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House of Cards: Reforming America's Housing Finance System

This research compendium presents a variety of articles that discuss the problems with housing finance in the U.S. and presents alternative reforms to the current GSE model.

REFORMING THE U.S. MORTGAGE MARKET THROUGH PRIVATE MARKET INCENTIVES 
Dwight M. Jaffee 
This paper assumes the government-sponsored enterprises (GSEs, specifically Fannie Mae and Freddie Mac) are unsustainable; the expected costs they create for U.S. taxpayers far exceed their expected benefits. The question addressed is, then, how to reorganize the U.S. mortgage market in the absence of GSEs. This paper focuses on a specific mortgage-market reform proposal to abolish the GSEs and substitute privatemarket incentives for mortgage originators, securitizers, and investors, while retaining the Federal Housing Administration and U.S. Department of Housing and Urban Development programs that support lower-income and first-time homebuyers. This paper assembles data showing that stable housing and mortgage activity can be sustained with minimal government intervention, including data that demonstrate the success of western European housing and mortgage markets that operate with little government intervention.
 
TWO APPROACHES TO GSE REFORM 
Arnold Kling 
This paper offers two alternatives for reforming the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae. The first approach is to restore the status quo ante, meaning that Freddie Mac and Fannie Mae would be returned to the investing public as private corporations with government backing, able to purchase loans for securities and hold securities in portfolio, subject to safety-and-soundness regulation and limits on loan amounts. This “devil-you-know” strategy would be safer than trying to create a new governmentguaranteed mortgage system. The second approach would be for the government to get out of the mortgageguarantee business and let the mortgage market evolve in a decentralized way. This “Jimmy Stewart banker” strategy would return mortgage lending to local banks, which would retain the loans they originate. 
 
A NEW HOUSING FINANCE SYSTEM FOR THE UNITED STATES 
Peter J. Wallison 
 
The United States government has had a large role in supporting housing for at least 80 years, but it is clear that the costs of these government policies far outweigh the benefits. The United States does not rank especially high in homeownership among developed countries, and the interest rates that Americans pay for their mortgages are also higher than the rates in other developed countries. In addition, and most importantly, the taxpayers have been called upon for hundreds of billions of dollars to bail out various government-sponsored housing-finance programs that have suffered major losses over this period. The solution is to eliminate the government’s role in housing, except for a limited and carefully structured program that will allow low-income borrowers to become homeowners. In general, however, legislation—by defining a prime mortgage—should ensure that the preponderance of all mortgages are prime quality and that only prime mortgages are securitized. Once this process is established, the government sponsored enterprises Fannie Mae and Freddie Mac can be gradually withdrawn from the market by reducing their conforming loan limits over a five-year period. As Fannie and Freddie leave the market, private-sector securitizers will establish a robust and competitive market in securitizing prime mortgages.
 
HOUSE OF CARDS 8 THE WAY FORWARD: U.S. RESIDENTIAL-MORTGAGE FINANCE IN A POST-GSE WORLD 
Lawrence J. White 
The insolvencies and conservatorships of Fannie Mae and Freddie Mac in September 2008 clearly established the inappropriateness of the government-sponsored enterprise (GSE) model for residential-mortgage finance in the United States. Three years later, however, the $5 trillion question—how to replace their presence in the secondary mortgage market—remains unanswered. Fundamentally, housing finance should embody the true societal costs—the opportunity costs—of lending for home purchases. Those costs encompass the fundamental time value of money, the costs of credit risk (that is, the probabilities and costs of nonrepayment), the costs of interest-rate risk, and the costs associated with a mortgage’s being a relatively illiquid instrument. This paper lays out an argument for a mortgage finance system that would rely on private markets. This system would have two major components: financing through depository institutions and financing through private securitizations. Given the widespread belief that a private residential-mortgage finance system may not be viable and that some form of government guarantee for mortgages is necessary, this paper also offers an alternative proposal for a side-by-side government guarantee that would be superior to the tail-risk proposals that are currently circulating. 
 
THE FUTURE OF FANNIE MAE AND FREDDIE MAC 
Michael Lea and Anthony B. Sanders 
Fannie Mae and Freddie Mac, two of the government-sponsored enterprises (GSEs), are in conservatorship, and taxpayers are on the hook for over $150 billion in losses. Can the private sector offer a less costly alternative to Fannie and Freddie that requires far less government involvement in the housing and mortgage markets? The GSEs and the private sector both have loan-underwriting models, both can purchase loans and create mortgage-backed securities (MBS), and both can offer mortgage insurance. The one attribute that GSEs have that the private sector does not is an explicit guarantee from the federal government. If the private sector can replicate the GSEs’ only unique “virtue,” then there is no justification for keeping Fannie and Freddie around either in conservatorship or in their preconservatorship forms. The original “gold standard” mortgage of Fannie and Freddie was the conforming loan with 20 percent or greater down payment and good borrower credit. The default rates on these mortgages have always been very low—typically less than 5 percent for 30-year fixed-rate mortgages)—as has the loss per default. The “gold standard” conforming-mortgage market does not need a federal-government guarantee. The private sector can handle that segment of the market through private insurance markets and portfolio lending. Fannie Mae and Freddie Mac should be phased out over a five-year period. Covered bonds—like those used in Denmark and Germany—and an improved private-label MBS market, along with an increase in lender-portfolio lending, should take their places. In a world without Fannie Mae and Freddie Mac, homeownership rates may drop slightly, mortgage interest rates may increase slightly, but taxpayers will save hundreds of billions of dollars.
 
