Why Housing Reform Still Matters

MichaelBrightandEdDeMarco

June2016

The2008financialcrisisleftalotofchallengesinitswake.Theeventsofthatyearledtoyearsofstag-nantgrowth,apainfulprocessofglobaldeleveraging,andtheemergenceofnewbankingregulatoryregimesacrosstheglobe.

ButattheepicenterofthecrisiswastheAmericanhousingmarket.AndwhileAmerica’shousingfinancesystemwasfundamentaltothefinancialcrisisandtheGreatRecession,reformeffortshavenotalteredAmerica’smortgagemarketstructureorhousingaccessparadigmsinamaterialway.

Thisworkmustgetdone.Eventually,legislatorswillhavetoresolvetheirdifferencestochartamodern-izedcourseforhousinginourcountry.Reflectingupontheprogressmadeandthefailuresenduredinthiseffortsince2008,wehavesetourselvestothetaskofoutliningaframeworkmeanttoadvancethepublicdebateandhelplawmakerscreateanachievableplan.Throughaseriesofupcomingpapers,ourgoalwillbetonotjustfosterdebatebuttopushthatdebatetowardresolution.

Beforesettingforthsolutions,however,itisimportanttoframetheissuesandstatewhyweshoulddothisinthefirstplace.Inlightofthegrowingchorusurgingsurrenderandgoingbacktothefailedmodelofthepast,ourobjectiveinthispaperistoremindpolicymakerswhyhousingfinancereformisneededandhelpdistinguishaspectsofthecurrentsystemthatareworthpreservingfromthosethatshouldbescrapped.

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Why Housing Finance Reform Is Needed, and What It Must Accomplish Structuralhousingfinancereformwasnevergoingtobeaneasyundertaking.Butitcan’tbeignored.Afteryearsofdebate,weunderstandthatsensiblereformsshouldseektopreservetheaspectsoftheoldsystemthatworkedwhileriddingthesystemofitsflaws.Andweunderstandthattransitioningtoanewmarketinfrastructuremustbecarriedoutwithoutdisruption—disruptionthatcouldupsetmort-gageavailabilityintheneartermorupsettheprocessesandoperationsofthethousandsoffirmsthatmakeupthecomplexhousingfinanceecosystem.

Sono,thiswasnevergoingtobeeasy.

Still,nearlyadecadeafterthefinancialcrisis,housingfinanceisnotableforitspoliticalandpolicycom-plexityaswellasthepassionthatitstirs.Meaningfulreformmustbeachieved,thevastmajorityofpoli-cymakerssay,yetthedecadeanniversaryoftheconservatorshipsoftheFederalNationalMortgageAs-sociation(FannieMae)andtheFederalHomeLoanMortgageCorp.(FreddieMac)looms.

AhomeisthelargestpurchasemostAmericanswillmakeintheirlives.Bysomeestimates,housingistheenginethatpropelsnearlyone-fifthoftheAmericaneconomy.Accesstodecenthousingiscrucialtoavibrantmiddleclass.Ontopofallthat,thesystemisenormouslyintricate;thisisnotyourgrandfa-ther’shousingmarket.Nolongeristhetypicalmortgagecharacterizedbya20percentdownpaymentandfundedwithcommunitydepositsfromthelocalsavingsandloan.Today,thevastmajorityofAmeri-ca’smortgagescomeintoexistenceviaacomplexfinancialinfrastructure,notvialocalbanksthatsimplytakeindepositsandlendthemout.Insteadwehaveawebofbankandnon-banklenders,bankandnon-bankmortgageservicers,mortgageinsurers,guaranteedsecurities,derivatives,creditinvestors,rateinvestors,andmorethattogetherconnectsaversacrosstheglobewithfamiliesacrossthecountrywhoseektobuyahouse.Allofthishasledtostructurallylowerandlessvolatileinterestrates.Butithasalsocreatedcomplexterraintonavigate.

Sohereweareeightyearsafterthefinancialcrisis,withthetwogovernment-sponsoredenterprises(GSEs)thatsitattheheartofAmerica’shousingfinanceecosystem—FannieMaeandFreddieMac—trappedinastateoflegallimbocalledconservatorship.Thegovernmentlifesupportgiventothemattheheightofthefinancialcrisiswasmeanttobetemporary,followedbylegislationreplacingthetoxicaspectsoftheiractivitiesandreformingourmarketstructure.Butalong-termdecisionabouthowtoreplacethelifesupportwithsomethingbetterwithoutdisruptingthehousingmarketrequirespoliticalcompromiseandpragmaticthinking.Politically,membersofCongressonbothsidesoftheaislewillhavetogiveonsomeissuestoachieveanagreement.Theywillneedtoputideologyasideandask,“Willthisactuallywork?”

ThechallengeoffindingsufficientpoliticalcommongroundtobreaktheGSEsoutofconservatorshiphasfeltsodauntingthatithasledtodoingnothing.Butcontinuedinactionisadefactodecisiontostaywithwhatwe’vegot.Othershavesuggestedwegiveupinadifferentway:return,hatinhand,totheoldmodelthatfailed.Theseargumentsaremisguidedanddangerous.Neitherapproachwouldaddressthefailuresofthepastortheeconomicchallengesofthepresent.

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Theformerchoice—remaininginconservatorship—wouldallowtheentirehousingsystemtorelyal-mostentirelyonthedecisionsoftheFederalHousingFinanceAgency(FHFA)directorandthetwoCEOsheorsheismeanttoregulate.Intheend,this“headinthesand”strategyisnotaseriousapproach.Suchalackoflegislativeclarityturnsmarketdecisions,suchashowtounderwritealoanorpriceitsrisk,intoabureaucraticexerciseorworse.Thisisnottheproperroleforaregulatoryagency.ButuntilCon-gressacts,theFHFAisstuckinitsroleofregulatorandconservator.

Thelatteridea—returningtotheoldmodel,inwhichtheGSEsoperateinablessedstateasgovern-ment-sponsoredenterprisesthataretaskedwithapublicmissionbutreporttoprivateshareholders,coupledwithamanagementteamincentivizedtoleveragealladvantagesnotforthelong-termhealthoftheeconomybutinsteadforimmediatefinancialgain—reliesontheassumptionthatfuturecon-gresseswillalsobailoutFannieandFreddiesuccessorentitiesthenexttimethereisamajormarketdis-ruption.(Andtherewillalwaysbemarketdisruptions.)Thispath,too,leavesthewell-beingofthehous-ingmarketverymuchtochance.

Astheeventsof2008demonstrated,theoldmodelworkedonlybecauseinvestorswereconfidentthattaxpayersstoodbehindthecompanies.IfFannieandFreddiewerereleasedfromgovernmentcontroland,forallintentsandpurposes,returnedtotheirpre-conservatorshipquasi-privatestatus,arewesurethatafutureCongresswillinjectemergencycapitalintothemwhentheybecomeinsolventorthemort-gage-backedsecurities(MBS)marketquestionsthestrengthoftheirguarantee?

Ofcourse,theanswerisno.YetfromCongress’perspective,asmuchasitmayneverwanttovotefortaxpayerlifesupportagain,thepressuretokeeptwodominantplayersoperatingcouldverywellleadtoanothervotetoallocateemergencycapitalintosuccessorentities.

Allofthisbegsthequestion:Where,exactly,dowegofromhere?

Therearenotable,impressivesuccessesinsideAmerica’shousingfinancesystem.Thesemustbepre-served.Yetwemustalsoreducethelikelihoodthatfinancialinstitutionswillneedemergencycongres-sionalactioninthefuture.Additionally,incentivesneedtobeproperlystructuredandtransparent,notcomingledandopaque.Putanotherway,housingfinancereformisaboutthrowingoutthedirtybath-waterbutkeepingthebaby.Fortunately,meaningfulstepshavealreadybeentaken,albeitslowly.AndwearewritingabouttheseissuesbecauseitseemsthatmeaningfulpolicydebateinWashingtonmaybeginanewin2017.

The Secondary Mortgage Market and Its Collapse WhiletheBaileyBrothers’BuildingandLoanfromtheclassicmovieIt’saWonderfulLiferendersaheartwarmingpictureoflocalhousingfinance,onlyremnantsofthatsystemremaintoday.Atleastsincethesavingsandloandebacleinthe1980s,theU.S.housingfinancesystemhasbeendominatedbythesecondarymortgagemarket,thatis,themarketplacewherelenders,bondinvestors,andtheinfra-structureofsecuritizationmeet.

Insimpleterms,thesecondarymarketiswhereindividualmortgagesmadeacrossthecountryarebun-dledintolargegroupsofmortgages,calledpools,andsoldtoglobalinvestorsinastructurecalleda

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mortgage-backedsecurity.TheprocessofpoolingmortgagesandissuingMBSiscalledsecuritization.Thissystemcanbeverypowerfulandbeneficial.Ratherthanrelyingontheavailabilityandstabilityoflocaldepositsatasavings(orbuilding)andloan,thesecondarymarketdrawsassetmanagersacrosstheglobetoinvestinpoolsofhundredsorthousandsofmortgages.

