Derivatives After Dodd-Frank

After the Bubble: Credit and Housing

On July 4, 2011, in Fannie Mae and Freddie Mac, housing, by Jon Lewis

Moving Forward: The Future of Consumer Credit and Mortgage Finance.  Edited by Nicolas P. Retsinas and Eric S. Belsky.  Brookings Institution Press 2011, pp. 264, $28.95 Although there are indications that the housing market may be improving, particularly in rural states with large agricultural, energy, and industrial sectors, the housing market is unlikely to recover [...]

Moving Forward: The Future of Consumer Credit and Mortgage Finance.  Edited by Nicolas P. Retsinas and Eric S. Belsky.  Brookings Institution Press 2011, pp. 264, $28.95

Although there are indications that the housing market may be improving, particularly in rural states with large agricultural, energy, and industrial sectors, the housing market is unlikely to recover fully any time soon.  Adding to the uncertainty about the future of home purchases is the fact that a significant number of recent college graduates are returning home to live with their parents, likely delaying their path to homeownership.

Minority and low-income communities, where homeownership was always more of a challenge than for middle-class and affluent Americans, have been hurt the hardest by ongoing unemployment.  Although it is difficult to generalize about the national housing market, marked minority unemployment makes it less likely that members of these communities will be purchasing homes in the same numbers as they did in the mid-2000s when consumer credit was more readily accessible.

Moving Forward: The Future of Consumer Credit and Mortgage Finance is the product of a February 2010 conference held at the Harvard Business School.  Convened by the university’s Joint Center for Housing Studies, participants met “to explore the roots of the crisis that caused credit markets to seize up in late 2008 and more, important, to focus on the way forward.”   Edited by Nicholas P. Retsinas and Eric S. Belsky, both of Harvard, Moving Forward contains academic papers on such disparate topics as how best to serve the short-term credit needs of low-income consumers; a retrospective on the Home Mortgage Disclosure Act; and a case study of payday lending in the context of the regulation of consumer financial products.  The overall theme of the conference, as enunciated by Retsinas and Belsky in their Introduction, was how to “reopen the spigots of credit to low- and moderate-income Americans” in an efficient and fair manner.

Although each chapter provides a different perspective on the housing market, two stood out as particularly engaging.  In Chapter 1, “Rebuilding the Housing Finance System after the Boom and Bust in Nonprime Mortgage Lending,” Belsky and Nela Richardson, also from Harvard, present a fairly objective overview of the boom and bust cycle in the nonprime and nontraditional mortgage lending markets and provide their vision for better mortgage markets.   The authors identify four broad factors, which, in their opinion, were essential in the causation of the nonprime boom and subsequent bust: global liquidity and low interest rates; relaxed underwriting standards; financial engineering (i.e., derivatives such as credit-default swaps and synthetic CDOs); and regulatory and market failures.   These are all reasonable factors to cite; the authors, however, could have devoted more attention to the role played by monetary policy in fueling the initial housing boom, wherein the Federal Reserve kept the federal funds rate unnaturally low.

Although their historical analysis is largely dispassionate, Belsky and Richardson adamantly reject the notion that the Community Reinvestment Act had a major role in fostering the housing crisis. “But the problem was not, as some have argued, the Community Reinvestment Act (CRA) which places affirmative obligations on banks and thrifts to lend in low- and moderate-income communities.  CRA played a minor role at best.”   With regard to Fannie Mae and Freddie Mac (it should be noted that Freddie Mac provided funding for the conference and that the editors did rightly disclose this fact), the authors contend that the GSEs would have performed better had there been more regulation of financial institutions in the private-label securities market and the nonprime market, in general.

In their view, regulatory failure, rather than the structural problems inherent in the government-sponsored enterprises, is to blame. “If there is fault to be found with capital requirements and the goals of Fannie Mae and Freddie Mac, it is not with the effort to regulate capital standards or to impose goals for low- and moderate-income lending, but rather with the actual standards that were promulgated.”  This misses a larger point; namely, that the main problem with Fannie and Freddie was less about regulation, per se, and more systemic, wherein implicit government guarantees allowed the GSEs to issue agency debt that was perceived by investors as inherently less risky than corporate bonds.

Not surprisingly, the authors, in their discussion of how to improve the housing finance system do not call for winding down Fannie and Freddie in a reasonable and timely manner that protects taxpayers.  Nor do they seem to acknowledge the problem of the Federal Reserve having interest rate-sensitive GSE securities on its balance sheet.   To the contrary, they argue that, “it is clear that federal insurances and guarantees are vital to the stability of the mortgage finance system, the broader financial system, and the national economy.”   This point is highly debatable, as a subsequent chapter of the book makes clear.

In “Alternative Forms of Mortgage Finance: What Can We Learn from Other Countries?,” Michael Lea takes a comparative approach to mortgage finance and demonstrates how very unique the American system actually is.  Lea, of San Diego State University, points out that, when compared with other industrialized countries, the United States “has the highest level of government involvement, the greatest use of securitization, and a product mix dominated by the long-term fixed rate mortgage.”  Indeed, readers would be interested to learn that “[t]he United States is unusual its use of all three types of government-supported mortgage institutions or guarantee programs: mortgage insurance, mortgage guarantees, and government-sponsored mortgage enterprises.”

In his discussion of what the United States could learn from other countries, Lea singles out Denmark for special treatment.  According to Lea, “Denmark is the only country in the world other than the United States in which the dominant product is the long-term fixed-rate mortgage that can be prepaid without penalty.”  What makes Denmark’s mortgage finance system different, however, is that it utilizes the principle of balance and also has its “funding through the issuance of covered bonds.”   Denmark’s system thus allows for borrowers to repay their mortgages through the bond market should rates rise and also keeps the credit risk on the lender’s balance sheet (as opposed to the American system wherein GSEs securitize mortgages into mortgage-backed securities that are then sold to investors).

Lea does a great service by providing this comparative perspective.   His discussion of Denmark, however, must be tempered with the very recent conflict between Moody’s, the credit rating agency, and Danish banks.   That said, Lea is on the mark in his observation that “[r]estricting the government role to guarantees without portfolio accumulation of mortgages would reduce the systemic risk of the U.S. housing finance system in line with the more targeted and stable Canadian system.”  Canada, as Lea notes, has a comparable rate of homeownership to that the United States, but does not have a government-sponsored enterprise such as Fannie and Freddie.

In conclusion, the housing market will likely not recover in the near term.  There are signs, however, that the market may be slightly improving.    In the meantime, it would be useful for policymakers to think critically about the ways to improve mortgage finance.  Winding down Fannie and Freddie would be a good first start.   For those interested in recent academic literature on housing and consumer credit, Moving Forward is worth a read.

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