PROJECTHousing Finance Reform Incubator

Alex J. Pollock: Seven Steps to Housing Finance Reform
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April 5, 2016

The giant American housing finance sector is as important politically as it is financially, which makes it hard to reform.  From the 1980s on, it was unique in the world for its overreliance on the “government-sponsored enterprises” (“GSEs), Fannie Mae and Freddie Mac—privately owned but privileged and with “implicit” government guarantees.  According to Fannie and Freddie, their lobbyists, and members of Congress reading scripts from Fannie in its former days of power and glory, this made American housing finance “the envy of the world.”  In fact it didn’t, and the rest of the world did not experience such envy.  But Fannie and Freddie did attract investment from the rest of the world, which correctly saw them as U.S. government credit with a higher yield: this channeled the savings of thrifty Chinese and others into helping inflate American house prices into their historic bubble.  Fannie and Freddie were a highly concentrated point of systemic vulnerability.

Needless to say, Fannie and Freddie, and American housing finance in general, then became “the scandal of the world” as they went broke.  What schadenfreude my German housing finance colleagues enjoyed after years of being lectured by the GSEs on the superiority of the American system.  Official bodies in the rest of the world pressured the U.S. Treasury to protect their investments in the insolvent Fannie and Freddie, which of course it did and does.  The Treasury is also protecting the Federal Reserve, which in the meantime became the world’s biggest investor in Fannie and Freddie securities.  

More than seven years later, America is still unique in the world for centering its housing finance sector on Fannie and Freddie, even though they have equity capital that rounds to zero.  Now they are primarily government-owned and entirely government-controlled housing finance operations, completely dependent on the taxpayers.  Nobody likes this situation, but it already outlasted numerous reform proposals.

Is there a way out that looks more like a market and less like a statist scheme?  A way that reduces the distortions of excessive credit that inflates house prices, runs up leverage, and sets up both borrowers and lenders for failure—in other words, can we reduce of the chance of repeating the mistakes of 1980 to 2006?  I suggest seven steps to reform American housing finance:

  1. Turn Fannie and Freddie into SIFIs at the “10% Moment”

  2. Enforce the law on Fannie and Freddie’s guarantee fees

  3. Encourage skin in the game from mortgage originators

  4. Form a new joint FHLB mortgage subsidiary

  5. Create countercyclical LTVs

  6. Reconsider local mutual self-help mortgage lenders

  7. Liquidate the Fed’s MBS portfolio

 

1. Turn Fannie and Freddie into SIFIs at the “10% Moment”

The original bail out deal for Fannie and Freddie created a senior preferred stock with a 10% dividend.  As everybody knows, the amended deal makes all their net profit a dividend, which means there will never be any reduction of the principal, no matter how much cash Fannie and Freddie send the Treasury.  It is easy, however, to calculate the cash-on-cash internal rate of return (IRR) to the Treasury on its $189.5 billion of senior preferred stock. So far this is about 7%-- positive, but short of the required 10%.  But as Fannie and Freddie keep sending cash to the Treasury, the IRR will rise, and will reach a point when total cash paid is equivalent to a 10% compound return plus repayment of the entire principal.  That is what I call the “10% Moment.”  It provides a uniquely logical point for reform, and it is not far off, perhaps late 2017- early 2018.

At the 10% Moment, whenever it arrives, Congress should declare the senior preferred stock fully repaid and retired, as in financial substance it will have been.  Simultaneously, Congress should formally designate Fannie and Freddie as Systemically Important Financial Institutions (SIFIs).  That they are indeed SIFIs, able to put not only the entire financial system but also the finances of the U.S. government at risk, is beyond the slightest doubt.

As soon as Fannie and Freddie are officially, as well as in economic fact, SIFIs, they will get the same minimum capital requirement as bank SIFIs: 5% of total assets.  At their current size, this would require about $250 billion in equity.  This is a long trip from zero, but they could start building capital, while of course being regulated as undercapitalized until they aren’t.  Among other things, this means no dividends on any class of stock until the capital requirement is met.

As SIFIs, Fannie and Freddie will get the Fed as their systemic risk regulator.  In general, they should be treated just like big bank SIFIs.  Just as national banks have the Fed as well as the Comptroller of the Currency, they will have the Fed as well as the FHFA. 

