Fixing the US Housing Finance System

This is a summary of a working paper available at the links for which comments are welcome. (An earlier post on related topics appeared here.)

Download the paper (500KB pdf).

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The Administration will soon propose legislation to address the future of the US housing finance system, and it’s a sure bet that this will include re-incarnating Fannie and Freddie in some form. Prominent Republican politicians have also recently called for “privatizing” these entities. This is sheer folly. The problem with keeping Fannie and Freddie or an alternative government sponsored capital market hybrid that seeks to limit and/or price government backing is that policymakers have always done just that! It was investors, not policy-makers, who conferred “agency status” on Fannie and Freddie in spite of their prior ill designed privatizations.

Regardless of whether you believe they were leaders or followers in the sub-prime lending debacle—and the evidence overwhelmingly favors the former view–they have always represented a systemic risk and are inherently inconsistent with a competitive financial system. There are significant roles for government in a competitive market oriented housing finance system, but this isn’t one of them.

Public deposit protection is here to stay. Nobody is suggesting getting rid of the Federal Deposit Insurance Corporation, but public protection requires appropriate regulation.

Whether homeownership subsidies such as the mortgage interest deduction are appropriate is an ongoing debate. Nobody is suggesting getting rid of all homeownership subsidies, but credit subsidies for low-income borrowers and other politically preferred groups should be budgeted, targeted and separated from finance.

Discrimination in lending that is not based on the ability to pay is illegal. Nobody is suggesting relaxing current anti-discrimination laws and regulations, but competition often mitigates all forms of inappropriate lending discrimination better than regulation.

Capital market financing will remain necessary. Nobody is suggesting getting rid of the FHA/Ginnie Mae program or the almost equally massive Federal Home Loan Bank System, but reforms of these programs are necessary after the housing markets recover.

Private label mortgage securitization contributed to the sub-prime lending debacle. Nobody condones the abuses, but private label securitization worked well until regulatory distortions encouraged securitizers to bypass the private mortgage insurance industry, the traditional gatekeepers responsible for preventing excessively risky lending.

A competitive market oriented system serves qualified home borrowers and lenders best but has few political constituents. Politicians much prefer the deferred off budget costs of Fannie and Freddie but the long run costs of delivering subsidies that way far exceed the benefits.

The four steps necessary to restore a stable competitive market oriented housing finance system are:

1. Liquidate Fannie and Freddie: For all new mortgage purchases the traditional private mortgage insurance requirement for all loans with less than a verified 20% cash down-payment should be re-imposed and MBS required for funding, with each new MBS explicitly capitalized with Treasury preferred stock. The entire stock of outstanding debt and MBS, by now indisputably backed by Treasury in any event, should be refinanced exclusively with new Treasury debentures, giving greater control of the underlying mortgages to the enterprises to assist in the foreclosure and liquidation of the remaining assets and facilitate the sale of operations and corporate closure.

2. Separate Enforcement of Social Goals from Prudential Regulation: The FDIC should be stripped of all enforcement responsibility for social lending goals and have final say in all matters of prudential regulation. The regulation of capital markets should be consolidated in a purely prudential regulator, the Federal Housing Finance Agency (FHFA). Enforcing social goals should be shifted from FHFA to HUD and prudential regulation of FHA (and Ginnie Mae) from HUD to FHFA. State insurance regulators should retain primary responsibility for oversight of the private mortgage insurance industry.

3. Establish and Enforce Appropriate and Uniform Risk-based Capital Requirements: Risk -based capital requirements should be based on the risk of the underlying mortgages rather than the financing technique chosen. The lowest requirement (50% under Basel I) should be reserved for loans with verified 20% cash down-payments–or with private mortgage insurance– that meet strict underwriting criteria. The requirement for other loans should be higher and high risk loans—including where appropriate those underwritten to meet social goals—higher still. Capital requirements should be uniform, whether funded with deposits, covered bonds or mortgage backed securities. Policymakers are off to an auspicious start implementing a new framework for capital market financing as Basel III capital rules, covered bond rules and securitization rules have all deteriorated into independent political negotiations within the same framework of SEC sanctioned reliance on credit rating organization ratings. Either risk-based capital rules should not refer to the ratings agencies regarding MBS or the regulators will also have to regulate the raters.

