[Senate Hearing 111-435]
[From the U.S. Government Publishing Office]
S. Hrg. 111-435
THE FUTURE OF THE MORTGAGE MARKET AND THE HOUSING ENTERPRISES
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING WHETHER RESPONSIBLE HOMEOWNERS WILL HAVE ACCESS TO THE LOANS
THEY WILL NEED TO REALIZE THE AMERICAN DREAM OF HOME OWNERSHIP
__________
OCTOBER 8, 2009
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin KAY BAILEY HUTCHISON, Texas
MARK R. WARNER, Virginia JUDD GREGG, New Hampshire
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Marc Jarsulic, Chief Economist
Jonathan Miller, Professional Staff Member
Misha Mintz-Roth, Legislative Assistant
Matthew Green, FDIC Detailee
Mark Oesterle, Republican Chief Counsel
Chad Davis, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, OCTOBER 8, 2009
Page
Opening statement of Chairman Dodd............................... 1
Prepared statement....................................... 49
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 3
Prepared statement....................................... 49
Senator Gregg................................................ 4
WITNESSES
Edward J. DeMarco, Acting Director, Federal Housing Finance
Agency......................................................... 5
Prepared statement........................................... 50
Responses to written questions of:
Chairman Dodd............................................ 100
Senator Menendez......................................... 102
Senator Kohl............................................. 105
Senator Corker........................................... 107
William B. Shear, Director, Financial Markets and Community
Investment, Government Accountability Office................... 34
Prepared statement........................................... 57
Responses to written questions of:
Chairman Dodd............................................ 109
Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy
Studies,
American Enterprise Institute.................................. 35
Prepared statement........................................... 76
Susan M. Wachter, Richard B. Worley Professor of Financial
Management, Wharton School of Business, University of
Pennsylvania................................................... 37
Prepared statement........................................... 81
Responses to written questions of:
Chairman Dodd............................................ 113
Andrew Jakabovics, Associate Director for Housing and Economics,
Center for American Progress Action Fund....................... 39
Prepared statement........................................... 84
Responses to written questions of:
Chairman Dodd............................................ 114
(iii)
THE FUTURE OF THE MORTGAGE MARKET AND THE HOUSING ENTERPRISES
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THURSDAY, OCTOBER 8, 2009
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 9:36 a.m. in room SD-538, Dirksen
Senate Office Building, Senator Christopher J. Dodd (Chairman
of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Chairman Dodd. The Committee will come to order. Let me
welcome our guest witnesses this morning, as well as my
colleagues. The title of this morning's hearing is ``The Future
of the Mortgage Market and the Housing Enterprises,'' and this
is a subject matter on which there has been a tremendous amount
of Committee interest and others over time. And we have had--
Richard, I counted up last night. I think we have had just this
year alone 70 hearings.
Senator Shelby. I believe it.
Chairman Dodd. I looked at the number, just on the various
subject matters. Most of it has been focused on reg reform
issues, and almost everything----
Senator Shelby. I do not know of any other committee----
Chairman Dodd. That had this many.
Senator Shelby. Because we both serve on other committees.
We would not have any sleep, would we?
Chairman Dodd. It has been a lot. I know yesterday Jack
Reed had a hearing as well. Judd, I think you participated in
that hearing that Jack had.
So we have covered a lot of ground, and there are so many
things, we could be just having--we could literally have a
hearing a day on the subject matters that the Committee has
jurisdiction over. And this is a subject matter Bob Corker,
others, obviously Richard--we all have a great interest in this
issue of the Government-sponsored enterprises and where we are,
where we are going, what is the future of all of this. And so
it is an important subject matter, and, therefore, I am glad we
have some time this morning to spend on this.
Let me share a few opening comments. I will turn to the
former Chairman, Senator Shelby, for his opening thoughts and
comments on it, and then we will get right to our witnesses,
unless any of the Members feel compelled that they want to
share a thought or two on all of this.
Well, today we meet to discuss the Government-sponsored
enterprises--Fannie Mae and Freddie Mac--and the role they will
play as we seek to restore normalcy to the mortgage market. But
let us not forget what we are really talking about here. We are
talking about whether responsible homeowners will have the
access to home loans they need to realize the American dream of
home ownership.
Last year, when the mortgage market collapsed, the Director
of the Federal Housing Finance Authority put Fannie Mae and
Freddie Mac into conservatorship. At the same time, Secretary
Paulson exercised the authority he was given by last year's
bipartisan Housing and Economic Recovery Act to provide back-up
funding for the two companies, ensuring that they would
continue financing mortgages during the housing crisis.
Today we are going to consider where we need to go from
here. Now is the time to look forward as well as looking back,
but with so much damage done by this financial crisis, the role
of the GSEs in that crisis is still hotly debated, as we all
know.
Let me just say Fannie and Freddie were neither the
villains that caused the crisis, in my view, as some claim, nor
the victims of that crisis, as others would make them out to
be. They did not create the subprime and exotic loan market,
but they did chase it into the general--to generate profits,
rather. And like many of the supposedly private financial
institutions that ended up becoming equivalent to GSEs, Fannie
and Freddie enriched their shareholders and management while
the public took the losses.
We cannot let that happen again, in my view, and as we look
forward, we must start by setting benchmarks to determine
whether the mortgage market is healthy so that American
families can once again begin to build wealth--not the kind of
wealth that buys mansions and yachts, but the kind of wealth
that sends a child to college or ensured an affordable
retirement.
First, the mortgage market must remain liquid and stable,
especially in times of stress. Otherwise, rates are driven up,
prices are driven down, and the American family loses.
Second, we must encourage product standardization such as
widespread availability of that unique American opportunity,
the 30-year fixed-rate mortgage, without prepayment penalties.
This helps both borrowers and lenders.
Third, mortgage credit must remain consistently available
and affordable. Home ownership remains part of the American
dream, as we all know. That dream should be accessible to as
many people as possible and sustainable for as many people as
possible as well.
Today the market is meeting these tests, but only through
massive Government intervention. The Federal Reserve, for
example, has committed to pumping more than $1 trillion into
the mortgage market. That cannot go on, as we all know.
Therefore, it is time to begin the conversation about how we
can re-create a functional market that stands on its own two
feet and to decide what role, if any, the GSEs or their
successors should play.
I want to start that conversation by posing a number of
questions. Can the market function with no Government
involvement? Should, on the other hand, the Government
completely and explicitly take over the job previously done by
Fannie and Freddie? Do we want a model where there is some
private capital at risk but only under strict Government
control, such as a utility? Hank Paulson and others have raised
this possibility or idea.
There are other important questions. The answers, in my
view, are critical to ensuring that American dream that we all
embrace, and I look forward to considering these questions with
our distinguished panel today that we are fortunate to have
with us.
Before turning to Senator Shelby, I want to quickly add
that I am hopeful that the higher GSE and FHA loan limits,
which were first established in HERA, will be extended again in
the HUD appropriations bill currently being negotiated. These
higher loan limits are helping many borrowers in States like
mine and others, frankly, where it is critical, to purchase
homes or refinance their mortgages. And I think we need to keep
this support in place. It is a controversial item, but I wanted
to mention that as a side item here this morning as well.
With that, let me turn to my good friend and colleague from
Alabama, Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
As we consider the future of the GSEs, I believe we would
be wise to remember the disastrous consequences that poorly
regulated GSEs can have on our financial markets. Just 1 year
ago, Fannie Mae and Freddie Mac were placed into
conservatorship when they could not cover billions of dollars
in losses.
Despite repeated warnings by me and other Members of this
Committee about the risk that GSEs presented, they were allowed
to accumulate more than $5 trillion--$5 trillion--in financial
obligations with only minimal amounts of capital. The
Congressional Budget Office now estimates--and this is probably
conservative--that resolving the GSEs will cost American
taxpayers $389 billion, perhaps more. We must ensure that this
never happens again, but the question is: Will we?
This hearing, therefore, comes at an opportune time as this
Committee is considering financial regulatory reform. There is
no doubt that the failure of Fannie and Freddie was a
significant actor in the financial crisis because their
activities touched nearly every aspect of our financial system.
In addition, their debt is among the most widely held in the
world. They are also major counterparties to our most prominent
financial institutions. Accordingly, regulatory reform, I
believe, must involve the GSEs.