Since it is impossible to take away Fannie and Freddie’s too-big-to-fail status, they should pay the government for its ongoing credit guaranty, just as banks pay for theirs.  I recommend a fee of 0.15% of total liabilities per year.

Fannie and Freddie will be able to compete in mortgage finance on a level basis with other SIFIs, and swim or sink according to their competence.

2. Enforce the law on Fannie and Freddie’s guarantee fees

In the Temporary Payroll Tax Cut Continuation Act of 2011, Title IV, Section 401, “Guarantee Fees,” Congress has already decided how Fannie and Freddie’s guarantee fees (g-fees) must set.  Remarkably, the law is not being obeyed by their conservator, the Federal Housing Finance Agency. 

The text of the statute says the guarantee fees must “appropriately reflect the risk of loss, as well the cost of capital allocated to similar assets held by other fully private regulated financial institutions.” [italics mine]

This is unambiguous.  The simple instruction is that Fannie and Freddie’s g-fees must be set to reflect the capital that private banks would have to hold against the same risk, and also the return private banks would have to earn on that capital.  The economic logic is clear: to get private capital into the secondary mortgage market, make Fannie and Freddie price to where private financial institutions can fairly compete.

This is in fact a “private sector adjustment factor,” just as the Fed must use for its priced services.  The difference is that the Fed obeys the law, and the FHFA doesn’t.

Of course, the FHFA finds this legislative instruction highly inconvenient politically, so ignores it or dances around it.  But Congress didn’t write the act to ask the FHFA what it liked, but to tell it what to do.  The FHFA needs to do it.

3. Encourage skin in the game for mortgage originators

A universally agreed-upon lesson from the American housing bubble was the need for more “skin in the game” of credit risk by those involved in mortgage securitization.  But lost in most of the discussion was the optimal point at which to apply credit risk skin in the game.  This point is the originator of the mortgage loan, which should have a junior credit risk position for the life of the loan.  The entity making the original mortgage is in the best position to know the most about the borrower and the credit risk of the borrower.  It is the most important point at which to align incentives for creating sound credits.

The Mortgage Partnership Finance (MPF) program of the Federal Home Loan Banks was and is based on this principle.  (I had the pleasure of leading the creation of this program.)  The result was excellent credit performance of the MPF mortgage loans, including through the crisis.  The principle is so obvious, isn’t it?

I do not suggest making this a requirement for all originators, but to design rules and structures in mortgage finance to encourage this optimal credit strategy.

4. Form a new joint FHLB mortgage subsidiary

Freddie Mac was originally a wholly-owned, joint subsidiary of the twelve Federal Home Loan Banks (FHLBs).  Things might have turned out better if it had remained that way.

FHLBs (now there are eleven of them) are admirably placed to operate secondary markets with the thousands of smaller banks, thrifts and credit unions—and perhaps others-- that originate mortgages in their local markets.  As lenders to these institutions, FHLBs know and have strong ability to enforce the obligations of the originators, both as credit enhancers and as servicers.  But to be competitive, and for geographic diversification, they need a nation-wide scope.

The precedent for the FHLBs to form a nationally operating mortgage subsidiary is plain.  They should do it again.

5. Create countercyclical LTVs

As the famous investor, Benjamin Graham, pointed out long ago, price and value are not the same:  “Price is what you pay, and value is what you get.”  Likewise in mortgage finance, the price of the house being financed is not the same as its value, and in bubbles, prices greatly exceed the sustainable value of the house.  Whenever house prices are in a boom, the ratio of the loan to the sound lendable value becomes something much bigger than the ratio of the loan to the inflated current price.

As the price of any asset, including houses, goes rapidly higher and further over its trend line, the riskiness of the future price behavior becomes greater--the probability that the price will fall a lot keeps increasing.  Just when lenders and borrowers are feeling more confident because of high collateral “values” (really prices), their danger is in fact growing.  Just when they are most tempted to lend and borrow more against the price of the asset, they should be lending and borrowing less.

A countercyclical LTV (loan-to-value ratio) regime would reduce the maximum loan size relative to current prices, in order to keep the maximum ratio of loan size to underlying lendable value more stable.  The boom would thus induce smaller LTPs (loan-to-price ratios), steadier LTVs, and greater down payments in bubbly markets—thus providing an automatic dampening of the price inflation and a financial stabilizer.

Often discussed are countercyclical capital requirements for financial institutions, which reduce the leverage of those lending against riskier prices.  The same logic applies to reducing the leverage of those who are borrowing against risky prices.  We should do both.

