Previously published in Bloomberg Law Reports
The United States Department of the Treasury (Treasury) recently unveiled dramatic proposals designed to reduce or eliminate government involvement in the national housing finance market. If adopted, these proposals would fundamentally alter the role that federal institutions have played in providing funding for home mortgages for nearly eighty years.
History and Development of the GSEs
Treasury's proposals are contained in a report titled "Reforming America's Housing Finance Market: A Report to Congress," released on February 11, 2011.1 The report recounts the creation of the Federal National Mortgage Association (Fannie Mae) in the late 1930s during the Great Depression.2 As originally designed, Fannie Mae purchased loans guaranteed by other government agencies in order to free up funding for these agencies to issue additional loans.3 In 1968, Fannie Mae was reborn as a public, for-profit company, albeit operating under a charter from Congress which mandated it to promote home ownership for Americans.4 Two years after that, Congress chartered a second company, the Federal Home Loan Mortgage Corporation (Freddie Mac), with a similar mandate.5 Over the next twenty years, these two "government sponsored enterprises" or GSEs, as they came to be called, played a crucial role in establishing "deep, liquid markets" for home mortgages6 and provided funding for millions of mortgage loans in all areas of the country.
The GSEs supplied this funding primarily by purchasing mortgages and then repackaging them into bonds called mortgage-backed securities which the GSEs then guaranteed.7 This practice allowed the GSEs to dominate the housing finance market in this country for several years. Because the GSEs purchased loans that met their standards (so-called "conforming loans"), but refused to purchase loans that did not, lenders were forced to issue conforming loans or lose the GSEs' funding.
Things began to change in the 1980s, when Congress passed statutes that pre-empted state usury laws and allowed lenders to offer more flexible products, such as adjustable-rate mortgages.8 These changes made possible the growth of the market for non-conforming loans, and in particular so-called "subprime" loans, meaning loans made to borrowers who were not sufficiently creditworthy to qualify for the conforming loans the GSEs purchased. This in turn made possible the development of a market for "private-label" mortgage-backed securities, i.e., mortgage-backed securities issued by private financial institutions, not the GSEs.9
As a result, by the early 2000s, as the now infamous bubble in the U.S. housing market began to inflate, the home mortgage origination market was divided into two segments in open competition with one another: a segment for prime or conforming loans, funded by the GSEs, and a segment for subprime loans, funded largely by private financial institutions. Naturally, the subprime segment significantly cut into the GSEs' business. The GSEs' combined market share for new originations declined from 70 percent in 2003 to 40 percent in 2006.10 According to the Treasury report, the GSEs' attempts to respond to this competition ultimately led to their insolvency.
Wind-down of the GSEs
In Treasury's view, the GSEs' profit-maximizing, private-shareholder structure led them to take excessive risks during the housing bubble when "their broader public mandate to support the [housing finance] market was needed most."11 The GSEs' "perceived government backing" gave them pricing power that purely private entities lacked and enabled them to "build up large [and risky] investment portfolios at a cost far lower than their competitors."12 Further, the GSEs' capital standards were inadequate and their regulator, the Office of Federal Housing Enterprise Oversight, was "structurally weak and ineffective."13 As a result, by September 2008, after the housing bubble had popped, the GSEs' "losses had become far too substantial for their thin capital buffers to absorb" and the federal government was forced to put them into conservatorship.14
But conservatorship was only intended as a temporary measure. The federal government now has to decide what to do with the GSEs. Treasury's report proposes winding the GSEs down "on a responsible timeline."15 As a first step, Treasury would end the GSEs' unfair advantage over their private competitors by forcing them to price their guarantees "as if they were held to the same capital standards as private banks or financial institutions."16 Further steps would include increasing the required down payment for mortgages purchased by the GSEs, and selling off the GSEs' investment portfolios.17 In the end, the GSEs' participation in the housing finance market would be completely eliminated.18
After the GSEs
The Treasury report is less clear as to what should replace the GSEs after they have been wound down. The report proposes three options. The first option would be a complete removal of the federal government from the housing finance market, except for narrowly targeted groups of borrowers, such as veterans and qualified lower- and moderate-income borrowers.19 The second option would be for the government to serve only as a "backstop"; it would have "a minimal presence in the market during normal times," but stand "ready to scale up" when the need arose.20 The government might accomplish this by charging lenders a loan-guarantee fee priced "at a sufficiently high level that it would only be competitive" in times of financial stress.21 The third option would be for the government to offer reinsurance for mortgage debt securities.22 The direct insurance for such securities would be provided by private entities meeting "stringent capital and oversight requirements."23 These private entities would purchase reinsurance from a federal agency, but the reinsurance "would be paid out only if shareholders of the private mortgage guarantors have been entirely wiped out."24
Notably absent from Treasury's discussion of these three options is any detailed consideration of the source of funding for future mortgage originations if the GSEs are removed from the equation. During the housing bubble, from 2002 through 2007, the GSEs were providing $1 to $2 trillion per year in funding for home mortgages.25 Private sources, such as private-label mortgage-backed securities, were providing comparable levels.26 Even in the years after the housing bubble's collapse, more than $1.5 trillion in mortgages for single families have been originated per year.27 The GSEs remain heavily involved in the mortgage market with Fannie Mae funding more than 2.7 million28 and Freddie Mac funding more than 1.8 million single-family mortgage loans in 201029 while, as discussed below, much of the private lender funding for single-family mortgages has evaporated. Thus, the elimination of the GSEs requires that some alternative source of funding for mortgage originations be identified or it requires the federal government to accept a potentially significant reduction in the percentage of homeowners in America.