4. Restore Investor Confidence: Restoring investor confidence in housing finance won’t be easy given the history of political risk, post debacle demagogic attacks on mortgage lenders, the accusatory legislative thrust of the Dodd-Frank Act and the wave of litigation attempting to undermine investor rights. The perceived political risk to home mortgage lending is currently greater than any time since the aftermath of the Great Depression and remains too great to attract sufficient investors without strong renewed assurances, and few investors believe that the federal government will ever withdraw its implicit backing. Hence a return to competitive private markets requires confidence building measures to reduce perceived political risk combined with an ironclad sunset on Fannie Mae and Freddie Mac.

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A Competitive Market Oriented Housing Finance System is Still the Best

By Kevin Villani

What Went Wrong

In the aftermath of the sub-prime lending bubble of 2005-2007 and subsequent systemic collapse of the global financial system, the US housing finance system remains on federal government life support with about 19 of every 20 new mortgages government funded. The current policy question is what sort of housing finance system should the US have after the economy and financial markets fully recover?

While contemporary housing finance systems evolved differently and vary significantly among countries, they fall into two broad categories: “market oriented” or “government-driven.” Not surprisingly almost all highly developed market economies have publicly regulated market oriented systems, some with limited government sponsored mortgage insurance, whereas many developing countries have government-driven systems.

The essential distinction between the US model of housing finance and those of other market economies had their origins in FDR’s response to the financial crisis of the Great Depression. Government sponsored deposit insurance and later government sponsored enterprises (GSEs) to create “secondary” mortgage markets sowed the seeds of a system with more widespread albeit largely implied saver and investor protection, increasing the potential for “moral hazard”–the incentive to take greater risks–that would nominally require a more regulated financial system than in other market oriented economies. This evolved into the hybrid deposit/capital market model of the 1970s for essentially two reasons. First, the somewhat unique state/federal political structure of the US and the advanced development of capital markets necessitated greater reliance on secondary or “wholesale” than primary or “retail” deposit market funding. Second, the privatization of Fannie Mae and Freddie Mac resulted in the exploitation of their prior government sponsorship for private gain.

Public insurance is typically under-priced and under-regulated relative to the market discipline it inevitably replaces. This distorts risk management in two ways. First, it provides an incentive for insured firms to make riskier loans. Second, it creates an incentive for regulated firms to maximize their leverage. The extra risk-taking is often profitable for the protected enterprises in the short run and excess leverage boosts returns to equity. The US reliance on “rules” based regulation invites exploitation, making moral hazard more likely than with a European style “performance” based regulatory system.

The implicit public subsidies inherent in greater public protection provided the rationale for social goals in regulation to “spend” the excess profits. Policymakers used prudential regulators to require two financial risks to be under-priced and over-leveraged in return for government backing, interest rate risk and credit risk. Social goals relating to interest rate risk mostly promoted homeownership financed with fixed rate mortgages pre-payable with no fee. Social goals relating to credit risk included lending targets and quotas for lower income borrowers at normal market terms.

Secretary Geithner co-sponsored a meeting with HUD on the future of housing finance topic last August. His invocation argued that the new system should keep the “benefits” of the old hybrid system while avoiding the “costs.” The guest list of political constituents invited to comment on the future system was dominated by advocates for “affordable housing,” “inner city reinvestment,” fixed rate prepayable mortgages and other petitioners. This selection reveals that the perceived benefits of our unique system continues to be the implicit subsidies directed to selected groups through regulatory preferences and requirements super-imposed over prudential regulation, the cost of which are not reflected anywhere on the Treasury’s budget.