Canada provides an interesting example of where countercyclical LTVs have actually been used.

6. Reconsider local mutual self-help mortgage lenders

In the long-forgotten history of mortgage lending, an important source of mortgage loans were small, mutual associations owned by their depositors and operating with an ethic that stressed saving, self-discipline, self-help, mutual support, and home ownership.  Demonstrated savings behavior and character were key qualifications for borrowing.  The idea of a mortgage was to pay it off.

In the Chicago of 1933, for example, the names of such associations included:  Amerikan, Archer Avenue, Copernicus, First Croatian, Good Shepherd, Jugoslav, Kalifornie, Kosciuszko, Narodi, Novy Krok, Polonia, St. Paul, St. Wenceslaus, Slovak, and Zlata Hora…you get the idea.

In my opinion, the ideals of these mutual associations are worth remembering and reconsideration; they might be encouraged (not required) again.  We would have to make sure that current loads of regulatory compliance costs are not allowed to smother any such efforts at birth.

7. Liquidate the Fed’s MBS portfolio

What is the Fed, a central bank, doing holding $1.7 trillion of mortgage-backed securities (MBS)? The founders of the Fed and generations of Fed officers since would have found that impossible to imagine.  The MBS portfolio exists because the Fed was actively engaged in pushing up house prices, as part of its general scheme to create “wealth effects,” by allocating credit to the housing sector using its own balance sheet.  It succeeded— house prices have not only risen rapidly, but are back over their trend line on a national average basis. 

Why is the Fed still holding all these mortgages?  For one thing, it doesn’t want to recognize losses when selling its vastly outsized position would drive the market against it.  Some economists argue that even big losses do not matter if you are a fiat currency central bank.  Perhaps not, but they would be embarrassing and unseemly.

Whatever justification there may have been in the wake of the collapsed housing bubble, the Fed should now get out of the business of manipulating the mortgage market.  It can avoid recognizing any losses by simply letting its mortgage portfolio steadily run off to zero over time through maturities and prepayments.  It should do so, and cease acting as the world’s biggest savings and loan.

Especially with the reforms to Fannie and Freddie discussed above, we would get closer to having a market price of mortgage credit.  Imagine that!

Envoi

Will these seven steps solve all the problems of American mortgage finance and ensure that we will never have another crisis?  Of course not.  But they will set us on road more promising than sitting unhappily where we are at present.


Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, DC. He was a resident fellow at the American Enterprise Institute from 2004 to 2015 and was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. Pollock focuses on financial policy issues, including financial cycles, government-sponsored enterprises, housing finance, banking, central banking, uncertainty and risk, retirement finance, corporate governance, and financial crises with their ensuing political responses. He is the author of Boom and Bust: Financial Cycles and Human Prosperity, as well as numerous articles and congressional testimony. Pollock is a director of CME Group, Great Lakes Higher Education Corporation, and the Great Books Foundation—where he was chairman of the board from 2006 to 2014—and is a past president of the International Union for Housing Finance. He is a graduate of Williams College, the University of Chicago, and Princeton University.

Pollock has no financial interest in Fannie Mae, Freddie Mac, or the Federal Home Loan Banks.  As a taxpayer, he has a strong financial interest in the risks undertaken by the US Treasury and the Federal Reserve.