The Treasury report acknowledges that not "all Americans should become homeowners",30 and suggests that an overemphasis on homeownership "encouraged housing purchases and real estate investment over other sectors of our economy."31 But the report seems to accept as a policy matter that funding for home mortgages for willing and able borrowers should not be reduced. The report specifically affirms that "we should make sure that all Americans who have the credit history, financial capacity, and desire to own a home have the opportunity to take that step."32 Yet the report never squarely addresses whether funding will exist to provide mortgages for all such Americans if the GSEs no longer exist.
Potential Non-GSE Funding Arrangements
The most obvious source of funding for home mortgages in the absence of the GSEs would be private-label mortgage-backed securities, but the market for such securities at present is close to lifeless. In 2010, there was a single issuance of a private-label mortgage-backed security, amounting to approximately $230 million.33 Similarly, only one private-label mortgage-backed security issue has been announced thus far in 2011, with a value of approximately $290 million.34 Each of these offerings would supply less than 0.02 percent of the $1.5 trillion in single-family home mortgages originated in 2010.35 Thus, the volume of private-label mortgage-backed securities would have to increase dramatically before such securities could serve as a viable source of replacement funding for the GSEs.
One possible private source of funding mentioned only briefly in the Treasury report would be a market for so-called "covered bonds."36 Treasury has been exploring such bonds since mid-2008, when funding for mortgage originations first began to seize up.37 Covered bonds are similar to mortgage-backed securities—they are debt securities backed by a portfolio of mortgages. The primary difference is that in a mortgage-backed security, loans are sold to a special-purpose vehicle that issues notes to investors. By contrast, when a financial institution issues covered bonds, it retains the loans on its own balance sheet.38 Further, in a mortgage-backed security, investors purchasing the notes assume the pre-payment risk and credit risk of the underlying loans. By contrast, in a covered bond, the issuer is required to actively manage the pool of loans, replacing loans that are paid off early and substituting performing for non-performing loans.39 Whether such covered bonds could ever become a viable source of private funding for mortgage originations is uncertain because a market for such bonds does not yet exist in this country.
Attracting Investors to Non-GSE Mortgage Securities
There is a further issue that must be squarely faced if the GSEs are eliminated. Whether future private funding for home mortgages comes in the form of traditional private-label mortgage-backed securities or covered bonds, investors may simply be unwilling to purchase such securities unless some form of federal protection is provided. As a possible solution to this problem, two Federal Reserve governors have proposed the creation of a federal insurance program for such securities analogous to the deposit insurance provided by the FDIC.40 This would represent far more significant federal involvement in the housing finance market than is envisioned in any of Treasury's three options discussed above. Even under Treasury's third option, which envisions the highest level of federal involvement, the federal government would provide reinsurance rather than direct insurance for mortgage debt securities. Moreover, the reinsurance would be triggered only in the drastic scenario where "the shareholders of the private mortgage guarantors have been entirely wiped out."41
While an FDIC-style insurance program has the disadvantage of entailing more federal involvement than Treasury's three options—precisely what Treasury wants to avoid—such a program nevertheless warrants serious consideration for two reasons. First, because investors likely will have little or no confidence in private-label mortgage-backed securities or covered bonds for the foreseeable future, it likewise may be unrealistic to expect private entities to be willing to insure such securities, at least in the next few years. Second, an insurance framework for private mortgage debt securities should be robust enough that its resources would not be completely consumed if another dramatic downturn in the housing finance market occurs. A private insurance framework with either no federal involvement or, at most, federal involvement that is triggered only after "shareholders of the private mortgage guarantors have been entirely wiped out" might enable the country to survive a catastrophic downturn, but it is likely the private insurers would have to be completely re-built afterwards. Direct federal insurance for private mortgage debt securities could avoid that cost.