Inthisway,pensionfunds,collegeendowmentfunds,insurancecompanies,mutualfunds,retirementsavingsplans,foreigncentralbanks,foreignwealthfunds,andotherinstitutionalmoneymanagersre-sponsibleforinvestingthesavingsofindividualsandinstitutionsprovidethemoneyafamilyneedstobuyahouseanywhereinAmerica.Interestingly,thesewidelydispersedinvestorsknowverylittleabouttheriskcharacteristicsofanyindividualborrowerintheirpool,nordotheyknowmuchaboutthecondi-tionofaparticularhouse,theneighborhoodinwhichit’slocatedandthelocaleconomy.Sowhyaretheywillingtofundthesemortgages?

Theanswerliesinthestructureandreliabilityofthesecondarymortgagemarketandtheinstitutionsandlegalarrangementsatitscenter.Intherun-uptothefinancialcrisis,andstilltoday,therearethreedistinctcomponentsthatcomposemostofthesecondarymortgagemarketandmakethisfinancialeco-systempossible.

First,inthegovernmentsegmentofthehousingfinancesystem,theGovernmentNationalMortgageAssociation,orGinnieMae,overseesthepoolingofmortgagesguaranteedbytheFederalHousingAd-ministration(FHA),theDepartmentofVeteransAffairs(VA),andafewsmallerfederalhousingpro-grams.TheGinnieMaelabelonamortgage-backedsecuritytellsinvestorsthatthefullfaithandcreditoftheUnitedStatesgovernmentguaranteesthattheywillreceivetimelypaymentofprincipalandin-teresteachmonthandthatinvestorswillnotloseanyprincipalasaresultofborrowerdefaultsontheunderlyingmortgages.

Inthiscase,theriskislargelybornebythefederalgovernmentthroughitsFHA,VA,andothermortgageinsuranceprograms.Loanoriginatorsandloanservicersretainsomeriskaswell,andGinnieMaebearstheultimateriskiftheseprivate-sectorentitiesfailtofulfilltheirresponsibilities.Ginniechargesthehomebuyersixbasispointsperyear(ortypicallylessthan$1permonth)forthisbackstopguarantee.Today,GinnieMaeMBSaccountfor$1.5trillionoftheroughly$7trillioninoutstandingMBS,ormorethan20percent,whichisahistorichigh.

Second,ontheotherendofthespectrum,inthepurelyprivate-labelsegmentofthehousingfinancesystem,banksandotherfinancialinstitutions(callthemWallStreetfirmsifyoumust,althoughmanyarenotlocatedanywherenearNewYork)puttogethermortgagepoolsandselltheMBStoprivatein-vestors.Inthismarketsegment,thenongovernmentinvestorsbearallthecreditrisk;thatis,ifborrow-ersdefaultontheirpayments,investorssuffertheloss.Asaresult,private-labelMBSarebrokenintomultiplesubgroups,calledtranches,whichcreateapredeterminedorderforbearingcreditlosses.Moresubordinatetranchesbearallthecreditlossesuntiltheyarewipedout,andthenlossesproceedtoholdersofmoreseniortranchesofthepool.

Inthedecadeorsoleadinguptothefinancialcrisis,theprivate-labelmarket(oftenreferredtoastheprivate-labelsecuritizationmarket,orPLS)explodedinsize,oftenbackedbysubprimemortgages,which

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wereunderwrittenaccordingtononstandardguidelines.Tonameafew,documentationofincomeorassetswasfrequentlynotrequired,therewereveryfewantifraudcontrols,andwhetherprospectiveborrowerscouldrepayaloanwasseenasasecondaryquestionatbest.ThePLSmarketfannedtheflamesoftheseproblems,butthegovernment-sponsoredenterprises,worriedaboutlosingmarketshare,werequicktofollow.

Theprivate-labelmarketisalsowhereso-called“jumboloans”aresecuritized.1By2006,private-labelMBSaccountedforabouthalfofoutstandingMBS,buttodaythatportionisdowntolessthan10per-cent.Infact,therehasbeenalmostnonewissuanceinthismarketsincethecrisis.Thereasonisthatthecrisisexposedseveraldeep,structuralflawsinthePLSmarket,includingalackofstandardizationindisclosures,opaqueandnonstandardlegaltermsfromonePLStoanother,andnofunctioningmecha-nismtoensurethatservicerswhodeterminedwhetherandhowtomodifyloansandenforcecontractsdidsointhebestinterestofinvestors.TheU.S.TreasuryDepartmentandotherentitiesareworkingtoaddresstheseflawsinanefforttobuildamoresustainablePLSmarket,butthismarketsegmentre-mainsmoribund.

Third,andthelargestbyfar,istheGSEmarketsegment,composedofloansbundled,securitized,andguaranteedbyFannieMaeandFreddieMac.2CharteredbyCongress,endowedwithuniquebenefitsunavailabletoanyotherprivatefirm,andtaskedwithdevelopingaliquidandstablemarketinwhichnon-FHAmortgagescouldbeboughtandsold,FannieandFreddiegrewintobehemothsinboththeirmarketpowerandpoliticalinfluence.

Themarketinterpretedthispackageofbenefits,includingtheGSEs’federalcharterandexemptionfromcertainsecuritieslaws,asgivingthetwocompaniesanimpliedgovernmentguarantee.Inturn,thesebenefitsandtheassociatedimpliedguaranteeallowedFannieandFreddietojoinGinnieMaeinsellingmortgage-backedsecuritiesinaforwardmarket,calledthe“ToBeAnnounced,”orTBA,market.BeingabletotradeMBSintheTBAmarketallowsforeasytradingandhedgingofmortgagesaroundtheglobeaswellasthestandardizationofunderwriting.Butin2008,ourrelianceontheseentitiesasapub-lic/privateduopolywasexposedasaFaustianbargain.

Ahybridbetweenpublicmissionandprivateownership,FannieandFreddieoftenreapedthebestofbothworlds.Operatingwithnumerouspublicbenefits,thecompaniesandtheirshareholdersoperatedwithlowercosts,muchlowercapitalrequirements,andfarweakerregulationthananybankorsavingsandloan.3Intheend,theiruniquestructureofprivateshareholders,private-sectorsalariesandbenefits,andanimplicitpublicguaranteecametosymbolize“Headswewin,tailsthetaxpayerslose.”Inthismarketsegment,FannieandFreddieboughtmortgages,packagedthemintoMBS,andguaran-teedtheMBSholderspaymentofprincipalandinterestifanyborrowerdefaultedonaloan.They 1.Jumboloanshaveaprincipalbalancegreaterthantheconformingloanlimit,thatis,thelargestmortgageFannieMaeandFreddieMacmaypurchase.Currently,theconformingloanlimitis$625,000inhigh-costareasand$417,000acrossmostoftherestofthecountry.2.FannieMaeandFreddieMacaretwoamongahandfulofGSEs,financialinstitutionscharteredbyCongressbutownedandoperatedbyprivateshareholders.GSEshaveapublicmissionstatedintheircharterandreceivesuchbenefitsaspreferentialtaxtreatmentandcheaperaccesstocapitalmarkets,whichareunavailabletootherprivatefirms.3.Forexample,theircapitallevelswereextraordinarilylow,attimeslessthan100basispoints.

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chargedborrowersaguaranteefeeembeddedintheinterestrate—effectivelyaninsurancepremium—forbearingthisrisk.Withnearly$5trillioninMBSoutstandingatthetimeofthecrisis—50percentofallU.S.mortgagedebt—wecanseeinhindsightthatthisconcentratedcreditriskexposurewasasystemicthreat.

Itwaswidelydiscussedbeforethecrisisthatthissetup,combinedwiththetwocompanies’importancetohousingfinanceandtheirgovernmentsupport,meantthattaxpayers,inalllikelihood,“implicitlyguaranteed”FannieandFreddieMBSinvestorsshouldtheGSEsfail.WhileCongressroutinelyinsistedthattherewasnogovernmentguaranteebehindFannieandFreddie,themarketthoughtotherwise—andwhentheenterprisesfailed,thatimplicitguaranteewashonoredandbecameexplicit.Inthesum-merof2008,CongressgavetheTreasuryDepartmentunlimitedauthoritytopurchaseFannieandFred-diesecurities.ThesubsequentappointmentoftheFHFAasconservatorbackedbydirectfinancialsup-portfromtheTreasuryprotectedtheholdersofFannieandFreddieMBS.