But the “excess profits” are illusory over the long run, whereas the costs of social programs aren’t. Interest rate risk results in losses over the interest rate cycle and credit risk over the economic cycle, so under-pricing theses risks eventually results in losses. The government is effectively financing the cost of social programs with the current interest rate savings from excessive leverage. SEC rules not only encouraged but required reporting of unearned profit prior to inevitable losses, contributing to the temporary illusion of a free lunch.

The systemic failure of 2008 reflects the accumulated distortions of the political response to past failures with political causes. Portfolio lending savings and loan associations, the traditional backbone of the US housing finance system, were forced to subsidize interest rate risk. Federally chartered S&Ls in particular were required to finance fixed rate mortgages– historically with both “assumption” and “prepayment” clauses–with short term deposits. They were granted significant tax and regulatory advantages relative to banks, but by the 1970s they were at a major disadvantage to GSEs that paid little or no tax and were required to have only negligible capital. This system collapsed in the 1980s when interest rates rose, replaced with a primary market dominated by too-big-to-fail (TBTF) insured commercial banks and an even more government-dominated secondary market. These commercial banks along with mortgage banks like Countrywide and finance companies developed a private securitization model of capital market funding parallel to that of the GSEs.

As private GSE and commercial bank shareholders further exploited the implicit subsidies of public backing, social goals were expanded from interest rate to credit risk. The introduction of various lending targets (e.g. the Community Reinvestment Act or CRA) for publicly insured private lenders began in the 1970s. Social lending goals were also introduced for Fannie Mae at this time, and later for Freddie Mac.

Regulations unintentionally favoring capital markets diverted most of the flow of credit through that system, even if still ultimately funded in the primary market by the retail deposit system. “Regulatory arbitrage” also determined how much flowed through the GSEs and how much the system of private securitization. That system worked through the end of the last century with the exception of privately securitized loans to sub-prime borrowers with high equity (20%-30%) reflecting cash down-payments and more often inflated collateral who defaulted in record numbers. The savings from financing a highly leveraged balance sheet near Treasury rates financed the cost of GSE “pool insurance” with limited residual interest rate and credit risk.

Several things happened during the last decade. First, there was a global housing and mortgage boom during the first half 2000-2004. Second, the housing goals were substantially ramped up in the late 1990s, so that from the peak of the housing boom mid-2004 through the lending bubble to 2007 they accounted for most of the market. Third, in order to accommodate these generally unqualified borrowers, regulators allowed Fannie and Freddie to by-pass the traditional primary mortgage insurance gatekeepers (and even encouraged the practice by double-counting purchase money piggy-back seconds along with the first mortgage on the same house towards the housing goals) and the SEC facilitated the same for private securitizers. Fourth, the SEC generally facilitated acceleration of revenues reported as profits while deferring credit costs.

Bypassing the primary mortgage insurers–breaking the link between the originator and investor–unleashed a torrent of moral hazard. Inconsistencies in regulation—mostly politically mandated but some reflecting regulatory incompetence at the FDIC, the Fed and OFEHO–created opportunities for “regulatory arbitrage” to fund with the maximum possible leverage (minimum possible capital requirements) at times exceeding 100 to 1. A competitive “duel” between insured banks and implicitly backed GSEs for risky loans directly or indirectly funding the excessive leverage fueled the bubble. The accounting policies at both Fannie and Freddie and private securitizers allowed the bubble to continue until the magnitude of subsequent loss was truly systemic.

Inappropriately regulated publicly backed financial firms and the associated social goals imposed on them was the root cause of the systemic sub-prime lending debacle. This explains why the sub-prime lending debacle occurred in the US and not in other countries with a market oriented housing finance system.

The political appeal of the US hybrid system is enormous. By delivering subsidies through finance (albeit mostly captured by Fannie and Freddie shareholders and management), it bypassed the constraints of the budget process. By treating the GSEs as “private” the normal balance sheet accounting of a government driven system was also bypassed. Politically costless, this system ballooned until it inevitably burst. When it did, Wall Street speculators and “shorts” were once again convenient scapegoats.

