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Reason
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Phasing out Fannie
and Freddie
Housing Finance Reform: Protecting Taxpayers, Ending Bailouts, Reducing
the Government’s Role, and Promoting Private Capital
By Anthony Randazzo
February 9, 2011
Testimony Before the U.S.
House of Representatives Committee on Financial Services Subcommittee
on Capital Markets and Government Sponsored Enterprises
Chairman Garrett, Ranking Member Waters, and distinguished members of
the subcommittee, thank you for the opportunity to join you in
discussing the important matter of reforming the nation’s mortgage
finance system. My name is Anthony Randazzo, I am director of economic
research at Reason Foundation, a non-profit think tank that researches
the consequences of government policy, works to advance liberty, and
develops ways the free market can be leveraged to improve the quality
of life for all Americans.
It is important, at the outset of this debate, to frame the issue
properly: mortgage finance policy and affordable housing policy are two
different things. Whether we should or how to subsidize low-income
Americans putting a roof over their heads must not cloud the analysis
and debate about the consequences of government policy distorting
mortgage prices for nearly the entire housing market. Separating
mortgage finance from affordable housing is important to shed light on
what policy options can best be pursued to prevent another
artificially-induced boom and catastrophic bust.
That being said, now is the time for major reform of the government’s
role in the mortgage finance market. The housing boom and bust of the
last decade is the main source of our recent economic crisis, lethargic
recovery, persistent unemployment, and the massive wave of
foreclosures. Yet, the past two Congresses have failed to reform
America’s housing finance system. It seems the time is never right to
make serious, much needed changes. When the market was going strong, no
one wanted to derail the train. And with the market weak, it’s been
argued that the government is needed to get housing back on track. This
Congress must resist the urge to maintain the status quo.
Significant reform is not only desirable, but also necessary. There can
be no sustainable recovery as long as public policy manipulates
mortgage prices and directs investment resources toward the housing
sector and away from more economically productive areas. And while it
may appear that the government is necessary to provide most of the
financing needed for mortgages today, the government-sponsored
enterprises (GSEs) and Federal Housing Administration (FHA) are
crowding out any possible return of private capital in the name of
preserving a fragile market.
Ideally, a fully reformed system would have no explicit or implicit
government guarantee for mortgage finance-such financial support only
subjects taxpayers to high risks and eventual losses. Taxpayers should
not be forced to guarantee payments to investors in any asset class,
including mortgage-backed securities. If we learned anything from
recent housing bust it is this: Federal guarantees lead to credit
misallocation, mispricing of risk, unstable price swings, and weakened
underwriting standards, all of which contributed to the destabilization
of the housing market (see Appendix A).
Allowing market forces to price credit and interest rate risks and no
longer shielding institutions from the consequences of poor investment
decisions, would avoid these traps and lead to stable and sustainable
growth in the housing sector. There must be no explicit guarantee and
Congress should ensure that any reform does not simply transfer the
implicit guarantee of Fannie Mae and Freddie Mac onto the banking
sector.
The subcommittee should focus on a robust proposal to overhaul the
housing finance sector. An effective way to start would be to place
Fannie and Freddie into receivership, and spend three to five years
winding down their mortgage business and portfolios. With the phase out
of the GSEs, private capital-without government backing-could begin to
move into the mortgage secondary market where it has been crowded out.
Realistically, this will take time to accomplish. And in the near term
there is still a need to protect taxpayers from additional, future
losses while ending the ongoing bailout of the GSEs. The
government’s role in housing must be reduced and private capital must
be allowed to return. The following are ten ideas that will help
achieve these goals.
Lower all conforming loan limits for Fannie Mae and Freddie Mac by 20
percent by the end of September 2011.
Increase the down payment requirement for mortgages backed by
government agencies to 20 percent over the next three years.
Instruct FHFA to begin slowly increasing the guarantee fee charged by
Fannie Mae and Freddie Mac.
End all affordable housing goals.
Raise the capital requirement for Fannie Mae and Freddie Mac.
Create a legal framework for covered bonds.
Cap expansion of Fannie Mae and Freddie Mac’s portfolios at a certain
date and have the Treasury Department buy their existing combined
portfolio to let them run off over time.