But the Administration made no effort to include the GSEs
in its financial regulatory reform proposal. Instead, the
Administration has said that it will not propose how to deal
with the GSEs until next year. Why? I believe that this is a
grave mistake that will make it more difficult to reform our
financial system that will potentially expose taxpayers again
to even greater losses.
I believe what we need is a clear path that addresses both
the GSEs' ongoing financial difficulties and the role that the
GSEs should play in our economy in the future. I fear that the
longer we wait, the more it is going to cost the American
taxpayer. Certainly the question of what to do with GSEs is
very difficult and complex. Yet it is a question that we ignore
at our peril.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you very much, Senator.
Do either of my two colleagues here have any comments at
all?
STATEMENT OF SENATOR JUDD GREGG
Senator Gregg. Well, Mr. Chairman, I know you want to get
to the witnesses, but I do not think the moment should pass
when we are taking up this issue to not acknowledge the fact of
the extraordinary work that you two did last summer--the summer
before last, to basically address this issue. The chaos which
would have occurred would have even been more severe if you two
had not joined and pulled together a very aggressive resolution
of the Fannie Mae/Freddie Mac issue and led the Congress in
this area. So I just wanted to acknowledge that.
Chairman Dodd. I thank you, Senator, very much for those
comments. Let me just say--I know people hear me say these
things, but it is a tremendous pleasure working with Richard
Shelby, and this Committee has been tremendous. We have got a
lot of work in front of us, but I am more than confident we are
going to do well at it as we move forward.
I want to introduce our panel, not only Mr. DeMarco but let
me introduce the second panel as well so we can just move
through and so we have a sense of everyone.
Edward DeMarco, Acting Director of the Federal Housing
Finance Agency, has served with the FHFA, the successor of the
Office of Federal Housing Enterprise Oversight, since 2006 when
he came on as Chief Operating Officer and Deputy Director.
Previously he served in various capacities with the Social
Security Administration and the Department of the Treasury. Mr.
DeMarco, we thank you very much for joining us.
Let me briefly introduce the second panel quickly as well.
Mr. William Shear is the Director of Financial Markets and
Community Investment at the U.S. Government Accountability
Office. In this capacity, Mr. Shear has conducted important
research on the Government-sponsored enterprises, including a
recent report published in 2009, and we all look forward to
hearing about that in your testimony.
Peter Wallison is the Arthur F. Burns Fellow in Financial
Policy Studies at the American Enterprise Institute. He serves
as cochair of the Pew Financial Reform Task Force and has held
a number of Government positions, including General Counsel at
the United States Treasury. He is the author of numerous books
and articles about the housing enterprises, and we welcome you
as well to our Committee.
Dr. Susan Wachter is a professor of real estate and finance
at the Wharton School. Dr. Wachter is the former Assistant
Secretary at the Department of Housing and Urban Development
for Policy Development and Research and has served on numerous
review and research boards in the public and private sectors.
And, last, Mr. Andrew Jakabovics--did I pronounce that
correctly?
Mr. Jakabovics. Close enough.
Chairman Dodd. Close enough? Thank you very much. Andrew,
welcome. Mr. Jakabovics is the Associate Director for Housing
and Economics at the Center for American Progress Action Fund,
and prior to this, he served as the research chief of staff for
the MIT Center for the Real Estate Housing Supportability
Initiative.
So we have a very distinguished group of witnesses to hear
from this morning as well, and I am very honored that all of
you agreed to appear before us this morning to talk about this
important subject matter.
With that, Mr. DeMarco, we welcome you and I am going to
just ask all of you--I am going to take all of your full
statements, by the way. I presume they are probably fuller
statements than what you are prepared to give publicly in the
statement, and any supporting documents and information you
think would contribute to our knowledge of this issue is
welcomed as well. And so if you would try and keep your remarks
in that 5- to 7-minute range, I would appreciate it so we can
get to questions.
Welcome.
STATEMENT OF EDWARD J. DeMARCO, ACTING DIRECTOR, FEDERAL
HOUSING FINANCE AGENCY
Mr. DeMarco. Good morning, Chairman Dodd, Ranking Member
Shelby, Committee Members. Thank you for the opportunity to be
here today. My written statement details FHFA's key activities
and accomplishments, the challenges facing the housing GSEs,
and their response to those challenges. I will summarize now
the GSEs' financial condition and key challenges, and I will
close with some thoughts about the future of our housing
finance system.
I will begin with the current financial condition of Fannie
Mae and Freddie Mac, or as I will refer to them, ``the
enterprises.'' In the first 2 years of this housing crisis,
combined losses at the enterprises totaled $165 billion. Their
financial performance continues to be dominated by credit-
related expenses and losses stemming principally from purchases
and guarantees of mortgages originated in 2006 and 2007.
Since the establishment of the conservatorships, the
combined losses at the enterprises depleted all their capital
and required them to draw $96 billion from the Treasury under
the Senior Preferred Stock Purchase Agreements. With continuing
uncertainty regarding economic conditions, employment, house
prices, and mortgage delinquency rates, the short-term outlook
for the enterprises remains troubled and likely will require
additional draws.
The Treasury and the Federal Reserve have made sizable
purchases of housing GSE securities to instill confidence in
their securities, provide stability to mortgage markets, and
lower mortgage rates. This combined support exceeds $1 trillion
and has allowed the enterprises to continue providing liquidity
to the mortgage markets.
The enterprises face four key challenges. First is
staffing. Both enterprises have filled vacancies at the
executive management level. However, several key vacancies
remain below that level. Moreover, uncertainties about the
future of the enterprises make staff retention a key concern.
As we see improvements in the economy, opportunities for
employees and officers to seek other employment will increase,
adding to the current retention challenge.
Second is credit risk. The credit risk in their mortgage
books remains a supervisory concern. While a few positive signs
of housing recovery have emerged, we recognize the risk
associated with the increasing number of seriously delinquent
loans and the uncertain path of the market's recovery. In
addition, the multifamily market is experiencing declining
property values and record vacancy rates.
Market risk. The enterprises' investments in mortgage
assets expose them to market risk that is challenging to manage
in today's environment.
And, finally, operational risk. The systems and models upon
which the companies have relied in the past have been greatly
stressed in this market, and the new management teams are
working on appropriate remediation. The implementation of the
new consolidation accounting standard, which will require the
enterprises to bring off-balance-sheet mortgage-backed
securities onto their balance sheets in January, is a
substantial operational challenge.
Turning to the home loan banks, Federal home loan banks
have not been immune from mortgage-related losses. Most notable
is the deterioration in the value of private label mortgage-
backed securities held by many Federal home loan banks.
In the first 6 months of this year, the home loan banks
collectively saw impairment charges of $8 billion in the
private label MBS portfolio. However, a change in accounting
rules resulted in only $1 billion of that being charged against
income.
Net income for the first half of 2009 was $1.4 billion,
compared to $1.2 billion for all of last year. This improvement
reflects in part these new accounting rules.
The home loan banks have two key challenges of note: First
is working through the issues associated with their private
label MBS, and the other is the failure or consolidation of
system members has shifted business volumes among the banks and
increased concentration of ownership by, and advances to, a few
large institutions.
Mr. Chairman, you asked me to address the future of the
housing finance system. The mortgage market in this country is
a $12 trillion market, yet this massive size is attained
through millions of individual transactions that have an
average size of about $200,000. In its broadest terms, then,
the housing finance system connects $12 trillion on the one
hand to these $200,000 transactions on the other. It connects
capital markets to local mortgage lending transactions.
Going forward, we might begin with the following simple
goal: to promote the efficient provision of credit to finance
mortgages. An efficient system would have characteristics such
as allowing for innovation, providing consumer choice,
providing consumer protection, and facilitating transparency in
the marketplace. While these characteristics provide a broad
framework, policymakers must determine the Government's role in
the following areas: ensuring adequate liquidity, absorbing
credit risk, and affordable housing.
Now, ensuring liquidity in this context addresses periodic
disruptions in credit markets that cause investors to
temporarily exit from holding or purchasing mortgages. During
such episodes, do we need to ensure there is a balance sheet of
last resort?
Second, markets have relied upon an implicit Government
guarantee of enterprise securities. Going forward, though, what
level of Government credit support is needed to have an
efficient mortgage market? One approach is having the
Government take a limited catastrophic credit insurance
position backing certain mortgage assets. Another approach
could be a combination of enhanced private sector market
discipline and regulatory oversight.