Politicians have attempted to deflect blame from the GSEs by arguing that they only followed where the private securitizers led them. The data early in the bubble seemingly provides some support for this assertion, but only because the GSE regulator did restrain Fannie and Freddie, not for risk but as punishment for their massive accounting scandals earlier in the decade. The more complete picture reveals a secondary market extremely distorted primarily by GSE social goals, GSE protection and lax regulation. Private securitization either had to abandon that market entirely or compete on similarly distorted terms. Politically sanctioned regulatory incompetence facilitated the latter.

Politicians bear complete responsibility for the failure of Fannie and Freddie where direct political pay-offs were the greatest. The ultimate costs of the taxpayer bailout of Fannie Mae and Freddie Mac will likely exceed $400 billion, while the bailout of private financial institutions and securities has been reported to have been essentially costless. But the politization of private securitization regulation is more opaque than for GSEs as are the costs, and regulatory incompetence limiting leverage seems to have played a more significant role in that failure. So politicians have generally shifted the blame there, where it can be more easily shifted further from regulators to private securitizers.

Economists generally prefer this political narrative while promoting with the alternative narrative that Fannie and Freddie—victims of unscrupulous private securitizers—prevent systemic risk by correcting private “market failures” and generate positive externalities in the process. But both of these narratives fail on even a superficial analysis of the facts.

Whether Fannie and Freddie led the sub-prime lending debacle or followed and was victimized by it can’t be definitively proven. Putting aside the fact that Fannie and Freddie financed more sub-prime loans than private label MBS and the timing issues, the case that Fannie and Freddie led and the private MBS followed is compelling. Both required extraordinary regulatory laxity. In the case of Fannie and Freddie this was almost entirely political, chronic and inevitable. The bank regulators proved unbelievably inept, but without the competition in regulatory arbitrage from the GSEs private securitizers could have earned comparable profits without taking the self-destructive risks.

The political response thus far, the 2,315 page Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, is named after the two politicians most closely associated with the politization of regulation. Not surprisingly, this bill ignores all of the political origins of the sub-prime crisis including the massive regulatory failures by shifting the blame on to the private sector. It maintains all of the social goals imposed on erstwhile “prudential” regulators and the fear is that the new consumer protection bureau will double down. This political diversion follows the blame-shifting pattern of the Great Depression era financial legislation that Dodd-Frank replaces and has set the stage for a return to the status quo ante.

How to Fix the System

Proponents of a return to the pre-failure status quo (see for example David Min, “Future of Housing Finance Reform” by the Center for American Progress, September and November, 2010) argue that their opponents want “a purely private housing finance system” that will not provide a 30 year fixed rate mortgage. But that’s a red herring. Governments play a substantial role in market oriented housing finance systems by providing a legal and regulatory framework for both retail and capital market mortgage finance and administering it in predictable ways that provide the appropriate balance of protection for savers and borrowers.

Publicly insured banks are here to stay, but prudential regulation should not be undermined by social lending goals. Nobody is suggesting getting rid of the Federal Deposit Insurance Corporation, but regulatory reform is an ongoing process that must work better next time.

Dueling charters are a systemic source of instability. Fannie and Freddie must go.

Capital market financing will remain necessary but the opportunities for “regulatory arbitrage” that bypassed the mortgage insurance gate-keepers and drove private securitization over the cliff must be eliminated. Nobody is suggesting getting rid of the FHA/Ginnie Mae program or the almost equally massive Federal Home Loan Bank System program, but that’s not to say that reforms of these programs aren’t necessary.

Whether housing subsidies are necessary is questionable, and the tax subsidy to home ownership is under attack. Nobody is suggesting getting rid of all homeownership subsidies, but most economists would presumably agree that credit subsidies for low-income borrowers should be budgeted, targeted and separated from finance.

Whether fixed rate mortgages fully repayable with a government mandated pre-payment fee exclusion is in the consumer’s best interest is questionable. Nobody is suggesting eliminating this instrument, but most economists would presumably agree that borrowing short to lend long–playing the yield curve–while providing borrowers with a free refinancing option has eventually but inevitably resulted in bankruptcy.