Put the staffs of Fannie Mae and Freddie Mac on the federal pay scale.
Require the Treasury Department to formally approve new debt issuance
by Fannie Mae and Freddie Mac.
Wipeout the remaining stock of Fannie Mae and Freddie Mac.
These should not be considered ways to fix the GSEs so that we can
continue government support of housing finance, but rather interim
steps that can help taxpayers and the housing sector while Congress
debates how to fully reform the mortgage market. I will now walk
through each of the ten ideas with more detail and am happy to follow
up with additional supporting data upon request.
Ten Ideas for Short-Term Mortgage Finance Reform
1. Lower all conforming loan limits
for Fannie Mae and Freddie Mac by 20 percent by the end of September
2011
The government should not subsidize mortgages, particularly mortgages
for the affluent. Congress could start the process of reducing maximum
loan amounts eligible for purchase by the housing agencies, but limit
it to a one-time decline. Even though the so-called high-cost area
limit is set to decline to $625,500 from $729,750 at the end of
September, I would propose a uniform, across-the-board reduction of 20
percent in the loan limits for Fannie Mae and Freddie Mac (and
FHA-backed mortgages, though their jurisdiction lies outside this
subcommittee).
This is needed in order to reduce the government’s role in housing
finance and to create room for private lenders to enter the mortgage
market as Congress debates how to reform the system as a whole.
The current traditional maximum loan the GSEs are allowed to buy and
securitize is $417,000, but this is well above median and average
housing values. According to the National Association of Realtors, the
median price for existing homes in the U.S. is $168,800 and the average
price is $217,900, both not seasonally adjusted. At the same time the
median price of new homes is $221,900 and the average price is
$271,600. Lowering the traditional conforming loan limit 20
percent would cap GSE loans at $333,600, still above even the average
prices.
For those concerned about removing government supports too quickly,
this would still leave plenty of room for the GSEs to operate for the
time being. In fact the conforming loan limit was $359,650 at the
height of the housing bubble in 2005, and the GSEs were still able to
support (and manipulate) the mortgage market.
At the same time, this would be a small step towards creating more room
for the private sector to engage the mortgage market, and it could be a
test case to see how far the jumbo market is able to expand in this
economic climate.
The same reduction should apply to the so-called high cost area
maximum. Currently, the high cost conforming loan limit is set to
decline to $625,500 from its temporarily ceiling of $729,750 at the end
of September 2011. Making the same 20 percent cut to the current level
would just reduce the high cost maximum to $583,800. And still this is
a very high number, especially if the objective of GSE loan purchases
is to assist lower income households.
The high cost areas of the country are located almost exclusively on
the coasts, as can be seen in Figure 1. The map on the next page was
produced from Federal Housing Finance Agency data detailing the Fannie
and Freddie loan limit maximums for fiscal year 2011, broken down by
county (see Appendix B for a larger version).
Given that federal guarantees supporting the purchase of loans
represents a subsidy, the map shows that, essentially, high cost area
mortgage purchases and guarantees are wealth transfers from Middle
America to the coasts. While it is true that the relative cost of
housing is higher in Los Angeles County and Nantucket County, that does
not mean individuals buying homes in those areas need or should receive
a subsidy to buy a house (see Appendix C for a list of counties that
qualify for the high cost area subsidy). It may even be preferable to
eliminate these high cost exemptions completely, but in the near term,
a 20 percent reduction would allow more private capital to phase into
the mortgage secondary market while avoiding the potential negative
effects of shutting down Fannie and Freddie immediately.
A robust overhaul of the mortgage finance system could build on this
proposal and phase out the GSEs by reducing the conforming loan limit
by 20 percent each year for five years. But while broader housing
reform is being discussed, this would be a good way to get private
capital flowing again while at the same time reducing the government’s
footprint in the mortgage market.
Note: A suggested means of winding down the GSEs over five years would
be to reduce the conforming loan limit by 20% per year from the
previous year’s cap. For the traditional conforming limit of $417K that
would wind up with a max of $137K after 5 years; for the high-cost
limit of $729K it would drop the limit to $239K over 5 years. That
would mean at the end of five years all of the GSE business would be in
FHA jurisdiction and could simply be taken over by the HUD agency
without any market disruption. Ideally, FHA’s limits would be lowered
to the same rates, or roughly 80% of the median housing value measured
on a local level.