Third, the Government has long promoted credit availability
for low- and moderate-income homeowners and renters. The
subsidies granted the enterprises were exchanged for
requirements, including housing goals, to ensure the
enterprises did not ignore these segments of the market. Going
forward, though, policymakers may consider alternative
approaches to targeting such subsidies.
Finally, we should remember the benefits of our current
system. Notable are the standardization of conventional
mortgages and a highly liquid forward market for mortgage-
backed securities that allows mortgage applicants to lock in
interest rates. We should strive to maintain those benefits as
we plan for the future.
I think we are in the early stages of an important national
discussion, one that the Administration has committed to
addressing in the coming months. I also believe that private
capital, properly regulated, has a critical role to play in the
housing finance system. But we need clear rules of the road for
private risk capital to fully return to this market. As for the
enterprises and the home loan banks, they each may well have
important roles to play in this future system. But the place to
begin the discussion is outside the existing framework of
institutional arrangements.
Thank you for the opportunity to be here today, and I would
be pleased to answer questions.
Chairman Dodd. Thank you very much, Mr. DeMarco, and let me
begin.
First, let me begin with something we do not do often
enough and, that is, to thank you and your staff and other
personnel at the Federal Housing Finance Agency. These are the
most difficult economic circumstances that any of us have had
to grapple with in our tenure here in the U.S. Congress. There
have been other periods of downturn, but nothing like what we
have been through. You have got to go back to the period of our
parents or grandparents to encounter a time that has been as
difficult. So I want to begin by thanking you and the staff.
You have had the equivalent of sort of an economic gun at your
head and have performed very, very well, in my view, and we
thank you.
Mr. DeMarco. Thank you very much, Mr. Chairman. On behalf
of the very hard-working staff at FHFA, I really appreciate
that.
Chairman Dodd. They do not get recognized and these
alphabet letters, most people do not understand there are
people behind those letters that show up every day and do a
tremendous job on their behalf.
Let me begin by--there is one of our witnesses in the
second panel is going to testify, and let me quote part of that
testimony to you. The witness says that, ``Perhaps the biggest
question policymakers face is whether U.S. housing finance can
attract sufficient capital to meet its needs without a
significant Government role, particularly in the wake of
massive failures in the private securitization market.''
What is your answer to this question? Will the United
States be able to attract the capital necessary to meet our
housing needs without a role of the Federal Government?
Mr. DeMarco. Mr. Chairman, as I said at the close of my
statement, I actually think that private risk capital can and
should return in a more fulsome fashion to the U.S. housing
finance system.
In terms of the role of the Government as a credit
backstop, there are multiple dimensions to that. Clearly, the
Government is playing a direct guarantee role through the FHA,
through the VA, through rural housing. So there already are
various mechanisms in which the Government is providing direct
credit guarantee to certain targeted mortgage activity. The
question becomes really, with the conventional mortgage market,
what sort of role the Government ought to play going forward
there. There are various options, but I think this actually is
a bit of the rub in terms of what should be done.
I would say that the system that we have had has attracted
a great deal of global capital investment, but it appears to
have done so with this much discussed perception of an implied
Government guarantee. And so I would hope, however policymakers
end up deciding on this question of the Government's role in
providing or not providing credit support to a broad swatch of
the mortgage market, that we not leave this hanging uncertainty
because this has the tendency to privatize the gains and put
the losses on taxpayers.
So I would hope for something that is either clear about
what the limit of Government support is, if there is going to
be some, or clarity in the fact that we are looking to private
financial institutions to be well capitalized and for private
market discipline to be the controlling influence on mortgage
credit risk.
Chairman Dodd. I do not begin with the presumption that we
ought to. In fact, I begin with the presumption that I would
like to figure out how we could do it without doing that. It
seems to me that ought to be the charge. Tell me how we can
achieve this without that role. The question I have is, in a
sense: Is that a realistic conclusion? I mean, looking down the
road, can it be done that way? Otherwise, we are trying to--
whether or not we deal with this in the reg reform proposal or
whether or not we deal with it after the fact, we are going to
have to deal with issue, and sooner rather than later. And the
question is: What do we do? We would all kind of like to know
the answer to the question as we proceed.
As policy setters, I begin, as I say, with the presumption
I would like to figure out a way we could do it without that.
Mr. DeMarco. Right.
Chairman Dodd. But if I am being unrealistic about that and
am going to destroy a great wealth creator, job creator, all of
the other things that we associate with home ownership, I would
like to get some sense of whether or not that is realistic.
Mr. DeMarco. Certainly. Mr. Chairman, I believe that we, in
fact, can develop structures and a framework by which this can
be managed in the private sector. So if the question is can it
be done, my response is, yes, sir, I believe it can be done. I
think that it requires structures in which there is competition
in the marketplace, that there is freedom of entry and exit for
market participants who would be engaging in secondary mortgage
market activity. There ought to be suitable regulatory
oversight of those functions, as there is for most aspects of
our financial system. But I think that with clarity in the
rules of the road, that will happen.
In any event, this is one aspect of a larger issue, Mr.
Chairman, about returning to a more traditional set of
underwriting so, in fact, we are being more honest with
ourselves about the risk of mortgages and the differential in
risk from one mortgage to another.
And so I think that, in fact, if we have appropriate
transparency in the marketplace so that investors know, if we
distribute risk appropriately so that there is good credit risk
management, global capital market investors will want to
purchase mortgages. They are not going to know about the
individual credit characteristics of any individual mortgage of
$200,000 if they are investing in securities in the millions.
Private mortgage insurance is one aspect today of where there
is other private capital at risk assessing that very issue of
what is the credit risk of this mortgage.
And so I think that our financial system can build upon
what we have today so that that credit risk can be, in fact,
managed and capitalized in the private sector. That is a
workable model.
Chairman Dodd. Let me ask you, the Case-Shiller Index has
shown that housing prices in most large American cities have
stabilized or turned around. At least that is according to the
Case-Shiller Index. Your own house price index shows some gains
at FHFA for the first time in many months.
On the other hand, we have millions of mortgages that are
in delinquency and heading to foreclosure. I saw a number the
other day, and I do not--I always see numbers on a TV screen,
but it talked about even an 18-percent increase this year over
last year in the number of foreclosures in the country. Now,
probably more of that is associated at this juncture with the
unemployment rates maybe than subprimes, since we seem to have
run through that a little bit. But, nonetheless, those numbers
seem pretty high.
I would like to ask what your expectations are regarding
housing prices and what impact that will have on the
performance of the enterprises, in your view.
Mr. DeMarco. Mr. Chairman, I do not have a forecast for
national house prices. I will affirm what you said, that FHFA's
own house price index, which is based upon repeat mortgage
transactions of mortgages that flow through Fannie Mae and
Freddie Mac, has been pretty stable this year. In fact, it is
up very slightly for the year. So that is one indicator that on
a nationwide basis there may be some bottoming out of house
prices.
The Case-Shiller number is more recent--it is the first
time in 3 years Case-Shiller has shown an uptick in house
prices.
These are, in fact, positive signs that perhaps were in
some sense bumping along the bottom. But if you had not, I
would have very much added I am concerned about the continued
increase in serious delinquency rates in mortgages around the
country, including in, you know, what have been considered to
be prime mortgages that Fannie Mae and Freddie Mac have
purchased and guarantee.
It is troubling to me to see that the serious delinquency
rates are continuing to rise, and the employment situation is
one factor that is certainly affecting that. But I think that
that is a very clear reason why it is too early to declare
victory.
Chairman Dodd. Let me just ask a couple of quick ones here
as well. You have pointed out that the enterprises are playing
a central role in carrying out the Administration's foreclosure
prevention plan in your testimony. Why did you turn to the
enterprises to perform this function, number one? And to date,
the loan modification effort has focused largely on payment
modifications. We have been through a lot here, Senator Shelby
and Members of the Committee, in trying to fashion a way that
would help out. And I think all of us wished it would have
worked better than it has.
I for one believe that principal reduction probably would
have done more than interest rate reduction. That was a view
taken by some, but we have not embraced that view nationally.
Is there any more that Fannie and Freddie can do to
encourage principal forgiveness? Is this the kind of thing you
are prepared to explore, or has it been rejected?