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A photo of Laurie Goodman. Dark hair, glasses, bright smile.
"It is time for an open-minded look at the housing finance system and what role, if any, today’s government-sponsored enterprises might play in the future."
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Tim Howard
"When invented narrative is replaced with verifiable fact, Fannie and Freddie cease to be a 'failed business model' that must be wound down and replaced; they instead become valuable resources that must be built upon and improved."
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A photo of Jim Millstein. White hair, slight smile, suit and tie.
"To address the conflict between their affordability mission and shareholder returns, the mortgage guaranty businesses should be subjected to utility-like regulation, with strict activity, leverage, and return on equity limitations."
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A photo of Alex Pollock. Slight smile, suit and tie.
"At the 10% Moment, Congress should declare the senior preferred stock fully retired, as in financial substance it will have been. Simultaneously, Congress should formally designate Fannie and Freddie as systematically important financial institutions.
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A photo of Mark Zandi. Slight smile, suit, brown hair.
"A group of us has put forward a reform proposal that addresses the system's structural problems and keeps what works."
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A photo of James Carr. Severe smile, suit, dark hair.
"The basic pillars of America’s housing finance system were enacted 80 years ago. Since then, major reconfigurations in our economy, demographic composition, and household locational preferences demand a bolder vision for housing finance in the 21st century."
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A photo of Andrew Davidson. Slgiht smile, greying hair, glasses.
"A realistic approach to GSE reform is to strip the GSEs down to the functions that promote standardization, liquidity, and access to credit, and adopt the best governance structures for those functions. This can be achieved in four steps: streamline, share risk, wrap, and mutualize."
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A photo of Mark Calabria. Slight smile, suit, dark hair, glasses.
“Mortgages, under any system, have to rest on someone’s balance sheet. Like water running downhill, the risk has flowed to the most leveraged sectors of our financial system. This is a recipe for instability.”
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A photo of Patricia Mosser. Dark hair, glasses, bright smile.
“The characteristics of mutuals that may be seen as disadvantages for some types of financial companies are in fact advantages for our financial market utility proposal because they align the utility’s incentives with other actors in the securitization chain.”
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A photo of Marc Morial. Big smile, suit, dark hair.
“In the aftermath of the Great Recession, the tragic loss of wealth, and the bailout of the big banks, our national government must continue to play a central role in the housing market to right previous wrongs, ensure access to all qualified borrowers, and keep the housing finance system afloat ...
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A photo of Laurie Goodman. Dark hair, glasses, bright smile.
"Between now and 2030, this country will face an unprecedented surge in rental housing demand. Already, rents are skyrocketing out of the reach for many families, especially in places with job opportunities. New multifamily housing construction is at its highest level since the 1986 Tax Refo...
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A photo of three individuals. All three are smiling, have suits, ties, and dark hair.
"There will be nuanced demands coming from the high concentration of household formation in African American, Asian, and Hispanic communities. Ginnie Mae 2.0 looks to be the safest way to build a sustainable platform to bring proven market stability to meet the needs of a materially changing demo...
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A photo of two individuals. Both are smiling, have suits, ties, and glasses.
“The most critical need for multifamily is simply that policymakers pay attention to it early and plan ahead.
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A photo of two individuals. Both are smiling, have suits, ties, and glasses.
We propose a spinoff of the multifamily business units of the GSEs and the formation of other new guarantors to increase access to affordable multifamily financing.
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A photo of two individuals. Both are smiling, have suits, and ties.
"Consensus exists that a reformed housing finance system must protect taxpayers, emphasize the private markets, support a broad variety of housing options and remain liquid throughout an economic cycle. Surprisingly, few recognize that a proven model already exists that meets those objectives-and...
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A photo of Jim Millstein outside. Dark hair, big smile, suit and tie, glasses.
"Mortgage finance reform discussions have failed to generate consensus assuring the widest possible access to sustainable mortgage credit at the lowest practical cost. We can resolve this impasse if we integrate all federal supports for mortgage finance into one cohesive whole."
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A photo of Pinto. White hair, glasses, slight smile, suit.
"Today’s government-centric housing finance system is an “economics free zone” indifferent to supply and demand. Composed of an alphabet soup of agencies, this system has fostered a massive liberalization of mortgage terms and provided countless trillions of dollars in lending. Yet housing has be...
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A photo of Taylor. White hair, suit.
"Much of the conversation on Capitol Hill and among policy thinkers has pushed affordability and access to the back burner. We need to bring it to the forefront of the conversation. The shape and quality of housing finance reform will have repercussions in every neighborhood and community and for...
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Mike Calhoun and Sarah Wolff
"Average price estimates obscure significant variation. To assess access and affordability, we need to look closely at differential prices, not just overall prices or prices for low–credit risk profiles."
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Rodrigo Lopez and Debra Still
"We believe that all housing needs, from the most directly-subsidized, affordable rental housing to the prime jumbo single-family lending market, lie along a single continuum. This housing continuum can be best served only by addressing single-family and multifamily, rental and homeownership, gov...
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Janet Murguía
"By 2020 half of all first-time homebuyers will be Latino. Without affordable access to credit for these prospective buyers, the housing market will decline, with harmful consequences on the larger economy."
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Jim Parrott
"Coming out of the crisis, there was thus almost universal agreement that we should reduce our reliance on this duopoly and shift more risk into a competitive private market."
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Research Areas Housing finance
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