2. Increase the down payment
requirement for mortgages backed by government agencies to 20 percent
over the next three years
It is universally accepted that weak underwriting standards contributed
to and exacerbated the financial crisis. One of the most pervasive
problems plaguing homeowners today is the lack of equity in their
homes. Contributing to this is the fact that mortgages with very low
down payments of just 10 percent or less became commonplace in the
bubble period. These underwriting standards were lowered by banks that
were ignorant of or defiant of the risks and by the GSEs because of
their affordable housing mandate and to compete with the private
sector.
While private businesses should still be allowed to lend to whom they
want and bear the responsibility of poorly underwritten loans going
bad, there is no reason the government should promote risky lending or
borrowing. Low down payments amplify cyclical fluctuations in housing
markets, both locally and nationally. Plus they set borrowers up to
fail and put lenders at risk. And, in this case, the ultimate lending
financer is the taxpayer.
I would propose gradually increasing the down payment requirement for
mortgages that are bought, securitized by, or guaranteed by Fannie Mae
and Freddie Mac to 20 percent by 2014 (or three years from the date of
enactment). If private mortgage insurance is also taken out on the
loan, then the goal should be that borrowers being supported by the
government are putting in at least 10 percent of their own cash.
This would decrease government exposure to risky mortgages and prevent
the government from supporting mortgages for those without the
resources to become a homeowner. Both those who want to prevent future
bailouts and those who are looking to protect consumers from loans that
would hurt them in the future should support this idea.
Corollary idea: Prevent Fannie Mae and Freddie Mac from buying or
guaranteeing any loan originated outside the yet-to-be-established
Qualified Residential Mortgage guidelines.
Note: Low down payments mean more individuals capable of buying homes.
This means increased demand, which can drive up prices. When the price
bubble being amplified on the front-end eventually collapses, the
homeowners with very little equity in their homes will quickly find
themselves underwater. A resulting wave of defaults and foreclosures
would put further downward pressure on housing prices. This is, in
part, also the story of the most recent housing boom-and-bust.
3. Instruct FHFA to begin slowly
increasing the guarantee fee charged by Fannie Mae and Freddie Mac
One way to decrease the government’s exposure to housing market risk
would be to begin increasing the guarantee fee (g-fee) charged by
Fannie and Freddie for ensuring payment on mortgage-backed securities
to investors. This could be done slowly so as to not cause the GSEs to
exit the mortgage market overnight. Over time this would increase the
cost of doing business with the GSEs and create room for private
capital to be more competitive with the government agencies. In the
meantime, the GSEs would be collecting more revenue to put back towards
the cost of bailing them out and taxpayers would be protected from the
risks of bailing out Fannie and Freddie again in the future.
4. End all affordable housing goals
Again, mortgage finance policy should not be considered the same as
affordable housing policy. Over the past several decades these two
issues have become confused, as policymakers used GSEs to expand access
to mortgage credit and advance the goal of increasing homeownership.
But conflating the two policy issues has resulted in failure on both
fronts: the mortgage credit market is more than 90 percent dominated by
Fannie Mae, Freddie Mac, and the FHA; meanwhile the homeownership rate
is lower today than before the housing bubble-68 percent at the end of
the 2001 recession, but just 66.6 percent in the fourth quarter of 2010
(see Appendix D).
Here is the good news: eliminating affordable housing goals and
removing government supports for mortgage finance does not mean
Congress has to end subsides for the poor. While I would argue that we
should have no subsidies for mortgages at all, it is possible that aid
for low-income families can be pursued in more effective ways that do
not distort the entire mortgage market.
It has now become widely accepted that it is not a good idea to push
people into homes they cannot afford. If Congress chooses to encourage
homeownership for low-income families they should ensure it is
sustainable for the homebuyer. Any subsidies provided by the
government should be 1) direct to the borrower, 2) on-budget and
subject to appropriation, 3) narrowly targeted so as not to compete
with the private sector, 4) built on sustainable underwriting
standards, and 5) governed by responsible accounting standards.