Mr. DeMarco. To start with the first part of that question,
Mr. Chairman, before the Obama administration took office, late
last year FHFA, in conjunction with Treasury and with HOPE Now,
a group of some of the largest mortgage lenders and servicers
in the country, developed a streamlined modification plan.
What we, collectively, the GSEs and many of these mortgage
servicers with their own mortgage books, as well as mortgages
that were in private label securities, faced was this
incredible increase in delinquent mortgages and the challenge
of how to mitigate the losses from those mortgages.
And so what we first tried to do last fall with the
streamlined modification program was to come up with a national
program that servicers could implement regardless of whose
mortgage it was, so there would be a consistent framework for
engaging in a massive-scale loan modification program. That was
set, what could be done voluntarily at that time, at a payment
rate of about 38 percent of a homeowner's monthly income.
When the Obama administration came into office, they looked
at the very early results from the streamlined program with us,
with the GSEs, and with industry, and we all collectively
concluded that more needed to be done here. And so the Obama
administration did lead an effort to develop the Making Home
Affordable program.
The reason for the enterprises' involvement in this is
twofold: One, the enterprises currently own or guarantee in
rough order about half the mortgages in this country. So
anything that brings liquidity and stability to the general
mortgage market goes directly to the financial benefit of
Fannie Mae and Freddie Mac in terms of stabilizing their credit
exposure.
The second thing is Fannie and Freddie, with all these
mortgages, their mortgages are actually serviced by several
thousand servicers around the country. Most of the servicing is
being done in these same large servicing shops that do private
label securities.
So to engage in a large-scale national loan modification
effort, it really made a lot of sense for there to be one
program that servicers had to learn the rules and had to
implement, regardless of whether it was a Fannie Mae loan, a
Freddie Mac loan, or a loan on some other balance sheet.
And so the reason that the enterprises do this is they have
the direct commercial relationships with these servicers, and
it allowed for this consistency, which was good for the
servicers, good for the borrowers--they get treated equitably
that way--and certainly facilitated loss mitigation for Fannie
and Freddie.
Chairman Dodd. Thank you very much.
Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Mr. DeMarco, on June 18th, the day after the Administration
released its regulatory reform plan, Secretary Geithner said to
this Committee, and I quote, ``We wanted to make sure we were
focusing on those problems that were central causes of this
crisis.'' Those are his words.
While I agree that we should address the problems that were
the central causes of this crisis, I am at a loss as to why the
Administration does not or did not consider the GSEs to be a
central cause meriting immediate consideration in regulatory
reform. Maybe it is something we have got to do; the
Administration did not understand or maybe looked the other
way.
Do you know why the Administration determined that Fannie
and Freddie were not central causes of the crisis when
everybody else knows better?
Mr. DeMarco. Senator Shelby, I am sorry, I cannot speak for
the Administration's view on this or why they did or did not--
--
Senator Shelby. But you are part of the Administration.
Mr. DeMarco. Well, I am running an independent Federal
regulatory agency, so in that sense, I really do not think I
am----
Senator Shelby. You cannot speak on that subject.
Mr. DeMarco. I cannot speak on that subject for Secretary
Geithner, no.
Senator Shelby. Do you have an opinion, if we do our job
well, if we do--and I hope we will--on reforming financial
services regulation, can we do that job really without
addressing the Fannie and Freddie problem? And if so, I wish
you would tell us all, both sides of the aisle, because that
would be an interesting statement.
Mr. DeMarco. Senator, there is no question that the U.S.
Congress needs to deal with Fannie and Freddie and more
largely, as I have tried to set out in my testimony, with the
housing finance system. And I think that that needs to be done.
I do not mean to be trite in saying this, Senator, but I think
it needs to be done expeditiously, but not hastily.
Senator Shelby. I agree we should not hastily do anything,
especially regulatory reform.
Mr. DeMarco, the General Accounting Office found, and I
will quote, that ``The enterprises' ''--meaning GSEs, Fannie
and Freddie--``structures undermine market discipline and
provided them with incentives to engage in potentially
profitable business practices that were risky and not
necessarily supportive of their public missions.''
Do you disagree with that statement?
Mr. DeMarco. Senator, I think it is quite clear that the
GSE structure had flaws in it, and that has been widely
discussed and reported. GAO has been reporting on that for many
years. I know the Treasury Department in multiple
Administrations has reported on that.
The structure in which Fannie and Freddie were allowed to
operate under for many years really did allow for excessive
leverage and risk taking and sending mixed signals to the
marketplace about just what the Government's stand with respect
to them was. And it is something that I think we all ought to
regret was not addressed earlier.
I would also acknowledge the Congress' enactment of HERA in
2008 that finally, after many years, created a single housing
GSE regulator and gave that regulator----
Senator Shelby. It helped some, did it not?
Mr. DeMarco. It helped some, but, frankly, Senator it would
have certainly been helpful to have had that earlier.
Senator Shelby. You referenced that--but I will bring it up
again--while the conservatorship itself would reduce incentives
to some degree--and we brought that up in the legislation
there--what other steps has your agency taken to bring Fannie
and Freddie practices in line with sound lending standards?
Mr. DeMarco. Senator, I think that clearly we are limiting,
and they are themselves limiting, their mortgage activity to a
more prudent approach to the credit quality of borrowers and
the realistic pricing of credit risk. That itself is subject to
some criticism, but I think that, in fact, we have for a long
time underpriced mortgage credit risk, and there is an ongoing
return to a more sensible price----
Senator Shelby. We have underpriced it at our own peril,
have we not?
Mr. DeMarco. Yes, sir.
Senator Shelby. What measures would you suggest through
your agency be adopted to ensure in the future that GSEs--
Freddie and Fannie--do not return to such bad practices that
they have had in the past after they emerge, assuming they do--
I hope they do and are privatized--from conservatorship?
Mr. DeMarco. Well, Senator, it would certainly be my
expectation that you have two institutions that have tremendous
expertise, personnel and otherwise, in servicing the U.S.
mortgage market. And so I do envision that there is some post-
conservatorship realm for them. But there is a certain
difficulty in answering that question because one does not know
what the model is that this post-conservatorship world is
operating in.
So I think that the sort of questions that I set forth in--
--
Senator Shelby. Do you envision a hybrid model like a GSE
or a totally private Fannie and Freddie or something like that?
Mr. DeMarco. Senator I know the GAO will testify in the
next panel, they have set out several broad ways this can be
done, of which privatization is one. Something that moves it
more into the Government is another.
As I have already said, in my view, whichever way we go
here, I would urge that we avoid the key pitfalls of the
current arrangement where there is this uncertainty or this
implied Government backing, and a set of exclusive charters
that are given a set of subsidies operating in this rather
unique fashion. That model does not work. And so I think those
are the things we need to fix.
Senator Shelby. I know I am over my time, but basically
what lessons have we learned? And that is important. Have we
learned anything from the debacle that went through Fannie and
Freddie? You testified, Mr. DeMarco, and I will quote your
words, ``To properly consider the future of the housing GSEs,
one should first consider the goals policymakers have for the
U.S. housing finance system, and specifically the secondary
market.'' I agree with that.
And as you consider this, what lessons do you see from our
past experiences related to Fannie and Freddie that should help
us shape, all of us, policymakers, those goals in the future?
And do you believe that the GSEs' housing goals may have
contributed to the buildup and subsequent fall of these
institutions?
Mr. DeMarco. Senator Shelby, I will try to hit on all the
different things that were in that question.
I think in terms of the lessons learned, I have already
talked about the model here. I think that we had a system
driven by statute where we ended up with different regulatory
capital requirements for a mortgage, depending upon where that
mortgage was held or how it was being financed. I think there
needs to be far greater regulatory harmony there.
I would extend that point to also say that, as a general
proposition, I think that, in whatever financial regulatory
reform we end up with, there will be multiple agencies of
Government with responsibility for some aspect of housing
finance. And I think creating mechanisms whereby those various
agencies are themselves in some coordination with each other so
that, as a Government, we are taking a more consistent approach
of analyzing what is going on in the mortgage market, how are
consumers being protected, and are we creating sort of
regulatory arbitrages someplace in the market, that we ought to
have mechanisms that address that in whatever regulatory reform
we end up with.