Competition mitigates all forms of illegal and otherwise inappropriate lending discrimination. Nobody is suggesting relaxing current laws and regulations, but most economists would agree that the system of selective government backing of favored too-big-to-fail enterprises stifles this competition.

A competitive private market oriented system serves qualified home borrowers and lenders best but has few political constituents. Not surprisingly, politicians are still turning to the petitioners for implicit subsidies inherent in social goals for advice on how the housing finance system should be reconstructed. Also not surprising, there are no political constituencies for a competitive market oriented systems or for transparently budgeting subsidies separate from finance.

Qualified mortgage borrowers have no political advocacy comparable to that of subsidy petitioners, and the cost to savers of special homeowner subsidies is extremely opaque (although retirees living off CDs are becoming increasingly vocal in opposition to the current policy). Investors benefit from earning higher yields, but their advocacy has historically been split on this issue, largely represented by Wall Street investment banks that profited handsomely from GSE business.

What is surprising is that, with a few notable exceptions, economists have not supported such a system for the US. The central issue is whether to liquidate or re-incarnate Fannie and Freddie in some form, and if the former, whether to replace them with a hybrid GSE model or rely on an appropriately regulated private securitization model. Most recommend a return to the hybrid model with regulatory modifications and safeguards, essentially rejecting or ignoring the political origins of the past debacle. The invitee list for most hearings on this issue thus far seems designed to produce a “consensus” opinion among economists supporting the continued need for Fannie and Freddie or comparable hybrids.

The perceived benefits are mostly the unbudgeted implicit subsidies or highly questionable or relatively minuscule positive externalities of government intervention. The GSE proponents all ignore the costs and distortions, assuming that they can be strictly controlled with regulation and pricing.

This is sheer folly. The problem with keeping Fannie and Freddie in some form as well as with the various proposed alternative capital market hybrids that seek to limit and/or price government backing is that policymakers have always done just that! It was investors, not policy-makers, who conferred “agency status” ex post in spite of the prior ill conceived privatizations of Fannie and Freddie. There is no right actuarially determined price for agency status, and user fees are priced politically in any event. Moreover, GSE portfolio lending to finance fixed rate prepayable mortgages with short term debt and other credit oriented social lending goals evolved under strict regulatory supervision with political oversight and would likely do so again for a reincarnated GSE or the proposed new hybrids, especially when they inevitably grow too big to fail.

So removing subsidies from finance is the first step toward reform. Subsidies, whether for credit or interest rate risk, should be transparently budgeted and provided separate from private finance.

The FDIC should be stripped of all enforcement responsibility for social lending goals and have final say in all bank prudential regulatory matters. The regulation of capital markets should also be consolidated in a purely prudential regulator, the Federal Housing Finance Agency (FHFA). Enforcing social goals should be shifted from FHFA to HUD and oversight of FHA (and Ginnie Mae) from HUD to FHFA. State insurance regulators should retain primary responsibility for private mortgage insurance oversight.

The US has a long history of administering direct homeowner subsidies transparently budgeted and targeted. HUD is already responsible for managing funded subsidy programs, enforcing anti-discrimination and other social lending goals and enforcing home-borrower protections. The newly formed Consumer Financial Protection Bureau (CFPB), without funded subsidy authority, represents a step in the wrong direction.

Once subsidy is separated from finance, the design issues of a competitive market oriented system of housing finance become fairly straightforward. Most market oriented systems have explicit or implicit deposit backing. Most also rely on capital market funding to some extent. Both systems require appropriate and consistent regulation. Beyond that, markets determine mortgage design and pricing. Market participants can figure out e.g. whether covered bonds work better than securitization funding all types of mortgage instruments including fixed rate pre-payable loans. This is the core of a competitive market oriented model.