Sincethecrisis,theprivate-labelmarketmostlyvanished,andGinnieMae,FannieandFreddiehaveex-pandedtheirmarketshares.DespiteFannieandFreddiebeingongovernmentlifesupport,theconser-vatorshipdesignsupportedbyTreasurybackstopfinancingenabledinvestorstocontinuebuyingtheirMBS,therebyensuringongoingliquidityintheU.S.mortgagemarket.Absentthislifesupport,thecoun-trywouldhavebeenwithoutaviablesecondarymarkettoprovideliquidityfornewmortgagesnotbackedbyagovernmentagencysuchastheFHA.

Whilethereareotherimportantconsiderationstotheworkingsofthissecondarymarket,twomorebackgroundpoints—clearlessonsfromthefinancialcrisis—areworthmakinghere.First,toreapthebenefitsofamarketliketheonewehavecometoknow,themortgagesinanMBSmustbehomoge-nous.Thatis,theyneedtosharecertaincharacteristicssuchasrepaymenttermandwhethertheloanhasafixedoradjustableinterestrate.Similarloansallowinvestorstoanalyzeandestimateprepaymentspeeds,whichaffectMBSpricing.Thisisacriticalcomponentofhowinvestorsmanagetheinterestrateriskofalong-termsecuritywithvariableprepayment.

Second,GinnieMae,FannieMae,andFreddieMacplayanimportantroleoverseeingandenforcingcer-taincontractscriticaltothemarket’soperations.Keyamongtheseareoverseeingmortgageservicersonbehalfofinvestorsandtakingappropriateremedialsteps,includingtransferringmortgageservicing,intheeventofproblems.Theprivate-labelworld,aswecametoseeinthecrisis,lacksaneffectivemech-anismforsuchoversight,whichtheTreasuryDepartmentandindustrygroupshavewrestledwithinre-centyears.

ThisbriefreviewremindsusthattheobjectiveofstrengtheningthesecondarymarketwhileavoidingfuturegovernmentbailoutsmeansreplacingwhatisbrokenintheFannie/Freddiemodel.Thatincludesthesystemicriskcausedbyconcentratingcreditriskontwobalancesheets.Wealsoneedtoeliminatethefeaturesoftheirchartersthatconcentratedriskandpoliticalpowerintwoquasi-privatecompanies.Nottobelostisthechallengeandopportunityofstrengtheningtheothertwocomponentpartsofthesecondarymortgagemarket—thegovernmentsegmentandthepurelyprivatesegment—andmoderniz-ingcriticalinfrastructuresthatsupporthousingfinance.

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Atthesametime,weneedtopreservetheliquidityandcapacityofanactive,globallyfinancedMBSmarketbecauseitensureslowermortgageratesandstableaccesstocredit.Andweneedtobetterde-finetheroleofeachsegmentofthehousingmarket.Thepurelyprivate,purelypublic,andhybridpartsofthesystemmustoperateasoneecosystem,notcompetitorsinaracetothebottom.

What Has Transpired So Far? Fromapublicpolicyperspective,itmakessensetobeginpolicyanalysisbyexaminingthepurelygov-ernmentalprogramsandinstitutionsinvolvedinhousingfinance,especiallytheFederalHousingAdmin-istration.Nonetheless,theFannie/Freddiespaceofthesecondarymortgagemarketisbyfarthelargestcomponentofthehousingmarket.Soweaddressitsflawshere,andwewillreturntotheFHAandothergovernmentprogramsinalaterpaper.

SinceFannieandFreddiewereputongovernmentlifesupportin2008,thequestion,“Whatdowedowiththemandthehousingfinancesystemnext?”remainsunanswered.Buttobeentirelypessimisticaboutpolicymakers’capacitytosolvecomplexproblemsmissesimportantpoints.Somehelpfulstepshavebeentaken,andtheyareworthquicklyreviewing.

Thefirstofthesepolicyinitiativesoccurredin2012withtheintroductionoftheFHFAStrategicPlanforEnterpriseConservatorships4anditsassociated“annualscorecards.”ThescorecardssettheFHFA’spri-orityobjectivesforFannieandFreddietoachieveoverthesubsequentcalendaryear.5ThestrategicplanandannualscorecardsdefinedinitiativesforFannieandFreddietomodernizetheiroperationsandbusinesspracticeswhilepreparingthegroundworkforapost-conservatorshipsecondarymortgagemar-ket.Thetwomostsignificantresultsoftheseeffortsarethedevelopmentofcreditrisk-sharing,orcred-it-risktransfer(CRT)productsthathavehelpedshiftriskawayfromFannieandFreddie(andthereforetaxpayers);andacommonplatformtoreplaceeachcompany’soutdated,proprietarysecuritizationin-frastructureandtechnology.

BeginningherewithCRT,credit-risktransfertransactionsbegansmallin2013—thescorecardgoalwasjust$30billioninunpaidprincipalbalance—buttheyhavesincebecomeasubstantiverisk-shiftingmechanismfortheenterprisesand,withabitmorework,canbecomeamarketassetclassoftheirown.Credit-risktransferaccomplishesanumberofkeytasksonthereformagenda.CRTbringsinmarketsig-nals,ushersinprivaterisktakersaheadoftaxpayers,andfocusesmarketpractitionersonthedevelop-mentofmodelsforcontinuedimprovementinmortgagecreditriskmanagement.Inshort,credit-risktransferhashelpedformafoundationforanewmortgagecreditmarketstructure.6Importantly,we

4.FederalHousingFinanceAgency,AStrategicPlanforEnterpriseConservatorships:TheNextChapterinaStorythatNeedsanEnding.February21,2012.Theplanwaswrittenbyoneoftheauthorsofthispaper.http://www.fhfa.gov/AboutUs/Reports/ReportDocuments/20120221_StrategicPlanConservatorships_508.pdf5.In2014,currentFHFADirectorMelvinWattrestatedthestrategicgoalsinanupdatedplan.SeeFederalHousingFinanceAgency,The2014StrategicPlanfortheConservatorshipsofFannieMaeandFreddieMac,May13,2014.http://www.fhfa.gov/AboutUs/Reports/ReportDocuments/2014StrategicPlan05132014Final.pdf.TheFHFAcontinuestopublishannualscorecardsprioritizingeffortsandsettingtargetsformeetingthestrategicgoals.6.Foradditionalbackgroundonthestepstakentodateandthosestillneededtofullydevelopamarketformortgagecreditrisk,seeEdwardJ.DeMarco,“(Re-)CreatingaMarketforMortgageCreditRisk,”October28,2015.http://www.milkeninstitute.org/publications/view/748

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alsonowknowthattheplumbingforcredit-risktransferworkswell—both“frontend,”inwhichtermsarearrangedbeforeloansaresoldtoaGSE,and“backend,”inwhichaGSEdetermineshowandwhentoshedrisk.

Thereisnodoubtthatthemortgagecreditmarketsareslowlycomingbacktolife.Weshouldcontinuetofosterthisdevelopmentbyexpandingthescopeanddepthofrisktransferanddevelopingalegalandregulatoryinfrastructurethatensurestransparencyandinvestorprotection.Thesestepsareneededforcreditriskinvestorstohaveconfidenceinthissectorforthelonghaulandforthemarkettoremainliq-uidduringperiodsofeconomicdifficulty.Withaproperlymodernizedarchitecture,thesecreditmarketscanbeharnessedtomeasureandpricecreditrisk,allocatecredit,andinsulatetaxpayersinatargetedandeffectiveway.TABLE1:Credit-RiskTransfer(CRT)HasEvolvedSince2012

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TABLE2:CRTHasBecomeaPermanentDe-RiskingFeatureoftheGSEsCHART1:TheSystemIsMakingProgress*ApproximateSource:SIFMA

In2012,theFHFAannouncedthatworkwouldbeginonacommonsecuritizationplatform,thatis,thesystemstechnologythatgovernspaymentsfromborrowerstoMBSinvestors.Theagencyhaddeter-

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minedthatneitherFannienorFreddiehadasecuritizationplatformcapableofbeingbuiltonforthefuture.Movingfromtheoutdated,proprietarysecuritizationinfrastructureeachcompanyusedtoasharedutilityprovidesnumerousbenefits.Amongthem,itcreatestheopportunitytostandardizedis-closures,dataterms,andevenbondadministrationfunctionsbetweenthetwoentities.

WenowknowthatmanyofthefunctionsthatunderpinMBSsecuritizationcanbemanagedasacom-monutility,whichisbeingcalledtheCSPorCSS.7Ifdoneproperly,acommonplatformforsecuritizationcouldremoveasignificantbarriertoentryforpotentialcompetitors.Unfortunately,thusfarthefocusoftheCSPprojecthasbeentheadoptionofasinglesecurityforusebyonlytheGSEs,andnotasameanstoallownewentrantsintothemarket.However,despitethisunfortunatedynamic,intheendwenowknowthattheplumbingoftheCSPcouldoperateasastandalonemarketutilityor,morepromisingly,itcouldbefoldedintoagovernmentagencythatprovidesthecatastrophicguaranteeforMBS(suchasaFederalMortgageInsuranceCorp.,aNationalMortgageReinsuranceCorp.,orsimplyGinnieMae).