Using these guidelines we can have a housing market, funded solely by
private capital, that has much milder cyclical fluctuations than the
past, and at the same time provide narrow, direct subsidies limited to
low-income Americans if Congress wants to appropriate the funds as
necessary. There need not be any arbitrarily established affordable
housing goals.
5. Raise the capital requirement for
Fannie Mae and Freddie Mac
It has been well documented that financial institutions were able to
take advantage of a capital arbitrage opportunity created by the
Federal Housing Enterprises Financial Safety and Soundness Act of 1992.
Single-family mortgages with 4 percent risk-based capital requirements
were shifted from banks and thrifts to the GSEs and, with federal
backing, only required 1.6 percent risk-based capital. However, Fannie
and Freddie themselves were only required to hold 0.45 percent against
the mortgages they held or were guaranteeing. This left a gap in the
capital being reserved that has still not been corrected. I would
propose that the GSE’s capital requirement be raised to 2.4 percent to
eliminate the current capital arbitrage opportunity and to protect
taxpayers. This would also raise the costs of doing business with
Fannie and Freddie and create incentives for more private capital to
compete with the GSEs.
6. Create a legal framework for
covered bonds
The mortgage market has changed permanently and the future will require
new ways of financing housing. One proposal is to create a legal
framework for covered bonds, which are debt securities backed by cash
flows from dedicated pool of mortgages. While covered bonds are not a
holy grail that will give the housing market eternal life, they may
help bring a substantive amount of private capital back to mortgage
finance and help the recovery process. Whether or not they will be
widely used, investors should be given the option to develop this
method of mortgage financing if it is profitable. Chairman Garrett’s
bill, introduced in the 111th Congress, would do this and could be used
as the basis for pursuing legislation in this Congress.
7. Cap expansion of Fannie Mae and
Freddie Mac’s portfolios at a certain date and have the Treasury
Department buy their existing combined portfolio to let them run off
over time
As Fannie Mae and Freddie Mac will soon need to begin reducing their
portfolios per the terms of conservatorship, I would suggest targeting
an end date-in the next 24 months-for the GSEs to be allowed to add new
mortgages to their portfolios (except for specified, short periods as
necessary to support securitization) and have all business activities
limited to mortgage securitization. All new single-family mortgages
purchased must be securitized and sold. Multi-family mortgages, which
are harder to securitize, could be subsidized elsewhere in the
government, in a more direct manner, if Congress chooses.
I would also suggest having the Treasury Department buy the combined
portfolios-about $1.6 trillion as of third quarter 2010
statements-purchased at par and place them in a separate liquidating
pool.
Having the GSE portfolios run down on the government’s balance sheet
would allow Treasury to take advantage of Uncle Sam’s debt funding
advantage. Treasury could fund the shrinking portfolio with roughly a
25 basis point lower borrowing rates than the GSEs. The exact savings
would depend on how much GSE debt is replaced with Treasury debt. For
example, Fannie Mae reported in its third quarter 2010 SEC filing that
39 percent of their short- and long-term debt will mature in the next
year, requiring reissuance.
Overall, this would help protect taxpayers from further losses and
would not undermine the ultimate reform of the housing finance system.
Also, because Treasury would be adding the assets in the portfolios to
its balance sheet as well, this action should not require Congress to
raise the debt ceiling. If it were determined this action would add to
the national debt, another means of running off the portfolio should be
pursued.
8. Put the staffs of Fannie Mae and
Freddie Mac on the federal pay scale
One way to reduce bailout costs and save taxpayers money would be to
put the GSE staff on the General Schedule (GS) pay scale like all other
government employees. Some have argued the staff and executives at
Fannie and Freddie need to earn more to be competitive with the private
sector. But for years, the staffs of Ginnie Mae and FHA have been able
to operate on the GS pay scale, and employees of Fannie and Freddie-now
being paid from taxpayer funds-should be able to do so as well.
Fannie Mae and Freddie Mac are, for all practical purposes, government
agencies. They are being used by FHFA and the Treasury Department to
support fiscal policy, social policy, and to protect banks. In these
capacities their employees should be treated the same as all other
federal staff. And, given that Ginnie Mae staff and executives are able
to operate on federal pay, there is no reason Fannie and Freddie should
not be able to operate at their existing capacity, even if the change
to federal pay reduced their compensation from current salaries. The
change in compensation policy would not necessarily have to occur
immediately. The adoption of the GS pay scale could be phased in over
two years. But at the very least, new employees should be subject to
government pay levels while the rest are phased in.