Senator Shelby. Mr. Chairman, you have been very generous
with me on the time, but if I could follow up on this. As we
get into regulatory reform, we are talking about and a lot of
the regulators are talking about more capital for banks, for
financial institutions. Yet if we deal with the GSEs in the
future, they are going to have to have a lot of capital
considering the risks out there in the marketplace. How do we
do that?
Mr. DeMarco. Well----
Senator Shelby. Because you cannot--I do not believe you
can have one institution or two institutions this big with very
thin capital, because you are waiting for the time bomb to go
off.
Mr. DeMarco. Well, absolutely, Senator. And I think that
OFHEO for many years testified to that very point, as have
other Government agencies that have studied this risk. So,
think about where we were statutorily. Since 1992, the
requirement was that Fannie and Freddie hold 45 basis points of
capital for the credit risk of mortgages that were in mortgage-
backed securities. That creates leverage----
Senator Shelby. Now, just tell the audience--and you are
talking to the American people here.
Mr. DeMarco. Sure.
Senator Shelby. ----what 45 basis points is. It is not even
a half of a percent, right?
Mr. DeMarco. That is correct, Senator.
Senator Shelby. Fifty would be----
Mr. DeMarco. Would be half a percent.
Senator Shelby. That would be the most thinly capitalized
financial institution in the world, would it not?
Mr. DeMarco. That is remarkably thin, Senator.
Senator Shelby. Would it be the most thinly capitalized
financial institution you ever heard of?
Mr. DeMarco. I am guessing so.
Senator Shelby. Thank you, Mr. Chairman.
Mr. DeMarco. But, I mean, Congress did address this last
year.
Senator Shelby. I know that.
Mr. DeMarco. But, unfortunately, it was just 6 weeks before
we were faced with the necessity to put them in
conservatorship.
Senator Shelby. Thank you.
Chairman Dodd. Thank you very much.
Senator Reed.
Senator Reed. Thank you, Mr. Chairman.
Can you give me an idea of the balance sheets today of the
two GSEs in terms of the category of assets they have, direct
mortgages, guarantees, mortgage-backed securities? Not with
numbers, but just a rough approximation.
Mr. DeMarco. Sure. Just roughly speaking, about $750
billion in mortgages on their balance sheet.
Senator Reed. And these are individual mortgages that they
are holding?
Mr. DeMarco. Mortgages and mortgage-backed securities.
Senator Reed. And what is the breakdown between the
mortgage-backed securities and----
Mr. DeMarco. It differs between the two companies, Senator.
I can give you the precise figures. But Freddie Mac tends to
hold more mortgage-backed securities. And then they each have
on the order of a couple trillion dollars in mortgage-backed
securities that are outstanding.
Senator Reed. And some of these mortgage-backed securities
were essentially--as I understand the process, they would put
the mortgage-backed securities together themselves. They would
buy the loans and then--is that correct?
Mr. DeMarco. There are a couple different ways in which the
transactions actually take place. But in simple terms, Senator,
yes. There is a pool of individual mortgages that are collected
and put in trust, and then there is a security issued that is
backed by the mortgages in that trust.
What Fannie Mae and Freddie Mac provide the holder of that
security is a corporate guarantee that if the borrower, if any
of the borrowers fail to make payment on any of the underlying
loans, that as a company they will make sure that the payment
of principal and interest is made to the holder of the
mortgage-backed security.
Senator Reed. But then they would go in and buy in the
market mortgage-backed securities that were put together by
other entities. Is that correct?
Mr. DeMarco. They did do that, Senator, yes.
Senator Reed. And to what extent do you think the due
diligence was done and underwriting was done on those purchases
by Fannie and Freddie?
Mr. DeMarco. Well, certainly in hindsight, Senator, not
enough. I think that, like other market participants, there was
a reliance upon the tranching that was done in these private
label securities whereby there were subordinate pieces or
tranches in the security class that were to absorb the initial
losses that might take place on individual mortgages. And so
the rating agencies were used to identify how much of that
needed to be done in order for the most senior class to be
rated AAA. And so not just Fannie and Freddie, but the home
loan banks as well, all the housing GSEs were engaged in
purchasing these private-label mortgage-backed securities,
almost all purchasing the AAA-rated pieces of it.
But as we have seen during this crisis, many of those, if
not most of those, AAA-rated securities have, in fact, been
downgraded.
Senator Reed. I understand also that they were given credit
by the regulators for their affordable housing goals with the
purchase of much of these market private label securities.
Mr. DeMarco. That is correct, Senator.
Senator Reed. Was there any way that they assured
themselves that these loans were actually, you know, providing
affordable housing for--in fact, I would assume that the
package of loans in the overall pool ranged from upper-income
people buying second homes all the way down to someone buying a
first home.
Mr. DeMarco. Well, Senator, the pools themselves or the
pieces of it that they purchased had to, of course, be
structured to satisfy the requirements of their charter. So the
loans could not exceed a certain size. And, in fact, there is a
review done--the Department of Housing and Urban Development
was the agency responsible for this until last year when FHFA
was created. But HUD did go in and review what the enterprises
reported in terms of what were the actual underlying mortgages
and did they satisfy the requirements of various housing goals.
And so, for example, a private label mortgage-backed
security backed by subprime loans might, in fact, be fairly
goals rich, and that, in fact, is one of the ways in which the
enterprises satisfied their housing goals. For other types of
private label securities backed by Alt-A loans where there was,
say, limited or no income documentation, in fact, those loans
would not qualify for at least some of the goals because
without income documentation, there was no way to verify
whether they met the income requirements of those goals. So
there was no goals credit given in that area.
Senator Reed. So you are confident that HUD actually went
in and credited those--looked at the mortgages underlying these
securities, gave credit where credit was due?
Mr. DeMarco. Well Senator, I was not at HUD. The HUD staff
that have come over to FHFA have told me that there was a
review process to look at what were the mortgages that were
being stated as backing these goals.
Senator Reed. Thank you very much.
Thank you, Mr. Chairman.
Chairman Dodd. Thank you, Senator, very much.
Senator Johanns.
Senator Johanns. Mr. Chairman, thank you.
Mr. DeMarco, thank you for being here. Do not take offense
at this, but I have listened to all of this and the challenges
you are facing, and I wonder what makes you tick. Why would you
take a job like this?
[Laughter.]
Senator Johanns. It is a temptation to revisit the past,
and I think that is important. But in my questions I would like
to focus on kind of a way forward and where do we go from here,
because this is important and I am one of those people that
believe unless we get some stability in the housing market, it
is going to be hard to build an economy that works.
In getting my head around this--and I would like your
reaction to this--it seems to me that we are kind of dealing
with two things in a global sort of ways, maybe a 50,000-foot
way. And the first thing is that we have got this book of
business that you have got to deal with, and it just sounds
overwhelmingly horrible, to be very blunt about it. You have
said, you know, we are about into this, from the standpoint of
the Federal Reserve, to the tune of about $1 trillion plus. You
anticipate additional draws will have to be made. Unemployment
is rising, so that is now impacting foreclosures. It is not
just the subprime phenomenon. It is almost like a snowball
coming down the hill. So we have got that book of business and
how to deal with that.
Then we have got the issue of the way forward. What do we
do? What is the right model in terms of looking at the
Government's role in the housing industry in the future?
First of all, is that a fair way of looking at it, number
one? And, number two, give me some thoughts on an idea that,
relative to that book of business, somehow some way we just
have to deal with that, bite the bullet, find the best way to
get out of that, deal with foreclosures, et cetera. Is that a
resolution trust authority? Talk me through that a little bit,
if you would.
Mr. DeMarco. OK. I think as a general framework, Senator,
that is about right, and I think it fairly accurately depicts
what not just our agency but others that are involved in the
current housing crisis are, in fact, doing.
The effort certainly since the creation of the
conservatorships to now has really been focused on bringing as
much liquidity and stability back to the mortgage market as we
can and working through those books of business where all these
losses are embedded. You mentioned about taking this job. I
think the thing that motivates our agency, our staff, is
motivating a lot of what is going on at Fannie and Freddie
right now and the folks that are working there. There is an
opportunity to try to help as many people in troubled mortgages
as we can. It is good for those people, it is good for their
neighborhoods, and it is good business sense to do everything
we can to prevent avoidable foreclosures. And so the efforts
that have been taken under the loan modification program is a
key aspect of bringing stability to the mortgage market.