Eitherway,bothoftheseinitiatives—theCRTandtheCSP—aremeaningfulundertakingsthatfacedskepticisminthebeginningbutarenowlargelyrecognizedasworthwhileendeavors.Thesechangesalone,solongastheyarecontinued,helpensurethatthepost-conservatorshipsecondarymarketseg-menttraditionallyservedbyFannieandFreddiewillnotlookthesameasitdidbeforethecrisis.Congress,foritspart,hasdonemorethanimmediatelymeetstheeyeaswell.ItistruethatwehavenothadaRoseGardensigningceremonyforamajorreformlaw.Butprogresshasoccurred.ConsiderthatboththeHouseandSenatecommitteesofjurisdictionpassedreformbillsin2013and2014.Alternativebillswerealsocraftedinbothchambers,andallweredonewithagreatdealofthoughtappliedtoahighlycomplextopic.Passionssometimesflaredasvariousapproacheswereoffered.ButsuchistobeexpectedwhendiscussinglegislationthatwillforeverimpactthemarketstructurethatenablesAmeri-canstopurchasehomes.It’sclear,though,thatbothsidesoftheaisleandbothchambersofCongress—withadministrationinput—havenudgedtheirwayforward.Intheend,wedonotthinkpoliticalconsen-susisasfarawayassomewouldsuggest.

TomanyAmericans,owningahomeisaquintessentialelementoftheAmericandream.Howthehous-ingmarketshouldservefamiliesisaquestiontobeansweredbyourelectedofficials.CongressandtheWhiteHousemustand,inourviewwill,setthefourcornersofhowthefuturesecondarymortgagemarketwilloperate.Afterall,anactoflawcharteredtheenterprises,andanactoflawinjectednearly$200billionoftaxpayermoneyintothemtokeepthemsolventsince2008.Anactoflawwillultimatelyresolvetheconservatorshipsanddecidethesecondarymortgagemarket’sfuturestructureandpartici-pants.Tothinkthatsomethingofthismagnitudeshouldbedonesimplyviaregulatoryactionis,tous,aninsulttoCongressandtheAmericandemocraticprocess.

7.OnOct.7,2013,theFHFAannouncedajointventurebetweenFannieMaeandFreddieMactoimplementtheCSP.ThenewentitywascharteredasCommonSecuritizationSolutions,LLC℠(CSS).Theideaofdirectingtheenterprisestoinitiatejointworkonacommonsecuritizationplatform,orCSP,firstappearedinthe2012StrategicPlanforEnterpriseConservatorships,andtheideawassubsequentlydevelopedinvariousFHFAwhitepapers,speeches,andannouncements.Seehttp://www.fhfa.gov/PolicyProgramsResearch/Policy/Pages/Common-Securitization-Platform-Background.aspx.

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Weunderstandthedifficulty,butthisisadebateabouttheroleofgovernmentandmarketforcesinnearlyone-fifthoftheAmericaneconomy.Theresponsibilityforresolvingthisdebatefallssquarelyontheshouldersofourelectedofficials.Sowebelievethedebatewillshiftbacktowardlegislatorsandthenextadministration.Here,fortheirconsideration,weofferanswerstotwocriticalquestions.

What Parts of the Currency Secondary Mortgage Markets Are Worth Pre-serving? Ifreformersaretobeguidedbytheprinciple“Don’tthrowthebabyoutwiththebathwater,”itisworthclearlyidentifyingwhichiswhich.

Therearemanyaspectsofhowthecurrentmodelworksthatareworthkeeping,andanyreformplanshouldtakecaretonotdamagethese.Webelievetherearethreebroadaspectsofthecurrentsystemthatallpartieswanttopreserve.Oneaspectconcernstheinvestors—thesuppliersofthemoneyusedtobuyhomes.Thesecondaspectconcernsthehomebuyersandlenders—thepartieswhorelyonthatsourceoffundstomakenewmortgageloans.Andthethirdaspectconcernsthenumberandreliabilityofthepipesconnectingborrowersandlenderstoinvestors.

1. MAINTAININGALIQUIDMBSMARKETIntoday’ssecondarymortgagemarket,thereare$6.3trillioninoutstandinggovernmentandagencyMBS,ledbyFannieMae($2.8trillion),FreddieMac($1.8trillion),andGinnieMae($1.7trillion).8Thesesecuritiestradeinglobalcapitalmarkets.ThevastscaleandliquidityofthesemarketsmeanthereisareliableflowofmoneyfromaroundtheglobetofundAmericanhomebuying.Asaresult,homebuyerscanobtainmortgageloansthroughtheupsanddownsoftheeconomy.Indeed,mortgagesremainedavailableevenasotherpartsofthecreditmarketsenduredconsiderablestrainsduringthefinancialcri-sis.Ontheinvestors’side,adeepandliquidMBSmarketiscertainlyacharacteristicofthecurrentsys-temtobemaintained.

TherearetwoaspectsofthisdeepandliquidMBSmarketthatwarrantspecialmention.

a. TheTBAMarketOneofmodernfinance’smoreinterestingandimportantinnovationswastheMBSfuturesmarket,re-ferredtobytradersandinvestorsastheToBeAnnounced,orTBAmarket,asmentionedearlier.Itena-blesmortgagelenderstolockinaforwardpriceformortgages,which,inturn,allowsahomebuyertolockinhisorherinterestrateinadvance.AbsenttheTBAfuturesmarket(orsomeequivalent),custom-ersmaynotknowtheirinterestrateuntilthedaytheycloseonaloan.

ThismarketservesasafoundationalpillaroftheAmericanhomebuyingprocessandshouldbere-formedbutkeptintact.Italsoprovidesthemeansforhedgingalargeportfolioofmortgagesagainstfluctuationsininterestrates,therebyallowingassetmanagersofvariousstripestosupporthomeown-ershipvialiquidinvestments.ItisimportanttorecognizethattheTBAmarkethasnotemergedinnon-

8.SIFMA,USMortgage-RelatedIssuanceandOutstanding.Feb.18,2016.

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governmentalasset-backedsecuritization.ItsfunctioningrestsontheeliminationofcreditrisktoMBSinvestorsduetoeitheranexplicitorimplicitgovernmentguaranteecombinedwiththegovernmentex-emptingtheissuingagenciesfromcertainsecuritieslaws.9

b. StandardizationMBSinvestorsrelyonasetofstandardstoensuretheirabilitytomodelandpricethesesecurities.ThedegreeofstandardizationvariesacrosstheGinnieMae,FannieandFreddie,andPLSsegmentsoftheMBSworld.Wherestandardswereweakest—thePLSmarket—iswherethemostsevereproblemsaroseduringthecrisis.Thepastseveralyearshaveseenmuchefforttoenhancestandardizationinallthreemarketsegments,andtheseeffortsshouldcontinue.

Datastandards—TheFHFAdirectedthatFannieandFreddiereleasesubstantialamountsofhistoricalloan-leveldataforanalysisbymarketpractitioners.InMay2010,theagencylaunchedtheUniformMortgageDataProgram,inwhichFannieandFreddiehavebeenworkingwiththeindustrystandard-settingbodytodevelopcommondatadefinitionsandanindustrywidemethodforelectronicreportingofmortgage-relatedinformation.Amechanismforensuringthecontinuedstandardizationandpublicreleaseofmortgagedatagoingforwardshouldbeestablished,buildingonthisrecenteffort.

Servicingstandards—Twohomeownerswhoexperiencesimilarlifecircumstancesthatleadtotheinabil-itytopayamortgageshouldnotbetreateddifferentlybecauseonehadservicingrightssoldtoamoreresponsiveservicerthantheother.Ittookyearsofeffortinthewakeofthefinancialcrisistodevelopmoreuniformmortgageservicingpractices,particularlyastheyrelatetoworkingwithdelinquentbor-rowers.Investorsneedtoknowtheservicingrulestoestimatetheirpotentialcostsandrecoverieswhenaborrowerdefaults.Inaddition,sinceservicersaretheagentsforenforcingthemortgagecontract,in-vestorsneedtoensurenotonlythattherearestandardsforservicingpractices,butthatthosestand-ardsareenforced.Clearly,thereisaneedforeffectivemanagementandoversightofservicers.

Securitystructureanddisclosures—ThemoreuniformthecontractualtermsfromoneMBStoanother,thelesssecurity-by-securityreviewinvestorsmustperformwhendecidingwhethertomakeapurchase.SoMBSuniformityaddsliquidity,whichultimatelylowersborrowingcosts.AkeyFHFAscorecardgoaltodayismovingFannieandFreddietoacommonsecurity,therebyeliminatingdifferencesbetweenthetwothatmayhamperliquidityandleadtodifferentialpricingbetweenthecompanies’MBS.TheTreas-uryandindustrygroupsarealsoworkingonamorestandardizedsecurityforthePLSmarket.