Establishing and enforcing appropriate and uniform risk-based capital requirements is the second step. In insured regulated markets, regulatory arbitrage will always direct funding to the greatest leverage. As a corollary, reporting unrealized and unlikely future profits up front should never be allowed, much less required by a government agency.

Policymakers are off to an auspicious start implementing a new framework for capital market financing. Basel III capital rules, covered bond rules and securitization rules have all deteriorated into independent political negotiations within the same framework of SEC sanctioned reliance on credit rating organization ratings. Dodd-Frank required securitizations to retain the “riskiest” five percent retained interest. There is now a political battle over which mortgage loans will be exempt from this requirement and which tranche is the “riskiest.” Based on the past experience with sub-prime loans, the securitizations of the worst predatory loan pools with the highest promised coupons can produce relatively worthless residual interests of five percent of the underlying pool– interests that can subsequently be written off–with reported securitization profits from stripping out illusory future yield exceeding the subsequent loss.

Private mortgage securitization is easily repaired so long as strict regulatory principles are established to prevent arbitrage. Regulators have long been aware of the generic problem of regulatory arbitrage in securitization, but remain unfamiliar with the details. The solution requires not only formulating and implementing Basel III correctly with capital requirements appropriate to the risk, but full coordination with capital market regulators for comparability of MBS with covered bonds and portfolio lending. Either risk-based capital rules should not refer to the ratings agencies regarding MBS or the regulators will also have to regulate the raters.

There is no need to ban senior/subordinated securitization structures, but to eliminate regulatory arbitrage all securitizations done by banks should be treated under GAAP as a financing–rather than asset sale–comparable to deposit or covered bond funded financing. In addition, risk -based capital requirements should be based on the risk of the underlying mortgages rather than the financing technique chosen. The lowest requirement—50% under Basel I—should be reserved for loans with verified 20% cash down-payments–or with private mortgage insurance– that meet strict underwriting criteria. The requirement for other loans should be much higher and high risk loans—including where appropriate those underwritten to meet social goals—higher still.

Non-bank mortgage banks (or independent subsidiaries of bank holding companies) should still be able to securitize conventional loans with asset sale treatment for PCs or REMICs as they do for Ginnie Mae securities. But primary mortgage insurance should be required for all loans with an initial l-t-v above 80% to mitigate moral hazard of loan originators, and excess servicing revenue should not be reported as income unless and until the servicing contract is sold as well. Non-bank finance companies could be allowed to finance riskier uninsured mortgages with senior/subordinate securitization structures, but these should be recorded as financings under GAAP to avoid the illusion of excess profitability caused by “present value” accounting. How much residual interest they need to retain would then be determined by the disillusioned stockholders and bondholders that fund them.

Minimizing GSE distortions is the third step. Fannie and Freddie cannot be politically contained and must be liquidated, and other GSEs are potentially problematic.

Transition Policies for Fannie and Freddie: Numerous technical issues to a managed liquidation will undoubtedly arise, but none insurmountable. A first step toward gradual liquidation would be to begin rolling back the maximum loan limit, re-impose the traditional private mortgage insurance requirement for all loans with less than a verified 20% cash down-payment, and require MBS funding for all new mortgage purchases. Each new MBS issue should be explicitly capitalized with Treasury preferred stock, with Treasury liability limited to that capital investment. This would restore the traditional risk distribution of GSE securitization: private insurance capital would back the credit risk while the interest rate risk would be passed on to investors, with GSE (Treasury) capital providing only residual pool insurance coverage. The second step would be to explicitly guarantee the entire stock of outstanding debt and MBS, by now indisputably backed by Treasury in any event. This could include calling or swapping this debt with new Treasury debentures which would give greater control of the underlying mortgages to the enterprises, assisting in the foreclosure and liquidation of the remaining assets. The third step is to shift the management and liquidating functions out—possibly back to HUD under Ginnie Mae–to facilitate the sale of operations and corporate closure prior to completing the asset management and liquidation.