Another part of it that has not been discussed yet at this
hearing is mortgage refinance activity, and there have been a
number of things done in that way, and that also is good. It is
good for individual households. It allows households to
strengthen their own balance sheet by being able to refinance
into a lower-rate mortgage. That makes them more committed to
their neighborhood, their home, and that helps stem future
delinquencies and foreclosures. And it improves, frankly, the
credit quality of the mortgage guarantee book that Fannie and
Freddie are running.
So I think that the effort today is focused where it needs
to be. This is a huge, huge problem, and it affects many, many
people. And so it has been a huge undertaking to address it.
And it cannot be fixed overnight, but I do, in fact, think that
the conservatorships have accomplished their basic goal of
getting the enterprises so that they can remain active in the
marketplace, so we can have some restoration of liquidity and
stability.
Clearly, the support provided by the Treasury and the
Federal Reserve have been essential to that. While we work
through this remaining book of business and, frankly, the
larger macroeconomic issues in the country, it is also the time
to be considering the future of the housing finance system and
what sort of institutional arrangements and regulatory
oversight is going to be most effective and efficient in
ensuring going forward that we have robust, liquid, and stable
capital market financing of these trillions of dollars' worth
of mortgage credit across the country.
Senator Johanns. You know, I do not know--my time is up
already, but I do not know how we accomplish all of this, and
that is what we are trying to figure out through this hearing
process. But just in terms of an ongoing relationship with this
Committee and maybe even individual Senators, it would be very,
very helpful to me to kind of understand how the current mess
is being cleaned up and the progress there and whether there is
something missing in your authority or whatever that would be
helpful on that.
Second, any advice you can give on the way-forward piece of
this problem, what role should Government have in the future
and how should that be executed.
But then I am going to add a third piece that is really
important to me, and if you could just give us a quick
observation on that. Fannie and Freddie are out there still
doing business. Are they further compounding the problem? Or is
it a new world for them? In other words, help assure me that a
year from now somebody will not be in here saying, ``Oh, man,
all of that work we did since January of 2009 has just created
a further mess.'' Assure me that that is not happening, if you
can.
Mr. DeMarco. Certainly, Senator. First, thank you for the
offer. I would be most pleased, as would my staff, to follow up
directly with you and with all the Members of this Committee on
an ongoing basis. As I said earlier, this really is the start
of a national discussion here, and we would be most pleased to
make ourselves available to talk individually about how we are
progressing in that way.
With respect to the assurance that you are seeking,
Senator, I can assure you that as conservator of each of these
companies, we are very focused on ensuring that we are, in
fact, conserving the assets of the companies and that the
companies' continued participation in the marketplace is done
in a way in which it serves its core mission of ensuring
liquidity and stability to the mortgage market. And so
everything that they are doing going forward is prudent, sound,
safe and sound business that is adding to the stability of the
market and not bringing additional risk to it. And that is very
much our focus.
And I would like to say that we have got new boards of
directors at each of these companies, new executive management
teams, and I do appreciate the effort that they have been
bringing to this effort. They see the companies' role in the
same fashion, and that is why I think we have had a good,
cooperative effort on the Making Home Affordable program,
because they realize it is good for borrowers, it is good for
communities, and it is good business sense all the way around.
And so that is going to help us get through this housing
recovery.
Senator Johanns. Great. Thank you, Mr. Chairman.
Chairman Dodd. Thank you, Senator, very much.
Senator Johnson.
Senator Johnson. Excuse me for having gone to the Energy
Committee to participate in the markup.
Mr. DeMarco, how have private label securities affected the
stability of the GSEs?
Mr. DeMarco. Senator, the private-label security
investments that the housing GSEs have made have been damaging
to their financial condition. They have all--both Fannie and
Freddie as well as the home loan banks that had sizable
private-label security investments--suffered impairments from
those investments, and those impairments have certainly had a
negative effect on their balance sheets.
With respect to Fannie and Freddie, a tremendous amount of
those securities, I think on the order of 90 percent--have been
downgraded. And so this has not been a pretty financial picture
for the housing GSEs.
Senator Johnson. Your statement includes two sentences
about market risk. Can you elaborate on your strategies
available to mitigate market risk and how they would impact
liquidity in the mortgage market?
Mr. DeMarco. Certainly, Senator. The combination of the
volatility and severe episodes of illiquidity that we have had
in financial markets--and not just in terms of debt markets but
with derivatives as well--have made it an increasing challenge
to finance and retain a portfolio of mortgages. There is added
complication for the enterprises in conservatorship.
On the one hand, there is something very positive, and that
is the Treasury Department's Senior Preferred Stock Purchase
Agreement with each company that established a very sizable
taxpayer backstop to the companies, and that continues on with
new debt issues that the companies have.
At the same time, the market is quite cognizant of what is
going on with the enterprises, that they are in
conservatorship, that there is public discussion, which is
quite necessary that we are having today, about the future of
the enterprises. And that goes to concerns or questions in the
marketplace about how much longer will they be around or
issuing debt in the form and fashion in which they have. And so
those sorts of uncertainties add some unique challenges to the
market risk activities that the enterprises' folks have.
Senator Johnson. In a relatively stable mortgage market
like South Dakota, there are families underwater. What steps
are being taken to assist those families, particularly in rural
areas?
Mr. DeMarco. Senator, I would immediately note two things.
One is the refinance program I alluded to a few minutes ago.
You know, with mortgage rates being down around 5 percent, or
perhaps even lower, it is a terrific opportunity for households
to strengthen their balance sheet and be able to take advantage
of that by refinancing the mortgage.
But there are many homeowners that took out very prudent,
sensible loans. They might have had 20 percent down and not
even needed mortgage insurance when they first got their
mortgage. But they happen to live in a community in which over
the last 2 years there has been a tremendous decline in house
prices. And so for them to be able to refinance their mortgage,
they, in fact, might be underwater today.
So one of the things we did with this refinance program is
we allowed for mortgages that are owned or guaranteed by Fannie
Mae or Freddie Mac, for those loans to be able to be refinanced
even if the current loan-to-value ratio on that property is up
to 125 percent. And so that gives these borrowers that are
underwater an opportunity to, in fact, take advantage of these
low rates.
The reason we did that is that this credit risk is already
on the books of Fannie and Freddie. They already own the
mortgage, so they already own that credit risk. So if there is
something that can be done to make that a more creditworthy
mortgage, that is good for the borrower, and it is good
business for the credit risk exposure that the enterprises have
to that. So that is one thing that has been done to help
underwater borrowers.
You asked particularly about rural housing, Senator. One of
the things that Congress did last year in enacting HERA is it
made a number of changes to the housing goals for Fannie and
Freddie going forward that our agency is supposed to implement
beginning next year. And one of those is a duty-to-serve
requirement for the enterprises, and Congress said that we want
to see--in addition to the housing goals, we want to have
expressed in regulation a duty-to-serve responsibility for
Fannie and Freddie to serve manufactured housing, certain
targeted multifamily housing, and rural housing.
So, Senator, what we have done in the path of implementing
congressional intent here is this summer, earlier this year, we
issued an Advanced Notice of Proposed Rulemaking to get broad
public comment on how to go about developing this duty-to-serve
requirement. My team literally has gone out and hit the road to
see what is actually going on across the country in these
areas. So we have gone out and visited manufactured housing
parks. We have gone out and visited with participants in the
manufactured housing industry. We have done likewise with
respect to rural housing and have been meeting with advocates
for and folks with direct knowledge of what is going on in
rural housing markets in this country. And we are trying to
gather that information so that as we develop our proposed rule
later this year, we will be informed by what we learn from
market participants so that we can implement congressional
intent with respect to these duty-to-serve requirements.
Senator Johnson. Thank you, Mr. DeMarco. My time has
expired.
Chairman Dodd. Thank you, Senator, very much.
Senator Gregg.
Senator Gregg. Mr. Chairman, I----
Chairman Dodd. I am sorry? We try to do it first to arrive
and----
Senator Gregg. Yes, but yesterday Senator Corker was nice
enough to yield to me after he had left and come back, so I
would yield to Senator Bunning or Senator Corker.
Chairman Dodd. I am not going to intervene here.
[Laughter.]
Senator Gregg. No, no. I am yielding to you guys. You stuck
around. I will go after the----
Chairman Dodd. Senator Bunning actually was next.
Senator Bunning. Thank you, Senator Gregg.