Beyondthetermsofthesecurity,standardizationofthedisclosuresmadetoinvestorsalsoenhanceli-quidityandinvestors’confidenceintheexpectedperformanceoftheunderlyingmortgages.Hereagain,theFHFAhasbeendrivingeffortstodeepenandstandardizedisclosuresbetweenFannieandFreddieMBS.Acommonsecuritymightalsofacilitateotherfirms’eventualentryintothesecuritizationbusiness

9.FormoreinformationontheTBAmarket,seeJamesVickeryandJoshuaWright,TBATradingandLiquidityintheAgencyMBSMarket,FederalReserveBankofNewYorkEconomicPolicyReview,May2013.https://www.newyorkfed.org/medialibrary/media/research/epr/2013/1212vick.pdfandCenterforAmericanProgress,TheImportanceoftheTo-Be-Announced,orTBA,Market,https://cdn.americanprogress.org/wp-content/uploads/2013/10/HousingFinanceReform_4.pdf.

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withagovernmentguarantee,sincetheMBSissuedbyanewfirmwouldtradeinacommonpoolwithexistingassetsratherthanbearingamassiveliquiditydisadvantage.

2. MAINTAININGNATIONWIDEACCESSTOTHESECONDARYMORTGAGEMARKETATALLTIMES

Fromthepointofviewofhomebuyersandmortgagelenders,thesecondarymarketneedstoprovidereliableaccessforalleligibleborrowersandlenders,withoutregardtoloansize,propertylocation,andtypeorsizeoflender.

Butachievingthisequitableaccesscanbechallengingbecausemanyofthecoststounderwritealoanarefixed,whichmeanstheyrepresentahigherpercentageoftheloanamountonsmallerloansthanonlargerones.Additionally,theseincentivesgenerallypushlenderstofocusontheloansthatareeasiesttomake.Asaresult,communitieswithrelativelyfeworlow-pricedhouses(mostlyruralandlower-incomecommunities)oftenfaceoriginationcoststhatarehigherasashareofloanvaluethanmoreur-banandwell-offcommunities.Amortgagecreditsystemthatsupportsaconsistentguaranteefeena-tionwidecanprovidelower-dollar-amountloanswithequitableaccesstothesecondaryMBSmarket.Reformshouldensurethatthesesmallerandmorechallengingloanshaveequitableaccess.

3. COMPETINGOUTLETSCONNECTINGTHEPRIMARYMARKETTOTHESECONDARYMARKET

WhilethiselementofmaintainingaliquidMBSmarketmightnotdrawuniversalagreement,inourviewthemechanismsthatconnecttheprimarymarket(wherelendersmakeloanstoborrowers)andthesecondarymarket(whereglobalinvestorsbuyandsellMBS)shouldthemselvesbesubjecttocompeti-tion.Therearethousandsoflendersandmillionsofborrowersoutthere.Forcingthemintojustoneortwogatekeepersthatcontrolthesecuritizationprocess(aswedidwithFannieandFreddie)diminishesinnovationandcustomerservicewhileincreasingsystemicriskassociatedwiththeoperationalorfinan-cialfailureofthegatekeeper.

Ifanything,itisremarkablethatFannieandFreddiestillcompetewitheachotherforbusinesswhileun-dergovernmentcontrol.Theyshouldbelaudedforcontinuingtoinnovateindevelopingtoolsandtech-nologiestoassisttheirsellerservicers.Butasweembracetheforcesofcompetition,weshouldremem-berthatinhousing,suchrivalrycancutbothways.Webelievethatcompetitionshouldbesegmentedintoareasthatarebeneficialandthosethataredamaging.

Forexample,proprietarydatastandardsatFannieandFreddieservedtoreducedataquality.Theywerenot,orshouldnothavebeen,asourceofcompetitiveadvantage.Competitioninpricingcanbehelpfulifitreducesmortgageratesforconsumersbutharmfulifitleadsthefirmstounderpricerisk.Moreover,insufficientcompetitioncandistortmarkets,suchasintheoldsysteminwhichFannieandFreddieof-feredinsurancepremium(i.e.,theguaranteefee)discountstolarge-volumelendersthatunderminedoverallunderwritingquality.Ontheotherhand,competingoncustomerserviceinworkingwithsellerservicersdidandshouldcontinuetopromoteefficiencyandbetteroutcomes.Thefuturesecondarymarketshouldmaintainincentivesforparticipantstoinnovateintechnologyandinfrastructure,tobeasresponsiveaspossibleandincreasethequalityoftheirinteractionswithparticipantsintheorigination

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market.These“competitive”aspectsoftheoldandcurrentsystemsareworthpreservingandenhanc-ing—andapplytoadditionalfirmscompetinginthesecuritizationmarket.Finally,asnotedabove,havingmultiplefirmsparticipateinsecuritizationensuresabufferincaseanyofthemfail.Noindividualfirmshouldbesoessentialtothefunctioningofthemarketortheeconomythatitmustberescuedfromfinancialdistress.Amarketstructurethatallowsnewparticipantstoentercanaddresssomeofthesystemicriskconcernsarisingfromaworldwithjustoneortwosecuritizationgate-keepers.

What Should a Reform Law Aim to Accomplish? Iftheaboveisworthsaving,whatmustweleavebehind?Thatis,whatchangearewetryingtobringabout?

Inourview,thereareglaringneeds.Webelievetheprimarychangesthathousingfinancereformmustaccomplishcanbroadlybebucketedintothefollowingfivecategories:

(1) ELIMINATEEMERGENCYBAILOUTS.(2) BUILDSOMEDEGREEOFCONSENSUSONAMODERNIZEDAFFORDABILITYANDACCESSPARA-

DIGM.(3) BRINGMARKETSIGNALS,PRIVATECAPITAL,COMPETITION,ANDINNOVATIONBACKTOTHEMAR-

KET,BUTWITHSTANDARDSANDGUARDRAILS.(4) ELIMINATEHIDDENORIMPLIEDGUARANTEESANDALLVESTIGESOFTHECRONYCAPITALISM

THATCHARACTERIZEFANNIEANDFREDDIE’SCHARTERS.(5) ALIGNINCENTIVESASMUCHASPOSSIBLETHROUGHOUTTHEMORTGAGEECOSYSTEM.

Inshort,weadvocatepreservingthebusinessfunctionsprovidedbyFannieandFreddiethatworkandareneededinthesecondarymarket.Buttheinherentconflictsneedtogo,andweneedtorelyfarmoreonnormalmarketmechanismstoanalyze,price,anddistributeriskacrossawidesetofparticipantsra-therthanconcentratethatriskinoneortwoentities.ThatbringsustochangeNo.1.

(1) ENSURETHATWEHAVENOMOREEMERGENCYBAILOUTSINHOUSINGTheGSEshavebeenstuckinastateoflimboforthebetterpartofadecade.Thatbeganwithanemergencyinjectionofcapitalin2008,whenCongresswasforcedtoauthorizetheTreasuryDe-partmenttodowhatmanyfeareditwouldhavetodoinacrisis—usetaxpayermoneytomakegoodonFannieandFreddie’sguaranteesbecauseshareholdercapitalwaswoefullyinadequate.Withoutthebailout,Congresswouldhaveriskedacollapseofthehousingmarket(nottomen-tiontheU.S.economyandtheglobalfinancialsystem).

Firstandforemost,housingreformmustdesignasystemthatensuresthiswillneverhappenagain.One-fifthofoureconomycannotrelyonemergencycongressionalactiontohelpthesec-ondarymarketremainsolvent.That’snotcapitalism.We’reprettysureit’snotsocialism,either.Itiscronycapitalism.Labelsaside,though,it’snotasmartsystemicdesign,anditisnotgoodpublicpolicy.Soatitscore,reformneedstominimizethelikelihoodofasituationinwhichCon-gressmustbailoutenterprisesthatenrichthemselveswithfederalbenefits,thensendthebilltotaxpayerswhentheygetintotrouble.

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Ofcourse,theinjectionofcapitalintoFannieandFreddieisn’ttheonlythingthathappenedin2008.Othermajorfinancialfirmsfailedandwereshutdown(e.g.,LehmanBrothers)orweremergedoutofexistencebythegovernment(e.g.,WashingtonMutual).Hundredsofbanks,rangingfromthelargestmegabankstohundredsofsmallcommunityinstitutions,receivedTARPfundstoshoreuptheirprecariouscapitalpositionsortohelpstabilizethefinancialsystem.