9. Require the Treasury Department to
formally approve new debt issuance by Fannie Mae and Freddie Mac
In the charters of Fannie and Freddie, Treasury Department is required
to review and approve any new debt issued by the GSEs. This process was
scaled back by the Clinton administration and by the middle of the last
decade debt issuance approval became a mere formality with the GSEs
simply notifying Treasury of their intentions.
I would suggest Congress reestablish this practice of having the
Treasury Department formally approve debt issued by the GSEs. Fannie
and Freddie should have to sufficiently justify their need for debt
issuance and the Secretary of the Treasury should have to personally
approve each debt issuance. This would help protect taxpayers by
providing more accountability and transparency to the GSEs while their
fate is being further considered.
10. Wipe out the remaining stock of
Fannie Mae and Freddie Mac
Had Fannie Mae and Freddie Mac been put in receivership in the first
place, their common stock would have been wiped out. Instead, the
conservatorship arrangement with the GSEs has preserved hope for some
of their common stockholders that the companies may one day be
resurrected with a return of value. However, the baseline for any
substantive reform of the housing finance system should start with the
premise that Fannie Mae and Freddie Mac have already failed and must be
shut down. This could most effectively be done through receivership and
with a structured wind down of the mortgage business and portfolios of
the GSEs as part of at transfer to a fully private system.
As Congress debates how to reform the mortgage finance market, though,
there should be no doubt that Fannie and Freddie will one day cease to
exist. I would suggest a simple statute wiping out the common and
junior preferred stock in both GSEs, bringing the end of bailouts one
step closer to reality. Stockholders will object. But this is now
taxpayer money. It should be clear that had Fannie Mae and Freddie Mac
been treated like private companies going bankrupt, the equity stakes
would have lost all of their value long ago.
The Importance of FHA Reform
It is critical that mortgage finance reform be paralleled by FHA
reform. Housing finance is more than just Fannie and Freddie. FHA has
also crowded out private lending, increased the exposure of taxpayers
to significant risks, and encouraged the sort of speculative housing
purchases that destabilize housing markets and lead to foreclosures. As
previously stated, if Congress chooses to maintain government
assistance to low-income individuals, those subsidies should be on the
budget with credible accounting measures, should encourage sustainable
underwriting standards, and should not take the form of open-ended
guarantees.
While FHA is not within the jurisdiction of this subcommittee, I would
encourage any proposed legislation to be coordinated with reforms
considered by the Subcommittee on Insurance, Housing, and Community
Opportunity.
Conclusion
These ten ideas should not be considered an adequate fix of Fannie Mae
and Freddie Mac or as sufficient to reform the housing market. They are
merely a starting point, a first step towards a robust overhaul, and
should open the door to further mortgage finance reform discussion, as
well as affordable housing discussion.
One the benefits of these ten proposals is that, while they are focused
on addressing short-term needs to protect taxpayers, reduce federal
bailouts, limit government’s role in the housing sector, and for
private capital to return to mortgage finance, they also can be the
basis for long-term reform.
The GSEs could be completely wound down by reducing the conforming loan
limits annually (suggestion 1). Underwriting standards for all
mortgages could be made safer (suggestion 2). G-fees could be increased
incrementally over a three-to-five year time frame until they are so
high as to be cost prohibitive for the private sector to do business
with the GSEs (suggestion 3). The remaining seven suggestions, which
include a portfolio wind down proposal, form the basis for the rest of
what would be needed to reform the housing finance sector. Other
financing innovations, like covered bonds, that are presented to
Congress should also have legal frameworks considered to help the flow
of private capital to the mortgage secondary market.
Ultimately the goal of housing finance reform should be to allow
private investors to replace the government-i.e. taxpayers-as financers
in the housing market while ensuring that any subsidies remaining in
the system are explicit, direct, narrow, and on-budget. Congress should
then continue in earnest to implement such reforms, ensuring that in
the future, America’s housing market is far closer to a free market.
Thank you for the opportunity to discuss this important issue with you,
and I look forward to answering any questions that you may have.
Read article with charts at Reason
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