Chairman Dodd. Senator Bunning, you are on.
Senator Bunning. Thank you. Thank you, Mr. Chairman.
It has been over a year since the creation of your agency,
yet you still do not have an Inspector General. Why is that
critical job still vacant? And when will it be filled?
Mr. DeMarco. Senator, when Congress enacted HERA, it did
establish--it did state in that law that there shall be
established an Office of Inspector General at FHFA. As the
Acting Director of FHFA, I would like to be very clear, I want
an Inspector General. I would like it, and I would like it now,
because I believe, Senator, that Inspectors General can be very
important elements of the functioning of a Federal regulatory
agency.
But, Senator, the answer to your question of why we do not
have one is that there is a requirement in the statute that the
Inspector General be Presidentially appointed and Senate
confirmed. So this position is awaiting a Presidential
nomination for the IG.
Senator Bunning. Well, I understand that, but you as the
acting head of it, you could at least make a suggestion to the
Administration that this is a critical position that needs to
be filled. It would really help your relationship with the
Congress of the United States, I can tell you, and with this
Committee if that position were filled.
Mr. DeMarco. Senator, I have had that communication with
the Administration multiple times.
Senator Bunning. Others have asked questions about Freddie
and Fannie. This one I do not believe has been asked. How many
more dollars, how much more money are we going to have to put
in Freddie and Fannie?
Mr. DeMarco. I do not know the answer to that question,
Senator, but I can tell you that from the time we created the
conservatorships, FHFA has been regularly evaluating that
question and working with both the Treasury Department and the
Federal Reserve to undertake various stress test approaches to
analyze under various scenarios what might be needed. And so
this has been an ongoing effort, and it is an effort that
continues today to assess where the losses are heading and what
future draws might look like. But it depends upon so many
variables about the future, not just of house prices but of the
economy.
Senator Bunning. Do you think there is any chance of us
getting taxpayers' money back?
Mr. DeMarco. To date, Senator, there has been about $96
billion drawn from the Treasury under the Senior Preferred
Stock Purchase Agreement. I do not envision any near-term way
in their current form for that money to be paid back.
Senator Bunning. Thank you. I agree with that.
Do you know how much profit mortgage banks are making off
new Government-guaranteed loans right now?
Mr. DeMarco. I am sorry, Senator. Would you repeat that?
Senator Bunning. Do you know how much profit mortgage banks
are making off new Government loans right now?
Mr. DeMarco. No, sir, I do not.
Senator Bunning. You do not have any idea?
Mr. DeMarco. What mortgage bankers are making? No, sir.
Senator Bunning. Mortgage banks.
Mr. DeMarco. No, sir.
Senator Bunning. OK. According to what I have been told by
people in the industry, recent profit margins are 2.5 to 3
percent per loan. Not that long ago, profits were more like 1
percent per loan. Does that seem fair to you that originators
are making that much money when all the risk is being taken by
the taxpayers? What are you going to do to bring those unfair
profits back down to a more reasonable risk to the originators?
Mr. DeMarco. Senator, I do not have oversight over mortgage
originators, so I believe that that would be a question for
other regulatory agencies. I am certainly concerned about what
is going on with Fannie Mae and Freddie Mac and their
earnings----
Senator Bunning. But you do have regulatory power over the
agencies.
Mr. DeMarco. Yes, sir.
Senator Bunning. That is the basic question.
Mr. DeMarco. So with respect to Fannie Mae and Freddie Mac,
I am concerned about the money they are still losing, Senator.
Senator Bunning. Me, too, since it is my money.
Mr. DeMarco. All of us, sir, as taxpayers.
Senator Bunning. Yes, everybody. I mean ``us.''
Mr. DeMarco. Yes, I understand that.
Senator Bunning. ``My'' being plural.
Mr. DeMarco. We are very cognizant of that at FHFA,
Senator.
Senator Bunning. Is it true that refinanced loans that you
were speaking about have better than a 50-percent failure rate?
Mr. DeMarco. Refinanced loans? No, sir.
Senator Bunning. Is that right? Would you like to----
Mr. DeMarco. The default rate of a mortgage that has been
refinanced?
Senator Bunning. Yes.
Mr. DeMarco. No, sir.
Senator Bunning. Do you have a figure?
Mr. DeMarco. Senator, are you actually asking me about loan
modifications as opposed to refinanced? To me, there is a very
important difference here. A modified loan is one where the
lender has redone the terms of the mortgage because the
borrower is failing to make payment. A refinanced mortgage is a
different animal.
Senator Bunning. OK. Let us take the first type.
Mr. DeMarco. OK. So on loan modifications, Senator, it had
been common practice, before we really got into the depths of
this housing crisis, that when an individual borrower got into
trouble, they would certainly have the opportunity to work with
their lender. There were times in which the loans would be
modified, the payment would be modified to help keep the
borrower from defaulting.
But the way that was done, Senator, is that the majority of
time that resulted actually in an increased payment to the
borrower. And so the performance rate or, if you will, the
redefault rate on modified loans had been quite high.
The approach that is being taken now is much, much
different than the way loan modifications were made even a year
ago. A year ago, a year and a half ago, there were very few
modified loans that resulted in a material decline in mortgage
payments. Today the loan modifications that Fannie Mae and
Freddie Mac are doing, over 80 percent of them are resulting in
a decline in the borrower's payment, and over 50 percent of
them are resulting in a decline of more than 20 percent.
Now, because this activity----
Senator Bunning. You are not answering my question.
Mr. DeMarco. Well, because----
Senator Bunning. You are evading my question.
Mr. DeMarco. No, Senator, I am trying to give you an honest
answer that says that, in fact, loan modifications that were
done 18 months ago did have high default rates, and I would not
transfer that experience, that data point as a presumption of
what we are going to see about loan modifications that are
being done today, because those modifications are fundamentally
different from the perspective of the borrower.
Senator Bunning. Well, but aren't the fees that have been
added to those loans, the loan level price adjustments, making
those loans more expensive?
Mr. DeMarco. Senator, the loan level price adjustments are
things that are affecting new loans, so that might be an
issue----
Senator Bunning. That is why I asked the question.
Mr. DeMarco. ----with the refinance, but that is not an
issue with the modified mortgages.
Senator Bunning. Then you did not answer the percentage for
me.
Mr. DeMarco. Senator, I can go back, and I would be glad to
try to get a percentage for you on redefault rates for
refinanced loans. And I would do that for the modified as well.
Senator Bunning. I would appreciate that, if you would give
it to the Committee.
Mr. DeMarco. Yes, Senator, I would be happy to do that.
Response: I am pleased to provide responses to questions you asked
me during the October 8, 2009, Committee on Banking, Housing, and Urban
Affairs hearing on the future of the mortgage market and the housing
enterprises. Your questions focused on redefault rates for refinanced
and modified mortgages.
Redefault Rate for Refinanced Loans
Fannie Mae and Freddie Mac eligibility requirements do not allow
for loans that are significantly delinquent or in default to be
refinanced. Loans in that condition would be more appropriate for
modification. The most significant benefit of the Home Affordable
Refinance Program (HARP) and other refinance programs is a reduced
payment, which increases affordability for the borrower, leading to
fewer defaults. Most of the borrowers refinancing their mortgages are
reducing their interest rates, reducing their housing payments, and
potentially substituting a new fixed rate mortgage for their original
adjustable-rate mortgage. All of these changes increase their
probability of successful long-term home ownership.
The Federal Housing Finance Agency (FHFA) reports on the
performance of refinanced loans in its monthly Refinance Report, based
on Enterprise data. The Enterprises have begun tracking the performance
of loans refinanced under HARP, but it will be several months before
they have sufficient information to establish a valid default rate. As
of September 30, 2009, of the 116,677 loans with loan-to-value ratios
over 80 percent to 125 percent that have been refinanced under HARP
over the last 9 months, only one loan is categorized as more than 90
days delinquent. For refinance loans originated in the first and second
quarters of 2008 and purchased by the Enterprises, (the most recent
period with enough data to establish a redefault rate), the early
payment default rate for refinance loans is approximately half the
early payment default rate of purchase loans. Based on the early
default data and the design of the program, FHFA does not expect a high
default rate for refinanced loans.