Butintheaftermath,atleastalawwaspassedthatwasdesignedtoreducethechancethatthenationwouldgothroughthisagain.Dodd-Frankiscertainlynotperfect,farfromit,anditre-mainstobeseenwhethertheresolutionauthorityinTitle2wouldsufficetopreventbailoutsinafuturesystemiccrisis.Butasignificantstepwastakenforbanks,andthedebateaboutbreak-ingthemupremainsamajorpartoftoday’spolicyconversation.

FortheGSEs,however,nosuchreformhasoccurred.Yetwehearagrowingchorusdemandingthatthecompaniesbereleasedfromconservatorshipandreturnedtothestatusquoante.

Webelievethatwouldbeagravemistake.In2008,CongresshadtorescueFannieandFreddieMBSinvestors(andthecompanies’debtholders).Wecan’thaveasystem“capitalized”byshareholdersintwoinstitutionsthataretoobig,tooimportant,andtooentrenchedtofail.Theriskconcentratedintheseentitiesmustbedistributedacrossthefinancialsystemsothatmar-ketscanbettermanageriskandabsorblosseswhenmisjudgmentsaremade.

Wealsoneedtobehonestaboutcertaineconomicandpoliticalrealities.WecannotenvisionaworldwhereCongresswouldallowacollapseofthenation’shousingmarketwithoutamean-ingfulresponsethatinvolvestaxpayers.Theeconomicdamageandfollow-oncostssuchacol-lapsecouldimposeandthesystemicimplicationsforfinancialmarketsmakecongressionalac-tionalmostcertain.Sotaxpayersalreadyownthetailrisk(orcatastrophicrisk).ThisputoptionwasprovidedtoFannieandFreddielargelyforfree.Itrepresentsafailureoftheoldsystemanditneedstoend.Morethanthat,policymakersshouldincludeautomaticstabilizersinthenewsystemtoactasshockabsorbersinextremeeconomicconditions.Withthoseinplace,marketparticipantswouldhavegreatercertaintyheadingintoacrisis,mutingvolatility.

(2) BUILDCONCENSUSONTHEOBJECTIVESOFACCESSANDAFFORDABILITYPOLICY,ANDMAKETHEMTRANSPARENTANDACCOUNTABLESenateeffortstoreshapethesecondarymarketfalteredin2014innosmallpartbecausesomesenatorsobjectedtochangesmadetotheaffordabilityparadigmsthatexistedpriortoconser-vatorship.Asareminder,thelegislationwouldhavereplacedhousing“goals”—therulesthatgovernwhatpercentageofGSEguaranteedloansmustbemadetoborrowerswithloworverylowincomesorwhoresideinlow-incomecommunities—withanoff-budget,10basispointtaxonmortgagesflowingthroughthenewsystem.Thisrevenuewouldhavedirectlyfundedhome-ownershipandrentalassistanceprograms.

Finalnegotiationsneverquitecametofruition,buttheconceptevolvedintoa“flexfee,”withthetaxincreasingordecreasingdependingonhowmuchtheprivateguarantorswereservicing

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designatedmarkets.Whiletheideareceivedhighmarksfortransparencyandaccountability,timeranoutbeforetheconceptcouldbefinalized.

Soreformshouldanswerthesequestions:Whatisthegoalofouraffordabilityandaccesspara-digm?Wheredomarketmechanismsfailtowork,andwhy?Howdowemostefficientlyandef-fectivelytargetandachievehomeownershipaccessgoals?Howcanwecreateasystemthaten-suresequitableaccessforallAmericans?Areareamedianincometargetedgoalsthebestway,oristhereabetterapproach?Sincerealestateconditionsaretypicallygovernedbylocaleco-nomicconditions,sometimeswithdifferinglaws,whatrolesshouldstateandlocalhousingagenciestake?Mostimportantly,doesthenewsecondarymarketstructureensureaccessforalleligibleborrowersandlenders,orareadditionalmandatesneeded?

Therecanbebotheconomicandsocialbenefitstoforcingsomecross-subsidizationofhome-ownership,thusloweringaccesscostsforborrowerswhoaretypicallyshowntobehigher-risk.Weshouldlookfirsttoprogramsthatofferthemostaccountability,transparency,andoppor-tunityforcongressionaloversight.Ifsuchprogramsarenotworkingasdesired,itisincumbentuponourelectedofficialstocorrecttheirshortcomings(oreliminatethem).Inaddition,ifthepublicpolicygoalofpromotinghomeownershipforthesefamiliesistoencouragelong-termwealthbuilding,weshouldthinkharderaboutwhetherourcurrentapproachesachievethatoutcome.(Forexample,weincentivizedebtoverequityaccumulationinmanyways,includingthroughthemortgageinterestdeduction.)

Thefactis,thecountryhasaregrettablelegacyofredlininganddiscriminationinhousingfi-nance,someofitofficiallysanctionedintheearlyyearsoftheFHAprogram.Thishistoryhasimposedlong-termcostsonthevictims.Low-incomecommunities,inaddition,oftenfeeltrappedbetweennoaccesstocreditandpredatorylending.Wewouldbenefitasacountryifwecouldenvisionahousingpolicythatnotonlyensurednondiscriminatorytreatmentbutcultivat-edopportunitiesforthosewhofacehomelessnessorstruggletofindanaffordablerentalorconfrontenormousobstaclestostartingonthewealth-buildingpathofhomeownership.Surely,withnewthinking,wecanfindamoreefficientapproachtopromotingaffordablehousingthanwhatwehavenow.

Inourview,anexampleofmisguidedassistanceisapprovingamortgageforsomeonewholacksthebasicpreparationfortheresponsibilitiesofhomeownership.Abetterlong-termapproachwouldentailhelpingsuchapersontogetprepared.Thatcanincludefinancialcounseling,pro-gramsdesignedtorepaircredit,assistanceinestablishingahouseholdbudget,andassistingwithasavingsplanfocusednotjustonadownpaymentbuttohelpthefuturehomeownerbuildarainydayfund.Andwemustrecognizethatwehaveaseriousproblemwhenalmostaquarterofrenterhouseholdsspendmorethanhalfoftheirincomeonrent.10

10.http://blogs.wsj.com/economics/2016/06/22/middle-income-families-are-increasingly-losing-ground-on-affordability-despite-a-housing-recovery/.

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Ratherthanmaintainthestandoffthistypeofpolicydiscussionnormallyproduces,weneedtofindnewapproaches.Wesubmitthattheremayberoomforagreementintherealmsofusingpre-andpost-purchasecounselingforfirst-timehomebuyers;disbursingsomefundstostateandlocalentitiesthathaveprovensuccessfulassustainablehomeownershipmodels;focusingonmakingrentmoreaffordable;workingwithwould-behomeownerstohelpthemsucceed,andmakingsurethataccessismaintainedforlow-dollar-amountloansandloansthatrequiremoreunderwritingresourcesbutcanbesuccessful.RepublicanorDemocrat,noonewantsthetaxpayertosupportasystemthatonlyservesborrowerswhowouldhavereceivedaloanany-way.Wealsodonotwanttaxpayerstosupportasystemfocusedonhigh-endrentals.WeneedahousingsystemthatworksforAmericanhouseholdsofallincomelevels.Itstartswithdialogueandopennesstoreform.

(3) BRINGPRIVATECAPITAL,COMPETITION,ANDINNOVATIONBACKTOTHEMARKET,BUTWITH

STANDARDSANDGUARDRAILSThegovernmenttodaydominatesthesecondarymortgagemarket.Itsetstherules,pricestherisk,anddetermineswhatproductsareacceptableorotherwise.Wehavelostmanyofthemar-ketforceswerelyonintherestofourfinancialsystem.Taxpayerscontinuetoprovidealmostallofthecapitalthatsupportsthesecondarymortgagemarket.Yetbeforeadvocatingfor,andmovingbackto,amoremarket-basedsystem,wemustcometogripswithhowthatmarketsys-temcontributedtothefinancialcrisisandensurethatourreformsrecognizeandaccountforthosefailings.Hereagain,weneedtoseparatebabyfrombathwater.

Wedonotsubscribetoone-sidedviewsofthecauseofthefinancialcrisis.Webelievethatstrenuouseffortsbypolicymakerstopromotehomeownership—suchashousinggoalsin2004thatencouragedsubprimelending—contributedtomarketinnovationsthatfailedspectacularly.Whatismostregrettableisthatthesefailuresinflictedenormousdamageonvulnerablehouse-holdsthepoliciesandprogramsweresupposedtohelp.

Yetwhilerespondingtogovernmentincentivesandencouragement,mortgageoriginatorsandsecondarymarketparticipantsalsopursuedtheirownself-interestandoperatedinaremarka-blypredatorymannerthathidrisksasthoseriskswereshiftedaroundthesystem.Andwhatev-eronethinksaboutthegovernment’sculpabilityinpromotingriskymortgagelending,nooneforcedthemanagersofthesebusinessestoabandontheirfiduciaryresponsibilitiesortheircommonsense.Theendresult,ofcourse,causedenormousdamagetohomeownersandneighborhoods,butalsoharmedMBSinvestors,includingregularfolkssuchasfamiliessavingforretirementorfortheirchildren’seducation.

