Edward J. DeMarco, Acting Director of the Federal Housing Finance Agency (FHFA) told lawmakers on Tuesday that the role of housing finance reform should be to promote the efficient provision of credit to finance mortgages for single-family and multifamily housing. Speaking at a hearing of the House Committee on Financial Services DeMarco said that an efficient market system for providing mortgage credit to homebuyers should have certain core characteristics: allowing innovation, providing consumer choice, providing consumer protection, and facilitating transparency. At the most fundamental level, the key question in housing finance reform is what, and how large, should be the role of the federal government?
DeMarco said that as an economist he would approach the issue in the context of a potential market failure which may lead the private market to produce less of, or more of, a particular good than would be economically optimal.
There are at least two potential market failures in housing finance that may lead to an under-provision of mortgage credit. If undue or unnecessary concerns about the stability and liquidity of mortgage credit prevail in a purely private market less credit will be provided than in the absence of this type of uncertainty. The government response could range from establishing standards and greater transparency; providing liquidity or credit support, or providing a government guarantee to eliminate uncertainty.
A second failure occurs when the benefits of homeownership are viewed as extending to the broader aspects of society. In such cases the market will never provide the optimal number of homeowners so government may seek to increase demand through subsidies or assistance to encourage or facilitate consumption, i.e. the mortgage interest tax deduction.
As of the fourth quarter of 2012, there was about $9.9 trillion in single family mortgage debt outstanding, 13 percent of which was directly government guaranteed and 52 percent guaranteed by Fannie Mae and Freddie Mac (the GSEs). In the third quarter of 2012 new single family mortgage originations totaled approximately $510 billion; 18 percent was guaranteed through direct government programs and, 66 percent through the GSEs. Measured by securities issuance, the proportion supported by the government is over 90 percent.
DeMarco said that the longstanding roles of FHA and VA suggest the government will continue a role in housing finance, but the relevant question is how to move from the massive government support of today to a future market with a larger private presence; particularly the $5 trillion GSE portion of the market.
If policymakers begin by defining which borrowers would have access to FHA and other government mortgage credit programs then it should be easier to consider the government's role, if any, in the remainder of the market.
Considering how to replace the government sponsored enterprise model, in particular developing an efficient secondary mortgage market that can access capital markets to serve the single family market that is not covered by traditional government credit programs is central to congressional consideration of ending the conservatorships.
DeMarco sees three options: a market-oriented approach that would ensure broad minimum standards; establishing a Federal backstop to provide liquidity when needed, or developing a government guarantee structure to ensure credit stability and limit market uncertainty.
A standard-setting approach would replace some of the GSEs' standard-setting and government guarantees with a regulatory regime or a market utility that sets standards to provide a degree of certainty to investors. The focus in such an approach could be on setting standards around key features that investors need to price credit risk which include standards associated with underwriting, pooling and servicing, and disclosures. Investors would also be responsible for enforcing their rights under the standard contracts developed under this framework.
To establish a liquid non-government guaranteed market with such standards would seem to require a greater homogeneity in borrower characteristics which, while it would broadly cover the bulk of the GSEs' business, might not be available serve all of their borrowers. Where characteristics do not fit neatly into the secondary market, we need to find a way to get insured depository institutions back into the business of funding mortgages, a role DeMarco sees the Federal Home Loan Banks suited to at least partially fill.
It would be important to consider how a standard-regulated market without government guarantees would operate in a time of stress. Preserving liquidity and the availability of credit are important functions and a determination should be made whether a federal backstop such as FHA for credit or the Treasury Department for liquidity is needed. Or alternatively, with a more standardized market and infrastructure, would it be possible for an existing guarantor, like Ginnie Mae, to play such a temporary guarantee function?
The third option would resemble a housing finance system with some type of government guarantee as we have today. A guarantee would enable securities to be priced favorably and have a high degree of liquidity to reflect that guarantee but would not provide the benefit of pricing the credit risk of the underlying mortgages. Private sector capital through equity investment would stand in a first loss position, with a government guarantee that was funded through an insurance premium being available to cover other losses.
Replacing the GSEs' implicit guarantee with an explicit one does not resolve all the shortcomings and inherent conflicts in that model, and it may produce its own problems. First, the presumption behind the need for an explicit guarantee is that the market either cannot evaluate and price the risk of mortgage default at a reasonable price or it cannot manage that amount of mortgage credit risk on its own. However, is there reason to believe that the government will do better? If the government backstop is underpriced, taxpayers eventually may foot the bill again.
Second, if it provides explicit credit support for the majority of mortgages it would likely want to determine the allocation or pricing of mortgage credit for particular groups or geographic areas, distorting risk pricing and risking further taxpayer involvement.
Third, explicit credit support for most mortgages in addition to the mortgage interest deduction would further direct our nations investment dollars toward housing and possibly drive up the price of housing, other things being equal.
DeMarco also told committee members about FHFA's 2013 goals under the 1212 Strategic Plan for the GSEs and about the proposed reform of the securitization platform. This was a reprise of information DeMarco sent to the committee on February 21 and covered by MND.
DeMarco concluded his testimony by saying that few could have imagined in 2008 "That we would be approaching the fifth anniversary of placing Fannie Mae and Freddie Mac in conservatorships and have made little meaningful progress to bring these government conservatorships to an end. He urged Congress to make the necessary policy determinations and then set about ending these conservatorships and transitioning to a future housing finance system that can serve our children, grandchildren, and beyond.
