How to Start the Housing Reform Process

Ten ideas to reform mortgage finance in the near-term while laying the ground work for long-term changes

Finally! The first Congressional salvo in the housing finance reform was finally launched Wednesday, with a hearing convened by Rep. Scott Garrett’s Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises. Even with the housing boom and bust of the last decade as the main source of our recent economic crisis, lethargic recovery, persistent unemployment, and the massive wave of foreclosures, the past two Congresses have failed to reform America’s housing finance system.

This Congress has an opportunity to reject the status quo-though it remains to be seen if there is the heart and cojones to push forward a substantive fix. Given the political alignment of the House and Senate, the subject of the Garrett hearing focused on the short-term steps that can be taken to begin fixing the housing market while more comprehensive reform is discussed.

I was invited to be one of four witnesses at this first of several hearings on the issue, and ask to suggest what could be done in the near-term to protect taxpayers, end the GSE bailout, reduce government’s role in housing, and get private capital flowing back into the mortgage market. A simple task this is not.

The starting point for this debate needs to be clear: mortgage finance policy and affordable housing policy are two different things. On this point even famed GSE defender Rep. Barney Frank said he agreed with me. Over the past several decades the two issues have become confused, as policymakers used Fannie Mae and Freddie Mac to expand access to mortgage credit and increase homeownership rates.

But conflating these two has resulted in failure on both fronts: the mortgage credit market is more than 90 percent dominated by Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA). Meanwhile, the homeownership rate is lower today than before the growth of the housing bubble. While homeownership was 68 percent at the end of the 2001 recession and grew to nearly 70 percent, today it is just 66.6 percent.

Whether we should or how we should subsidize low-income Americans putting a roof over their heads must not distract from establishing clear rules for mortgage origination, securitization, secondary sales, servicing, and related components. Separating mortgage finance from affordable housing is vital to prevent another artificially-induced boom and catastrophic bust.

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 GSEs and 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.

Instead, Congress should develop a system that protects 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. 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.

Realistically, this will take time to accomplish. This week I encouraged Congress to consider ten ideas that would help the housing sector in the near term, but that als lays the ground work for long-term reform:

  1. Lower all conforming loan limits for Fannie Mae and Freddie Mac by 20 percent by the end of September 2011. This would be a modest reduction in the maximum size loan that the GSEs are allowed to purchase, securitize, and guarantee. The limit would drop to allow the private sector to take over a slightly larger part of the mortgage secondary market, but it would still leave the top limit above national average and median housing prices.
  2. Increase the down payment requirement for mortgages backed by government agencies to 20 percent over the next three years. This would decrease taxpayer exposure to risky mortgages, which fiscal conservatives should jump at. It would also reduce the practice of the government supporting mortgages for those not financially ready to afford a home, which progressives should favor.
  3. Instruct the Federal Housing Finance Agency to begin slowly increasing the guarantee fee charged by Fannie Mae and Freddie Mac. Incrementally, this would make the cost of doing business with the GSEs more expensive, and allow the private sector to be more competitive. It would also raise more money in the short-term for the GSEs to reduce future bailout costs (and maybe even help pay back the roughly $150 billion already paid out in bailouts to Fannie and Freddie.)
  4. End all affordable housing goals. As I stated at the start, mortgage finance and affordable housing are two different things. If we want to subsidize housing for a narrow segment of the population as a social goal we can, but that is a different policy discussion.
  5. Raise the capital requirement for Fannie Mae and Freddie Mac. Right now, the GSEs hold less capital relative to their risk than the rest of the banks. This should be remedied to protect taxpayers and to level the playing field, allowing the banks be more competitive with Fannie and Freddie.
  6. Create a legal framework for covered bonds. This is a finance method that has worked well overseas, and could be part of the answer for getting private capital flowing back to the American mortgage market. Even if it is not the answer, the option to finance mortgages this way should be available.
  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. This would save taxpayer money by using the debt funding advantage of Uncle Sam.
  8. Put the staffs of Fannie Mae and Freddie Mac on the federal pay scale. They are defacto government agencies and should be paid as such. Ginnie Mae and FHA both are able to operate on federal compensation, the GSEs should be able to as well.
  9. Require the Treasury Department to formally approve new debt issuance by Fannie Mae and Freddie Mac. This has been the law for decades, but it has been ignored since the 1990s. Returning to this practice would add transparency and accountability for the GSEs until they are shut down.
  10. Wipe out the remaining stock of Fannie Mae and Freddie Mac. If they were a private company, dealt with in a normal process, this would have happened long ago. And the premise of this whole debate should be that the GSEs are not coming back.

These should not be considered only interim steps that can help taxpayers and the housing sector while Congress debates how to fully reform the mortgage 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.