Soinreturningtoamoremarket-basedsystem,thegovernmenthasarolepromotingbothcon-sumerandinvestorprotection.Inparticular,thismeansensuringthatmarketsoperatetrans-parentlyandcompetitivelyandareaccessibletoall.Italsomeansmarketsshouldevolvetomeetnewcircumstancesandbeallowedtoinnovatetobettermeetconsumerneeds.Thehardlessonsofthefinancialcrisisalsoshouldinstillinusameasureofhumilityastotheefficacyofeffortstopromotemarketoutcomesthatareincompatiblewiththedynamicsofriskandre-

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ward.Weshouldnotaskprivatemarketparticipantstoachievesocialpolicygoalsthroughawebofhiddensubsidiesandpenalties.Forstarters,moretransparencycanbehelpful.

Thegoodnewsiswehavealreadystarteddowntheroadtosuchanoutcome.Progresssince2013inthecredit-risktransfermarket—thesellingofmortgagecreditriskawayfromFannieandFreddieandbacktoprivatecapitalmarket—isthefoundation.Ifreformerswanttoseemorepricesignalstoindicatewherenationalmortgageratesshouldbe,thenthecontinueddevelop-mentofthecredit-risktransfermarketisessential.ButitsprogressdependsonthewillingnessoftheFHFA(andFannieandFreddie)todirectthisriskawayfromtaxpayersandbacktomarketparticipants.Congressshouldmakeitclearthattheseprogramsareapermanentfeatureofthesecondarymortgagemarket.

Ifgovernmentsawitsrolemoreasprovidingdirectsubsidieswhereneededandotherwiseen-suringtransparentandopenmarketssupportedbyconsumerandinvestorprotections,thepowerofprivatemarketstoinnovateandprovidecapitalforhousingwouldbeunleashed.Therootwordof“capitalism,”ofcourse,iscapital,andtoday’smarketrelieslargelyontaxpayercapital,notprivatecapital.Butfornow,withtaxpayersguaranteeingroughlythreeofeveryfourmortgages,thefederalgovernmentisoccupyingthefield.Marketsignals,innovation,andcom-petitionarestifled,precludingthefullreturnofprivatecapitaltomanagemortgageriskandheapingthatriskonthebacksoftaxpayers.

(4) ELIMINATEHIDDENORIMPLIEDGUARANTEESANDALLVESTIGESOFTHECRONYCAPITALISMTHATCHARACTERIZESFANNIEANDFREDDIE’SCHARTERSOfcourse,whilemarketsignalsareimportant,housingisacriticalhumanneed,soitshouldcomeasnosurprisethatmarketfailures,realorperceived,drawthegovernmentintothissphere.TheFHAprogramisjustoneexample.ThemortgageinteresttaxdeductionandGSEhousinggoalsalsoreflectelectedofficials’judgmentthatthesociallyoptimalamountofhousingfinanceisgreaterthanwhatapurelymarket-basedsystemwouldprovide.

FHAisfundedbyitsusersandhasdirectaccesstotheTreasuryDepartmentforrevenue,solossesthatexceedtheprogram’sself-fundingaretransparentlytheresponsibilityoftaxpayers.Theprogramismanagedbygovernmentofficialswhoarepaidatgovernmentpayscales,andtheprogramisoverseenbyCongress.

Asexplainedearlier,FannieandFreddieoperateinadifferentworld.Pre-conservatorship,theywereinaworldofcronycapitalism,privatelyownedbutendowedwithspecialprivilegesthatenrichedtheiroperations.Theyregularlylobbiedformorewhilefiercelyprotectingwhattheyhad.Theywereclosetothegovernmentwhenitsuitedthem(aswhenborrowingmoneyincap-italmarkets)andfullyprivatewhenitdidn’t(compare,forexample,thesalariesofFannieandFreddieCEOstothatoftheFHAcommissioner).11

11.In2007,theyearbeforetheconservatorships,FannieMae’sCEOtookhome$12millionandFreddieMac’sCEOreceived$18million.TheFHAcommissionerearnedlessthan$200,000.

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Itisnotillogicaltolookatthe78-yearhistoryofFannieMaeandthe46-yearhistoryofFreddieMacandconcludethata)theyadvancedtheirpublicmissionandmadepositivecontributionstocreatingastableandliquidsecondarymortgagemarketandb)theiroperatingstructurewashorrendousforthesystemicriskitbuiltupandthecorrosiveeffectithadonthebodypolitic.12Thechallengeofreformistoensureastableandliquidsecondarymarketaswellasthesystem-aticremovalofallvestigesoftheflawsinherentintheheads-I-win-tails-the-taxpayers-losestructure.

Thatmeansnomoreimpliedguarantees,nomoreexclusivechartersthaterectbarrierstoentrywhilegrantingoperatingadvantagesthatreinforcesuchbarriers.Thatmeansthenewsecond-arymortgagemarketinstitutionsmustbeabletofailwithoutthrowingourhousingfinancesys-tem,andindeedtheglobalfinancialsystem,intoturmoil.Thatmeansthesystemmustbetrans-parentandallmarketparticipantsmustfacethesamecapitalandoperatingrequirements.

(5) ALIGNINCENTIVESTHROUGHOUTTHEHOUSINGSYSTEMThelackofincentivealignmenthasbeenasignificantfailingoftheoldandcurrentmodels.The-semisalignmentscameinallsortsofflavors:originatorswhohadnoskininthegameonmort-gageperformance;second-lienholderswhoservicedfirstliensownedbysomeoneelse;home-ownerswhousedtheirhousesasATMstotakeoutequitythroughsecondmortgagesandequitylinesofcredit;brokerswhohadincentivestohelpinvestorscommitfraudandlenderswhohelpedborrowersdothesame;appraiserswholosttheirjobsiftheydidn’thittheirnumbers;servicingcompensationrulesthatdidn’thelptroubledborrowerswhenmarketsbecameun-glued;noonehelpinghomeownersunderstandthecostsalongwiththebenefits….Wecouldgoon.

Thebottomlineisthatmortgagecreditriskshouldnotbea“hotpotato”passedfromoneinsti-tutiontothenext,whereitisalwayssomeoneelse’sproblem(andultimatelybecomesthere-sponsibilityofgovernment).Lendersandsecondarymarketfirmscan’tbeinthebusinessofget-tingrichbyhandingthegovernmenttheburden.GSEscan’tbeinthebusinessofgettingrichbygamblingthatthetaxpayersgivethemafreeputoption.Shareholderscan’tbeinthebusinessofgettingrichbyknowingthatthecompaniestheyowncannevergounder.

Thereisawaytohelprightthesewrongs,anditinvolvesaligningincentives.Reformshouldhelpeveryonewhooperatesinthemortgageecosystemhaveastakeinitscollectivesuccess.Itshouldincentivizethebuildupofequity,notjustdebt.Itshouldputeveryone’sskininthegame—borrowers,servicers,lenders,guarantors,andthegovernment.

12.See,forexample,OwenUllman,“CronyCapitalism:AmericanStyle,”TheInternationalEconomy,July/August1999.http://www.international-economy.com/TIE_JA99_Ullmann.pdf.

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Consequences of InactionBeforeconcluding,weshouldremindreadersofsomepotentialconsequencesofinaction.The114thCongresshasbeenlargelyabsentfromthedebateabouthousingfinancereform.Withthenotableex-ceptionoftwolawsthatactuallypassed—onethatrestrictedCEOcompensationatFannieMaeandFreddieMacandonethatplacedlimitationsonthesaleofTreasury-ownedsharesintheenterprises(theso-called“JumpstartGSEReform”bill)—littlehasoccurred.

Thiswasperhapsaconsequenceof“housingfinanceexhaustion”afterthepreviousCongresssawtwoeffortsstallafterdevotingmuchtimeandresources.Suchexhaustionisunderstandable,butdangerous.Itisfortunatethateffortstobringinmarketsignalsandunifytheenterprises’securitizationfunctionshavecontinuedduringthistime.Butitshouldnotbetakenforgrantedthatwewillremainonthistra-jectoryabsentcongressionaloversight.

ThefirstglaringconsequenceofinactioncouldbeFannieandFreddie’sentrenchmentintooureconomyinsomebarelyevolvedversionoftheiroldselves.WithoutmoreguidancefromCongress,forexample,theFHFAandtheGSEscouldverywellchoosetopositionthemselvesasthegatekeepersofmortgagecreditfortheentiremarket.Weareconcernedthatcongressionalinactioncouldleadtheenterprisestofurtherembedthemselvesintothemarkets,notfurthermovethemandtaxpayersoutofharm’sway.Unlesslawmakersareinvolved,thiswillbelefttochance.