DO WE NEED THE 30-YEAR, FIXED-RATE MORTGAGE? 
Michael Lea and Anthony B. Sanders 
A central argument in the ongoing discussion about the fates of Fannie Mae and Freddie Mac is the importance of the 30-year, fixed-rate, prepayable mortgage (FRM). The FRM has been held up as the “gold standard” in mortgage instrument design and an essential element of the U.S. housing finance system. Supporters of Fannie Mae and Freddie Mac argue that a government guarantee eliminating credit risk is essential to ensuring the FRM remains the main instrument for housing finance. The FRM has benefits for the consumer through payment stability and the right to prepay the mortgage without penalty. But these benefits come at significant cost. The interest rate and prepayment risk in the FRM are costly and difficult for investors to manage. There is a premium for both the long-term and the prepayment option paid by all users of the mortgage, regardless of whether they use these features. The FRM causes instability in the mortgage market through periodic refinancing waves. The FRM can create negative equity in an environment of falling house prices—a situation many borrowers find themselves in today. And the taxpayers are on the hook for hundreds of billions in losses backing the credit-risk guarantees provided by Fannie Mae and Freddie Mac to support securities backed by the FRM. International experience suggests that mortgage markets work fine without an FRM (only Denmark has an equivalent instrument). Borrowers rarely stay with the same mortgage for 15–30 years so it is not necessary to fix the rate for such a long time period. Shorter-term, fixed-rate mortgages would be less expensive than the standard U.S. FRM in most interest-rate environments, particularly if lenders were allowed to charge prepayment penalties. The taxpayer is exposed to too much risk in supporting Fannie Mae and Freddie Mac to justify continued government support for a product for which the costs outweigh the benefits.

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SUMMARIES

REFORMING THE U.S. MORTGAGE MARKET THROUGH PRIVATE MARKET INCENTIVES 
Dwight M. Jaffee 

This paper assumes the government-sponsored enterprises (GSEs, specifically Fannie Mae and Freddie Mac) are unsustainable; the expected costs they create for U.S. taxpayers far exceed their expected benefits. The question addressed is, then, how to reorganize the U.S. mortgage market in the absence of GSEs. This paper focuses on a specific mortgage-market reform proposal to abolish the GSEs and substitute privatemarket incentives for mortgage originators, securitizers, and investors, while retaining the Federal Housing Administration and U.S. Department of Housing and Urban Development programs that support lower-income and first-time homebuyers. This paper assembles data showing that stable housing and mortgage activity can be sustained with minimal government intervention, including data that demonstrate the success of western European housing and mortgage markets that operate with little government intervention.

TWO APPROACHES TO GSE REFORM 
Arnold Kling 

This paper offers two alternatives for reforming the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae. The first approach is to restore the status quo ante, meaning that Freddie Mac and Fannie Mae would be returned to the investing public as private corporations with government backing, able to purchase loans for securities and hold securities in portfolio, subject to safety-and-soundness regulation and limits on loan amounts. This “devil-you-know” strategy would be safer than trying to create a new governmentguaranteed mortgage system. The second approach would be for the government to get out of the mortgageguarantee business and let the mortgage market evolve in a decentralized way. This “Jimmy Stewart banker” strategy would return mortgage lending to local banks, which would retain the loans they originate. 

A NEW HOUSING FINANCE SYSTEM FOR THE UNITED STATES 
Peter J. Wallison 

The United States government has had a large role in supporting housing for at least 80 years, but it is clear that the costs of these government policies far outweigh the benefits. The United States does not rank especially high in homeownership among developed countries, and the interest rates that Americans pay for their mortgages are also higher than the rates in other developed countries. In addition, and most importantly, the taxpayers have been called upon for hundreds of billions of dollars to bail out various government-sponsored housing-finance programs that have suffered major losses over this period. The solution is to eliminate the government’s role in housing, except for a limited and carefully structured program that will allow low-income borrowers to become homeowners. In general, however, legislation—by defining a prime mortgage—should ensure that the preponderance of all mortgages are prime quality and that only prime mortgages are securitized. Once this process is established, the government sponsored enterprises Fannie Mae and Freddie Mac can be gradually withdrawn from the market by reducing their conforming loan limits over a five-year period. As Fannie and Freddie leave the market, private-sector securitizers will establish a robust and competitive market in securitizing prime mortgages.