Conclusion
Whatever option ultimately is pursued, Congress appears receptive to Treasury's proposal to wind down the GSEs. At the beginning of March, just three weeks after the report was released, Treasury Secretary Timothy Geithner appeared before the House Financial Services Committee to discuss it.42 While there was some resistance from Democratic members of the committee, Republican members stated their willingness to "phase out Fannie and Freddie and . . . move toward a privately financed mortgage system."43
Thus, the housing finance market in this country faces an uncertain future in which the GSEs likely will have little if any role to play, but the sources of replacement funding—and the effect on home ownership for willing and able buyers—remain unclear.
Footnotes
1 United States Department of the Treasury and United Stated Department of Housing and Urban Development, Reforming America's Housing Finance Market (February 2011) (Treasury Report), available at http://www.treasury.gov/initiatives/Documents/Reforming%20America%27s%20Housing%20Finance%20Market.pdf .
2 Treasury Report, supra note 1, at 4. For additional history on the development of the housing finance market in this period and after see Bethany McLean & Joe Nocera, All the Devils Are Here: the Hidden History of the Financial Crisis 6-7 (Penguin 2010).
3 See McLean & Nocera, supra note 2, at 6.
4 Id. at 7.
5 Id.
6 Treasury Report, supra note 1, at 4.
7 Id.
8 McLean & Nocera, supra note 2, at 29.
9 See generally id. ch. 2.
10 Treasury Report, supra note 1, at 7.
11 Treasury Report, supra note 1, at 8.
12 Id.
13 Treasury Report, supra note 1, at 9.
14 Treasury Report, supra note 1, at 7.
15 Treasury Report, supra note 1, at 12.
16 Id.
17 Treasury Report, supra note 1, at 13.
18 Id.
19 Treasury Report, supra note 1, at 27-28.
20 Treasury Report, supra note 1, at 28.
21 Id.
22 Treasury Report, supra note 1, at 29.
23 Id.
24 Id.
25 See United States Department of the Treasury, Best Practices for Residential Covered Bonds, at 4 (July 2008), available at http://www.treasury.gov/about/organizational-structure/offices/General-Counsel/Documents/USCoveredBondBestPractices.pdf .
26 Id.
27 See Fannie Mae, Annual Report (Form 10-K), at 3 (February 24, 2011) (reporting that $1.917 trillion of single-family mortgages were originated in the United States in 2009, while $1.530 trillion were originated in 2010).
28 Id. at 8.
29 Federal Home Loan Mortgage Corporation, Corporate Facts—Efforts to Support the Housing Market (Full-year ending December 31, 2010) available at http://www.freddiemac.com/news/corp_facts.html .
30 Treasury Report, supra note 1, at 19.
31 Treasury Report, supra note 1, at 1.
32 Id.
33 See Residential Mortgage-Backed Securities: Tremors, The Economist Online, Feb. 18, 2011, http://www.economist.com/blogs/newsbook/2011/02/residential_mortgage-backed_securitie s; see also Sequoia Mortgage Trust 2010-H1, Prospectus Supplement (Form 424B5) (April 23, 2010) (To Prospectus dated April 22, 2010).
34 See The Economist Online, supra note 31; see also, Sequoia Mortgage Trust 2011-1 Prospectus Supplement (Form 424B5) (Feb. 28, 2011) (To Prospectus dated Feb. 16, 2011).
35 See Fannie Mae Annual Report, supra note 10.
36 Treasury Report, supra note 1, at 14.
37 See supra note 25.
38 See generally supra note 25, at 7-8.
39 Id.
40 See Diana Hancock & Wayne Passmore (2009) Three Initiatives Enhancing the Mortgage Market and Promising Financial Stability, The B.E. Journal of Economic Analysis & Policy, Vol. 9, Iss. 3 (Symposium), Article 16, at 19, available at http://www.bepress.com/bejeap/vol9/iss3/art16 .
41 Treasury Report, supra note 1, at 29.
42 See Alan Fram, Key House Republican Praises Obama Housing Plan, Associated Press, March 1, 2011; see also Mortgage Finance Reform: An Examination of the Obama Administration's Report to Congress, Before the House Committee on Financial Services, 112th Cong. (March 1, 2011) (written testimony of Timothy F. Geithner, Secretary of the Treasury).
43 See Fram, supra note 40.
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