Whichbringsustothenextriskofinaction:TheFHFAwasneverenvisionedasthepermanentmanageroftheenterprises.Itwasmeanttobetheirregulator.WhiletheHousingandEconomicRecoveryActof2008gavetheFHFAmoreauthoritythanthepreviousFannie/Freddieregulator(theOfficeofFederalHousingEnterpriseOversight)had,wecouldbeonamarchbacktothedayswhenFannieandFreddiehadmorepoliticalinfluencethandidtheirregulator.PoliticizingFHFAleadershippositionscould,forexample,easilyneutertheagencyandgivetheGSEsevenmoreswaythantheyheldinthe1990s.Suchanoutcomeshouldterrifypolicymakersonallsides.

ThecurrentFHFAdirectorandhispredecessor(aco-authorofthispaper)haverepeatedlyspokenoftheneedforCongresstoprovidedirectiontotheagencyand,moreimportantly,totheentiremarket.Aswenotedearlier,wearetalkingaboutone-fifthoftheAmericaneconomy.Ourelectedrepresentativesareresponsibleforcraftingavisionforthefutureofhousingmarketsandhousingpolicy.

Thethirdriskisthatanothereconomicdownturncouldleadtolargelossesattheenterprises,anotherroundoftaxpayerassistance,potentialmarketdisruptions,andlegislationcraftedinacrisiswithdeci-sionsmadeintheheatofthemoment.Noonewhocaresabouthousingshouldwantsuchanoutcome,noteventhosewhobelieveitwouldputthepoliticalwindattheirbacks.Andbesides,waitingforsuchamomentisadangerousstrategy,inpartbecause…

…inactioncouldthwartthenascentdevelopmentofthecreditmarkets,whichhaveshownsignsoflifeinrecentyears.Thesemarketshaveevenbegundevelopingmodernizedinfrastructuretoprice,hedge,andmanagemortgagecreditrisk.

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WhatworriesusmostisthatalackofmeaningfulsupervisionbyCongresscreatesadynamicinwhichtheplayersdonotactwiththegoodofthebroaderecosysteminmind.Itisnotdifficulttoenvisionpeoplefightingtoprotecttheirturf,allowingegostodrivedecisions,andmakingspeechesdesignedtoprovidepoliticalcoverintheeventofacapitalshortfallratherthandoingthehardworktostructurallyredirectriskawayfromtheTreasuryDepartment’sbackstop.Allofthisiscorrosivetonotonlythefunc-tioningofthemarketsbuttoCongress’abilitytomonitorthefunctioningofoureconomy.

Incremental Administrative Steps While Reform Percolates ThereareaseriesofstepsthattheFHFAandtheGSEsshouldtakewhilepolicymakerswrestlewiththecontoursoflong-termreform.TheFHFAshouldcontinuetoembracevariousformsofcredit-risktrans-fertobringinprivatecapitalandidentifypricesignals.TherecentFHFAscorecardmovesinthisdirec-tionbutcoulddosomuchmoreforcefully.Italsobuildsontheseeffortssubstantivelybyproposingthataformalrequestforinformationbedisseminatedtogathermarketfeedback.WehopethattheFHFAandmarketparticipantscontinuetoadvocateforrisktransferand,inparticular,thekindthatlessensdependenceonFannieandFreddie’sGSEstructureandisaimedmoreatlong-termsolutions.Tous,ifthereisoneincrementalreformthatiscrucialtocontinuingthemomentumwehave,thisisit.

Twootherstepsstandout.ThecommonsecuritizationplatformshouldbebroadenedbeyondFannieandFreddieinanticipationofotherissuers’accessingthisplatforminthefuture.Andtheconformingloanlimitshouldnotbeallowedtoincrease.ThereisnojustificationforexpandingGSEsubsidiesandtaxpayerprotectionattheupperendofthepricedistributionasthemarketrecoversandtheenterpris-esremainsupportedbytaxpayers.

Whatmakesnosensetouswhatsoeveristheideathattheenterprisesthemselvesshouldbereturnedtotheirpriorroleandstructure.Priortoconservatorship,therewasalonghistoryofwarningsfromana-lyststhatthisGSEstructurewasboundtofailattaxpayerexpense.Withthoseforecastsrealized,weshouldnotfallbackonthatbrokensystemjustbecauseachievingpoliticalconsensusishardandwillneedmoretime.

Conclusion Thisinitialpaperinourseriesoutlinestheobjectivesofreformasweseethembecausewebelieveitisimportanttoidentifywhatwearetryingtoaccomplishbeforewecraftacomprehensivereformplan.Werecognizethatachievingtheseobjectiveswillrequirehardwork.Wealsorecognizethattheywon’tattractuniversalagreement,althoughwebelievemostofwhatwehavesetforthiscloselyalignedwithobjectivesinmanyotherreformproposals.WearealsowellawarethatthesystemneedstogetfrompointAtopointBwithoutdisruption.Transitionmatters.Anyreformlegislationshouldallowforasuffi-cienttransitionalperiod.

Webelieve,however,thatreformispossible.Aswestatedearlier,importantstepshavealreadybeentakentomoveourhousingfinancesystemdownthispath.

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Therearegoingtobetradeoffsandcompromisesalongtheway.Someoftheseobjectivesmayprovepoliticallychallengingatfirst.Butlawmakersneedtogetseriousabouttheseissues,andtheyneedtogetgoing.

Next Steps Inforthcomingpapers,weintendtodefineanapproachconsistentwiththegoalsdescribedhere,ad-dressingwhatweseeasthethreebroadcategoriesofhousingfinancereformthatCongressmusttack-le.Specifically,wewillpresent:

• Adetailedproposalforasecondarymortgagemarketstructurethatenablescapitalmarketstooperateefficiently,safely,andsoundly.ThisstructurewouldreplacethefailedGSEstructurewhilecombiningmarketmechanismswithappropriategovernmentstandardsetting,oversight,andtransparentsupporttoensureadeepandliquidmarket.

• Amodernizedframeworkforhousingpolicythatwouldallowfederalprogramstoaddressmar-ketfailures,achievesociallyandeconomicallydesirableoutcomes,andinnovatetodealwithchallengesfamiliesfacefindingaffordablerentalpropertiesorreachingthatfirstrungontheladderofhomeownership.

• Aninventoryoflegalandinstitutionalstructuresthatsupportourhousingfinancesystembutareingreatneedofmodernization.Fromappraisalstomortgageregistriesandbeyond,weneedlegislativechangestobringimportantcomponentsofourhousingfinancesystemintothedigitalage.

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About the Authors MichaelBrightisadirectorintheMilkenInstitute’sCenterforFinancialMarkets.Brightworkedasatraderofagencymortgage-backedsecuritiesandinterestratederivativesforsixyears,leavingWa-chovia’scorporateandinvestmentbankin2008attheheightofthefinancialcrisistocometoWashing-ton.HeworkedattheOfficeoftheComptrolleroftheCurrencyinthedivisionoflargebanksupervisionbeforejoiningtheofficeofSen.BobCorker(R-TN)andservingasaprincipalauthorofS.1217,the“Corker-Warner”andlater“Johnson-Crapo”housingfinancereformbill.Brighthasalsobeeninvolvedinthedevelopmentofseveralcredit-risktransferdealssinceleavingCapitolHill.

EdDeMarcoisaseniorfellowinresidenceattheMilkenInstitute.Priortothat,hewasa28-yearcivilservant,culminatingwithhisroleasactingdirectoroftheFederalHousingFinanceAgencyfromSep-tember2009toJanuary2014.Therehedealtwiththechallengesofmanagingthemega-institutionsFannieMaeandFreddieMac.DeMarcocraftedthe2012FHFAStrategicPlanforEnterpriseConserva-torshipsandtheassociatedscorecardsandsetintomotionthecredit-risktransferandcommonsecuriti-zationinitiativesthatunderpinadministrativeeffortstoday.About the Center for Financial Markets BasedinWashington,D.C.,theMilkenInstituteCenterforFinancialMarketspromotesfinancialmarketunderstandingandworkstoexpandaccesstocapital,strengthen—anddeepen—financialmarkets,anddevelopinnovativefinancialsolutionstothemostpressingglobalchallenges. About the Milken Institute TheMilkenInstituteisanonprofit,nonpartisanthinktankdeterminedtoincreaseglobalprosperitybyadvancingcollaborativesolutionsthatwidenaccesstocapital,createjobs,andimprovehealth.Wedothisthroughindependent,data-drivenresearch,action-orientedmeetings,andmeaningfulpolicyinitia-tives.©2016MilkenInstituteThisworkismadeavailableunderthetermsoftheCreativeCommonsAttribution-NonCommercial-NoDerivs3.0UnportedLicense,availableatcreativecommons.org/licenses/by-nc-nd/3.0/