incentive fee. In our new commentary, we explain our concerns, and suggest solutions for both sets of issues.

The problems with dual structure

One of the goals of housing finance reform is to increase the supply of private risk capital in the housing market. Today, about 80 percent of new mortgage originations are backed by the federal government, while the other 20 percent are almost entirely in bank portfolios. Yet in 2002, before the housing bubble, the government share (of a much larger market) was slightly over 50 percent. Johnson Crapo, like the initial version introduced by Senators Bob Corker (R-TN) and Mark Warner (D-VA), provides for a catastrophic government guarantee to support the liquidity of certain mortgage-backed securities (MBS). In both bills, the guarantee can be accessed through either of two channels: (1) by well-capitalized credit insurers (“guarantors”) and (2) by entities who pool mortgages into securities (“aggregators”) through individual capital markets structures (“capital markets execution”). In theory, the two channels should increase competition and reduce mortgage interest rates.

In practice, the dual structure raises three major concerns:

  • It will be close to impossible for regulators to ensure that the capital markets execution is backed by capital of equivalent quantity and quality as that backing the guarantors. Capital markets investors are on the hook for 10 percent on a given deal; guarantors are on the hook until they go out of business, with excess capital from some groups of loans absorbing the losses from others. The result: in good times, the capital markets execution will both attract the lowest risk loans and dominate the market.
  • Because capital markets are volatile and fickle, their dominance during good times may well be followed by flight during periods of uncertainty. We are concerned that when that happens, the guarantors will be unable to ramp up quickly enough to keep the market operating and housing credit available—this is the situation we would have seen in 2008 had Fannie Mae and Freddie Mac not been available.
  • Because of the variety of potential capital markets structures, and the amount of information private investors will demand to put their capital at risk, those MBS will likely not be eligible for the To Be Announced market. The result will be reduced liquidity in a market that is critical to both interest rate lock-ins for consumers and portfolio management by many fiduciaries.

We conclude that the capital markets execution adds excessive volatility, complexity, and uncertainty to the housing finance system, and recommend that it be deleted in favor of the guarantor channel.

Johnson Crapo establishes a series of strategies relating to affordable housing and “the broad availability of mortgage credit,” including the creation of an affordable housing fee in section 501. To incent aggregators and guarantors to serve underserved markets, the bill has an incentive structure for the fee, which must average 10 basis points (bps) on all guaranteed MBS. While innovative and intriguing, it poses some concerns:

  • The fee would be determined after the close of each year, a process that makes it highly unlikely that the incentive’s benefit will be passed through to borrowers, reducing the incentive to increase the supply and affordability of loans to underserved markets.
  • The fee attempts to incent activity in up to eight market and product categories and requires that aggregators and guarantors be evaluated in three different ways, including against each other. It is unclear how guarantors (who are likely to be quite diversified) and aggregators (who are more likely to be small and specialized) can be ranked together. And the calculation’s complexity will dampen the fee’s incentive impact.
  • The bill’s requirement that the highest fee not exceed twice the lowest, combined with the fact that the fee is only charged on guaranteed MBS and the requirement that all fees average 10 bps, reduces the effect of the incentive on both market participants and borrowers.

The impact of the incentive could be improved by structuring it as a fee schedule, known in advance, for serving underserved and other markets. If underserved markets were 10 percent of the total market, and loans to adequately served markets were assessed at 15 bps, the cost of mortgages for underserved markets could be reduced by 35 bps, thereby incenting both primary and secondary market participants to offer underserved markets prices that compensate participants for any additional risk and are attractive to borrowers.

Johnson Crapo represents important movement toward housing finance reform.  We hope our suggestions will help the process.

House photo from Shutterstock.

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As an organization, the Urban Institute does not take positions on issues. Experts are independent and empowered to share their evidence-based views and recommendations shaped by research.

Comments

What can be done for home owners with excellent credit rating who would like to re-fi to take advantage of low rates but are required to pay private mortgage insurance because their houses values haven't recovered . PMI should be eliminated for consumers with good credit. Help stop this insanety