Fannie, Freddie, and the U.S. Covered Bond Act of 2011

On July 13, 2011, in Dodd-Frank, Fannie Mae and Freddie Mac, housing, moral hazard, by Jon Lewis

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95 There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of [...]

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95

There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of it based on securitized mortgages – responsible for nearly bringing down the entire financial system.  The Dodd-Frank Act has attempted to reform the derivatives market by imposing a clearing requirement on swaps.   That said, the ongoing challenge is how to reform the housing market itself so working Americans can afford to purchase homes.   A separate question, of course, is whether the federal government’s emphasis on homeownership for all (or as many as possible) during a time of exceedingly low interest rates was itself partially to blame for the financial crisis.

With housing apparently now back on President Obama’s agenda, the release of The American Mortgage System: Crisis and Reform could not have come at a more opportune time.  Edited by Susan M. Wachter, from the Wharton School and PennDesign, and Marvin M. Smith, from the Federal Reserve Bank of Philadelphia, this volume contains a collection of fifteen essays on the housing crisis, its community impact, and ways to reevaluate and to reform housing and mortgage finance.

In their Introduction, Smith and Wachter premise their argument on the notion that, in order for the United States to have a sustainable mortgage system, it is necessary to remake that system, and that redesign is indeed possible.  They call for a separation of “innovations that increased – and sustained – homeownership from those that merely increased profits and risk.”

Although they acknowledge that the current system is broken, Smith and Wachter emphatically do not want to replace long-term fixed rate mortgage with an entirely new system.  Indeed, the authors argue that “[w]ith interest rates preparing to rise and sovereign debt at nosebleed levels, consumers need the long-term, fixed-rate mortgage now more than ever.”  They note that the focus of the collection is “[h]ow to create such a system and safeguard it from recurrences of the recent catastrophe.”   Smith and Wachtel are thus more interested in reforming, rather than fundamentally restructuring, housing finance.

For readers interested in an accessible and brief introduction to Fannie Mae and Freddie Mac, Chapter 1 is worth particular consideration.  In “The Secondary Market for Housing Finance in the United States,” New York University faculty members Ingrid Gould Ellen, John Napier Tye, and Mark A. Willis, enumerate what they consider to be the strengths and weaknesses of the GSE (government-sponsored enterprise) model prior to the federal government’s putting Fannie Mae and Freddie Mac into conservatorship.

The authors are on the mark in citing the following as weaknesses: the implicit federal guarantee which made Fannie and Freddie susceptible to moral hazard; a favored regulatory status which created “a net bias toward investing in housing in the economy overall”; lack of proper oversight; duopoly power; a race to the bottom with lower underwriting standards; and their too-big-to-fail large size, which concentrated systemic risk.

It is notable that the authors point out how Fannie and Freddie’s structure created a net bias toward investment into the housing sector.   Although this is not necessarily an original point, it is nevertheless an important one.   The very existence of the GSEs (and indeed, the mortgage interest tax deduction) provides incentives for individuals to invest in housing, rather than in savings or in the money market.

Ellen, Tye, and Willis conclude with the observation that, while the GSEs should indeed be improved, “it would be a mistake to assume that simply reforming the GSEs, without making significant reforms to the private-label market would prevent another crisis.”  While technically correct, this misses the larger point; namely, that the GSEs, at least prior to their being placed into conservatorship, were very unique entities in which an implicit guarantee allowed gains to accrue to shareholders, with losses socialized and, hence, passed on to taxpayers.

In Chapter 13, “Improving U.S. Housing Finance Through Reform of Fannie Mae and Freddie Mac: A Framework for Evaluating Alternatives,” co-authors Ingrid Gould Ellen and Mark A. Willis list nine characteristics that, in their view, can be utilized to distinguish among the different approaches for reforming the secondary mortgage market: credit enhancement; regulation; securitization of non-favored products; market concentration; provision of credit to underserved markets; financing multi-family rental properties; allowing direct investments; methods of ownership; and transition issues.

The authors devote significant attention to the question of credit enhancement, which they consider “[a]rguably the most critical feature of any proposal.”  Free market advocates who would like to see the federal government exit the mortgage guarantee business entirely (something that is unlikely in the near term) would likely disagree with the authors on various points.

That said, their proposal for limiting federal guarantees to mortgage backed securities only – as opposed to corporate obligations and debt – should be given serious consideration.  They argue that “to limit moral hazard and taxpayer risk, the government should only guarantee MBS holders’ timely payment of interest and principal in the case of default rather than guaranteeing the corporate obligations of the issuer or even the underlying mortgage debt.”  Ellen and Willis should be commended for their acknowledgment of the correlation between the GSEs’ moral hazard problem and taxpayer risk.

In light of the House Financial Services Committee’s recent vote in approval of H.R. 940, the United States Covered Bond Act of 2011, perhaps the most salient aspect of Ellen and Willis’ essay is to be found in their discussion of covered bonds in their Appendix B.   They argue that covered bonds differ from mortgage-backed securities (MBS) in two ways: the covered bonds, unlike MBSs remain on a bank’s balance sheet and that bonds are usually regulated so as to be over-collateralized, with the mortgage pool exceeding the value of outstanding bonds.   Although the authors doubt the likelihood that covered bonds will replace the GSE MBS system of housing finance, they do suggest that “[I]n a more radical restructuring, the GSEs could be abolished, and the entire system could switch to covered bonds, or the GSEs could be reformed into covered bond issuers.”  This, in their view, “would seriously disrupt the housing finance system.”

Covered bonds do offer significant promise.  The Senate should take up similar legislation.  It should be noted, however, that George Soros’ proposal to eventually wind down the GSEs and to replace the current housing finance system with a Danish-style covered bond system based on the principle of balance would not be the best option for a dynamic American housing finance system.  What would be far more preferable would be to allow market forces to operate as freely as possible and to allow consumers and investors to have choices.  Indeed, as Ellen and Willis astutely note, covered bonds “could directly compete with the GSEs in the prime mortgage market.”  This may be the best option.

The goal should not be to replace the current American housing finance system with a model that has worked, until now at least, exceedingly well in a relatively geographically small and homogenous Nordic country and to expect that that model could be replicated in the United States.   Furthermore, Soros’ proposal that the GSEs should now begin to introduce securities based upon the Danish principle of balance should be rejected.  If this is to be done at all, it should be done by the private sector under a proper regulatory framework established by Congress, not by the GSEs.

In conclusion, bold thinking is needed to reform the American housing market.  Reforming the GSEs is a good idea.  Replacing them entirely and minimizing the federal government’s involvement in promoting the housing sector at the expense of other sectors of the economy, while still preserving opportunities for responsible homeownership, would be even better.  For those policymakers interested in a recent collection of essays on housing finance, The American Mortgage System: Crisis and Reform is worth ample consideration.

Jon Lewis (c) 2011

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