HOUSE OF CARDS 8 THE WAY FORWARD: U.S. RESIDENTIAL-MORTGAGE FINANCE IN A POST-GSE WORLD 
Lawrence J. White 

The insolvencies and conservatorships of Fannie Mae and Freddie Mac in September 2008 clearly established the inappropriateness of the government-sponsored enterprise (GSE) model for residential-mortgage finance in the United States. Three years later, however, the $5 trillion question—how to replace their presence in the secondary mortgage market—remains unanswered. Fundamentally, housing finance should embody the true societal costs—the opportunity costs—of lending for home purchases. Those costs encompass the fundamental time value of money, the costs of credit risk (that is, the probabilities and costs of nonrepayment), the costs of interest-rate risk, and the costs associated with a mortgage’s being a relatively illiquid instrument. This paper lays out an argument for a mortgage finance system that would rely on private markets. This system would have two major components: financing through depository institutions and financing through private securitizations. Given the widespread belief that a private residential-mortgage finance system may not be viable and that some form of government guarantee for mortgages is necessary, this paper also offers an alternative proposal for a side-by-side government guarantee that would be superior to the tail-risk proposals that are currently circulating. 

THE FUTURE OF FANNIE MAE AND FREDDIE MAC 
Michael Lea and Anthony B. Sanders 

Fannie Mae and Freddie Mac, two of the government-sponsored enterprises (GSEs), are in conservatorship, and taxpayers are on the hook for over $150 billion in losses. Can the private sector offer a less costly alternative to Fannie and Freddie that requires far less government involvement in the housing and mortgage markets? The GSEs and the private sector both have loan-underwriting models, both can purchase loans and create mortgage-backed securities (MBS), and both can offer mortgage insurance. The one attribute that GSEs have that the private sector does not is an explicit guarantee from the federal government. If the private sector can replicate the GSEs’ only unique “virtue,” then there is no justification for keeping Fannie and Freddie around either in conservatorship or in their preconservatorship forms. The original “gold standard” mortgage of Fannie and Freddie was the conforming loan with 20 percent or greater down payment and good borrower credit. The default rates on these mortgages have always been very low—typically less than 5 percent for 30-year fixed-rate mortgages)—as has the loss per default. The “gold standard” conforming-mortgage market does not need a federal-government guarantee. The private sector can handle that segment of the market through private insurance markets and portfolio lending. Fannie Mae and Freddie Mac should be phased out over a five-year period. Covered bonds—like those used in Denmark and Germany—and an improved private-label MBS market, along with an increase in lender-portfolio lending, should take their places. In a world without Fannie Mae and Freddie Mac, homeownership rates may drop slightly, mortgage interest rates may increase slightly, but taxpayers will save hundreds of billions of dollars.

DO WE NEED THE 30-YEAR, FIXED-RATE MORTGAGE? 
Michael Lea and Anthony B. Sanders 

A central argument in the ongoing discussion about the fates of Fannie Mae and Freddie Mac is the importance of the 30-year, fixed-rate, prepayable mortgage (FRM). The FRM has been held up as the “gold standard” in mortgage instrument design and an essential element of the U.S. housing finance system. Supporters of Fannie Mae and Freddie Mac argue that a government guarantee eliminating credit risk is essential to ensuring the FRM remains the main instrument for housing finance. The FRM has benefits for the consumer through payment stability and the right to prepay the mortgage without penalty. But these benefits come at significant cost. The interest rate and prepayment risk in the FRM are costly and difficult for investors to manage. There is a premium for both the long-term and the prepayment option paid by all users of the mortgage, regardless of whether they use these features. The FRM causes instability in the mortgage market through periodic refinancing waves. The FRM can create negative equity in an environment of falling house prices—a situation many borrowers find themselves in today. And the taxpayers are on the hook for hundreds of billions in losses backing the credit-risk guarantees provided by Fannie Mae and Freddie Mac to support securities backed by the FRM. International experience suggests that mortgage markets work fine without an FRM (only Denmark has an equivalent instrument). Borrowers rarely stay with the same mortgage for 15–30 years so it is not necessary to fix the rate for such a long time period. Shorter-term, fixed-rate mortgages would be less expensive than the standard U.S. FRM in most interest-rate environments, particularly if lenders were allowed to charge prepayment penalties. The taxpayer is exposed to too much risk in supporting Fannie Mae and Freddie Mac to justify continued government support for a product for which the costs outweigh the benefits.

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