Post Transition Policies for FHLBs: The FHLB System, which relies on collateralized advances with full recourse generally performed admirably during the crisis, although some losses inevitably occurred. But the potential for regulatory arbitrage between and among deposits, advances and GSEs has long been recognized. The policy concerns regarding mortgage market “liquidity” or countercyclical support have always been the responsibility of the FHLBs, but the last vestiges of the independent S&L system are gone. The FHLB System arguably should have been dissolved at that time, as access to the Fed discount window now protects liquidity at all insured deposit institutions. The excessive bias toward growth since the 1989 FIRREA reorganization opened access to commercial banks should be addressed, their affordable housing requirements eliminated and the ongoing need for them once the mortgage market recovers seriously re-evaluated.

Post Transition Policies for FHA/Ginnie Mae: When added to the large subsidy provided by Ginnie Mae financing, FHA will retain its monopoly advantage over private insurers in its expanded market share. Recapitalization and reform of FHA should follow the transition, including lowering the regionally based qualifying house limit and limiting it to first time homebuyers.

Restoring investor confidence during the transition back to a competitive market oriented model is the last step. While this may be the best time politically to get control of the GSEs since President Kennedy’s Chairman of the Council of Economic Advisors Gardner Ackley first called for this in the 1963 Economic Report to the President, it may also be the worst economic environment since then for doing so.

The housing market and economy are in the worst shape since then, and Fannie and Freddie continue to deliver massive unbudgeted subsidies to home borrowers as the major instrument of current housing policy. This is compounded by today’s Federal Reserve policy that is keeping mortgage interest rates at artificially low levels. In addition, the litigious attempts to shift the cost of the sub-prime mortgage debacle ex post have created legal and regulatory ambiguity that further discourages any private home mortgage finance.

Few investors believe that the federal government will ever withdraw its implicit backing. Restoring investor confidence in housing finance won’t be easy given the history of political risk, post debacle demagogic attacks on mortgage lenders, the accusatory legislative thrust of the Dodd-Frank Act and the wave of litigation attempting to undermine investor rights. The perceived political risk to home mortgage lending is currently greater than any time since the aftermath of the Great Depression and remains too great to attract sufficient investors without strong renewed assurances. Hence a return to competitive private markets requires confidence building measures to reduce political risk, combined with an ironclad sunset on Fannie Mae and Freddie Mac. Legislation clarifying and asserting lender property rights, e.g. a federal foreclosure law, should be considered. Without such actions, many investors may prefer government guaranteed securities to mortgages, seeking comfort in aligning their interests with that of Chinese investors.

It goes without saying that both the liquidation and prospective future mortgage system should be designed to minimize long term direct and indirect taxpayer expense. Mortgage rates on appropriately capitalized private mortgage backed debt will be higher, reflecting the lack of an implicit subsidy from regulatory arbitrage. But the current subsidy expense has never been transparently budgeted, and doing so by separating subsidies from finance would increase the stated budget deficit while reducing taxpayer expense. So requiring that reform not “increase the budget deficit” by making costs transparent is another red herring. This worked spectacularly to thwart social security reform in 1982 and again in 2002 and will likely be employed once again in an attempt to maintain the status quo ante.

Lacking a sufficient political commitment to a competitive market oriented model with transparently budgeted subsidies, political forces will likely align in favor of Fannie and Freddie re-incarnation or substitution of a hybrid model. This is the worst choice. A transparently budgeted government-directed model segregated from private finance would represent a giant leap backwards from the market model of an earlier era but is far preferable to recurring global financial crises spawned by GSEs and their hybrids.

Download the paper (500KB pdf).

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Kevin Villani is former SVP/acting CFO and Chief Economist at Freddie Mac and Deputy Assistant Secretary and Chief Economist at HUD, as well as a former economist with the Federal Reserve Bank of Cleveland. He was the first Wells Fargo Chaired Professor of Finance and Real Estate at USC. He has spent the past 25 years in the private sector, mostly at financial service firms involved in securitization. He is currently a consultant residing in La Jolla, Ca. He may be reached at kvillani at san dot rr dot com.