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What’s after Fannie and Freddie?
Reforming the U.S. housing finance system remains perhaps the largest piece of unfinished business from the 2008–2009 financial crisis. The Obama administration in February proposed phasing out mortgage giants Fannie Mae and Freddie Mac, the two government-sponsored enterprises whose collective missteps have cost taxpayers more than $134 billion since being placed in conservatorship in September 2008. With their fate all but sealed, attention has turned to what will replace Fannie and Freddie.
The administration has outlined three options designed to frame the congressional debate expected to unfold over the months ahead: (1)privatization of the mortgage market, (2) new private, for-profit mortgage securities companies fully backed by federal government guarantees, and (3) privatization backstopped in times of financial crisis by federal government guarantees only for new loans.
The third option reflects a middle-ground position advocated by HBS professor David Scharfstein and Adi Sunderam (PhDBE ’11), who will soon join the HBS faculty as an assistant professor in the Finance Unit. They detail their proposal in a paper titled “The Economics of Housing Finance Reform: Privatizing, Regulating, and Backstopping Mortgage Markets.” Scharfstein recently answered questions about the proposed reforms.
Some conservatives advocate a private- sector mortgage market without any government backing. Why don’t you favor that approach?
The vast majority of mortgage credit can be provided by the private sector without government guarantees. But given the systemic risk associated with mortgage credit, we can’t just assume that private market participants will end up with the right level of risk taking, so regulation is important. There are also periods of crisis, like the one we just experienced, when financial markets generally break down. And that’s when the government can play a role in supporting new mortgage credit.
What about new privately owned, for-profit companies that guarantee mortgage-backed securities and pay the government to back those guarantees in case the companies themselves fail?
That’s essentially the system we had with Fannie and Freddie, except in this proposal private, for-profit companies would be expected to pay the government up front for bailing them out. The old system didn’t work too well, and this one wouldn’t either.
Wouldn’t the pool of reinsurance money paid by these private institutions shield the government from any losses?
Not necessarily. The problem is that whenever you mix government guarantees with private, for-profit entities, those private entities put the government at risk. There’s an incentive for the private entities to hold as little capital as possible against their own loan guarantees, and they would lobby to keep capital reserves relatively low. They also would lobby for expanding their footprint to guarantee a wider range of mortgages, including potentially risky mortgage products. And so, while we might start off with institutions that are well capitalized with a relatively small mandate to guarantee prime, well-underwritten mortgages, when you have for-profit entities that have this government backstop, over time you end up guaranteeing riskier mortgages backed by inadequate capital. That’s how Fannie and Freddie got into trouble in the first place.
How does your reform option improve on the first two options?
We argue that the main goal of housing finance reform should be financial stability. We should not be trying to use government guarantees to lower mortgage interest rates per se. So what we call for is regulated privatization with the government playing the role of guarantor of last resort for new mortgage credit in a time of crisis. That’s why we propose creating a government-owned corporation that would guarantee new well-underwritten mortgages when private markets fail.
We agree that private markets, for the most part, can provide mortgages without government guarantees. But private markets are subject to booms and busts with serious consequences for the financial system. So we argue that it’s crucial to regulate mortgage markets, and we need new approaches to regulating securitization.
What new regulations do you advocate to enhance stability in the system?
If your only goal is financial stability, you can achieve that with strict underwriting standards. In a number of European countries, for example, there are quite strict regulations on down payments; many require 20 percent.
I don’t think U.S. policymakers are willing to go that route; the ability to buy a home with 5 or 10 percent down is just too entrenched in the system. So what we’re saying is, OK, if people are going to buy homes with low down payments, we need to recognize that these sorts of mortgages are riskier. Regulators should limit the use of adjustable-rate mortgages for these loans, which compound the risk to the homeowner. Banks should be required to have significant “skin in the game” when they securitize these mortgages, probably more than the 5 percent required by the Dodd-Frank Act.
Lenders should have to hold significantly more capital to protect against losses from these riskier loans. That should also be the case for financial firms that hold the mortgage-backed securities used to fund these riskier loans. And if the borrower defaults, the lender with significant skin in the game should be the one that deals with the borrower, not some servicer with minimal economic interest in the loan.
How would your government backstop for the mortgage market work?
Our notion is that if government guarantees matter at all, they matter in a time of crisis. If there is a housing bust, it will be amplified by the reluctance of private investors to supply housing credit. In such circumstances, we advocate a government-owned corporation that would play a stabilizing role by stepping in and guaranteeing new mortgages. The corporation would exist in normal times and guarantee a small percentage of mortgages even then, but would scale up its activities during a period of crisis. From a financial stability point of view, it would dampen the adverse effects of a housing price bust that would harm the financial system.
How does this approach differ from the mortgage guarantees provided by Fannie and Freddie and the reform option with government guarantees favored by the financial services and real-estate industries?
Unlike what happened at Fannie and Freddie, we’re not proposing that the government step in and bail out the existing holders of mortgage-backed securities. The same bailout risk would occur with the proposed private institutions. What we advocate is that the government guarantee only newly issued mortgages in a time of crisis. And these mortgages would be well underwritten with low loan-to-value ratios so that the risk to the government would be modest.
Do you think that your proposal will gain any traction in Washington?
Well, it’s always hard to predict where Washington is going to go. But I think one nice thing about our proposal is it sits squarely in the middle between the two extremes: broad-based government guarantees on the one hand, and no government guarantees on the other. Ours is right in the middle, where there are no guarantees most of the time, but guarantees on newly issued loans in a time of crisis.
— Roger Thompson
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