Redefault Rate for Modified Loans
The Home Affordable Modification Program (HAMP) was established in
March 2009, with the first trial modifications under HAMP in place in
May 2009. HAMP requires a 3 month trial period where homeowners can
adjust to the modified payment before the modification is final. The
first trial modifications just completed their trial period in August
2009. There has not yet been enough time to establish a valid redefault
rate for this program.
As I mentioned in my testimony, redefault rates for modified loans
have been an area of concern for policymakers focused on keeping
homeowners in their homes. Modified loans are more at risk for
redefault than refinanced loans because the borrower was experiencing
financial hardship. However, FHFA expects lower redefault rates for
loans modified under HAMP than older modification programs developed by
individual servicers for one key reason: HAMP loan modifications
generally result in lower monthly payments for homeowners. Prior
modification programs focused on ``catching up'' the loan and, with
fees rolled in, often resulted in higher monthly payments. This is a
significant difference, making the HAMP loans more sustainable over the
long term.
FHFA's most recent monthly Foreclosure Prevention Report
demonstrates this difference. In the first quarter of 2008, 82 percent
of modified loans resulted in an increase in the monthly payment made
by the homeowner. In the second quarter of 2009, after HAMP was
established, only 12 percent of modifications resulted in an increased
payment. Although not all borrowers qualify for HAMP modifications,
some homeowners seeking a modification may still qualify for the older
programs.
FHFA will continue to publish and share with Congress information
on the performance of both refinanced and modified loans through the
agency's Foreclosure Prevention Reports and Refinance Reports,
available on the FHFA Web site, www.fhfa.gov. These reports are
submitted to the Committee monthly as part of FHFA's Federal Property
Manager Report.
Senator Bunning. Thank you.
Senator Johnson [presiding]. Senator Reed.
Senator Reed. I have already gone.
Senator Johnson. Senator Merkley.
Senator Merkley. Thank you very much, Mr. Chair, and thank
you for your testimony. In your written testimony, you note
that important features of the mortgage system include
innovation and consumer choice but also consumer protection.
There is sometimes some tension between those goals.
I was wondering if you would elaborate on your
perspectives, if you will, how two of the features of mortgage
practices that developed might have impacted this overall
puzzle, those being prepayment penalties and steering payments.
If you could kind of give us some sense of how those practices
reverberated through the markets.
Mr. DeMarco. Senator, steering payments? I want to make
sure I understand what you are meaning by that.
Senator Merkley. Yield spread premiums.
Mr. DeMarco. Oh, I am sorry. Yes. So on the issue of
consumer protection, prepayment penalties, it seems as though
prepayment penalties on subprime mortgages have been one of the
very detrimental features of those mortgages for borrowers.
That is an issue. I would say that the enterprises have little
or no mortgage activity that involves prepayment penalties.
I would not be quite so blanket as to say that there is not
opportunity for where some of the various features in subprime
loans, in fact, could not be sensible for a particular borrower
in a particular circumstance and with the financial
sophistication to know what it is that they are undertaking.
But what we saw is that when some rather tailored mortgage
products with certain features that might make sense to a
sophisticated borrower with a particular situation got
generalized in mortgage lending, and then offered to and
encouraged for borrowers that were not the strongest credits or
did not have the characteristics for which those specialized
features were originally developed that has been a cause of a
great deal of the problem here. A lot of that has taken place
sort of outside of the normal regulated mortgage lending
channels, but, nonetheless, I think we all share a concern that
this activity really went too far and needed an appropriate
response.
With respect to yield spread premiums, Senator, this is
something that has been the object of a great deal of debate
and discussion at HUD and the Fed and other regulatory agencies
with responsibilities in this area, and I think that it is
really kind of unfortunate we cannot get to having that
resolved once and for all.
Senator Merkley. Well, that was not exactly an answer on
yield spread premiums on either the role they played or your
opinion on them.
Mr. DeMarco. I do not have information specific to the role
yield spread premiums played on mortgage defaults.
Senator Merkley. Well, let me enlighten you a little bit
then. Ordinary families went to their mortgage brokers. They
saw on their spread sheets that they were paying their broker a
certain amount of money. What they did not know is that their
broker was being paid a separate fee off the books to steer
them into a subprime. So if you have a broker system where the
brokers who are presenting themselves as the financial adviser
to the American consumer on the most important transaction that
an American family faces are actually being paid separately
with an undisclosed conflict of interest payment to put people
into something that is not in their best interests, not only
does that result in tons of people being steered into subprime
loans, but it also means that any sort of good advice that the
customer is paying for, they are not getting because they are
being outbid on the back side. That had a huge impact on the
multiplication of the subprime switch. Fannie and Freddie then
began to purchase.
So when I go through this, it puzzles me that you would not
have any insight or thought on the role that this played,
because it was a massive part of the increase in subprime
lending.
Mr. DeMarco. Senator, fair enough. I think it perhaps was a
misunderstanding of the question, because, in fact, yield
spread premiums are an issue there, but they are also an aspect
of normal or more prime transactions as well. And it has been a
focus of a great deal of regulatory discussion.
So I think, Senator, that what I would say is that yield
spread premiums, prepayment penalties, and a whole array of
characteristics of what was going on in the subprime market are
characteristics that need to be either removed from the
marketplace or restored to the limited usage where, as a
tailored aspect of a mortgage product, it makes sense for that
borrower.
But, clearly, Senator, I share with you the concern that we
had a lot of activity here steering borrowers into mortgages
that perhaps either were not suited for them or they were, in
fact, qualified for something else, of which yield spread
premiums may well be part of that explanation. But I would not
go so far as to say that was the only thing that was going on
here. But I do share your concern with this.
Senator Merkley. Thank you.
Senator Johnson. Senator Gregg.
Senator Gregg. I think Senator Corker is next.
Senator Johnson. Senator Corker.
Senator Corker. Thank you, Senator Gregg and Mr. Chairman,
and, Ed, for your testimony. You know, I know we need to focus
on the future. I want to make just one statement before we do.
When you listen and you watch what has occurred with Fannie
and Freddie and the GSEs, you really could not make up a
scenario that is as strange and has such a competing undoable
goal. So, you know, to have an entity that has under 45 basis
points in capital, had a Government guarantee, that was
actually keeping mortgages in order to juice up its profits,
and then we had target groups that the Government was telling
had to be lent to, really an odd model that hopefully is going
away very quickly, and certainly numbers of things happened
during this last crisis that would be hard to make up, again.
So hopefully as we do regulation we will make sure that
this is something that we deal with, that this is not left to
the side.
Mr. Chairman, I want to say I think we have a tremendous
opportunity to do the right thing having this gentleman at the
helm. This is a person that, you know, does not have a fiefdom
he is trying to protect. The fact is he stated here that these
GSEs should not exist, that the private sector can deal with
this issue perfectly adequately. And so I hope this Committee
will move ahead with whatever regulation is necessary to do
away with the GSEs, move it to the private sector, and ensure
that that is part of our regulation.
Let me just ask you, how do we do that? I read the GAO
report--which, by the way, I thought they did a very good job.
I know they are coming up on the next panel. We talked about
some good bank/bad bank. You know, it seems to me that they
exist as basically entities that are going to continue to lose
money and there is no reason to really separate those.
Walk me through how we go from having this mortgage
portfolio and the insurance, how we move from there to moving
this to the private sector. And what are some of the pitfalls
that might exist along the way? But thank you again for your
service and for your testimony. Again, I think we are very
fortunate to have someone like you in this position.
Mr. DeMarco. Thank you, Senator. That is very kind. I hope
I do not now disappoint you with this answer, but I do not have
a fully developed model for how one does this, but I think I
can at least help move it along the way.
One of the things is that if Congress does decide on a
model going forward that really relies on private capital and
market discipline to be the core functioning of our housing
finance system for conventional--that is, non-Government-
guaranteed--mortgages, the transition point that is done with
Fannie and Freddie is going to have to be very clear to market
participants about what is old and what is new. Because we have
clearly told the market that activity that is going on now is
backed by this Senior Preferred Stock Purchase Agreement of the
Treasury Department, and so there is an important
responsibility that we have made to make sure that we carry
that through.
So there are different ways of actually doing that
separation, but I think being crystal clear about what that
separation looks like is an essential element to the transition
that you are talking about. So an investor knows if they are
purchasing something from an old Fannie, old Freddie that has
this Government support to it, they know what that is and what
that means separate from any going-forward entity that comes
out of a post-conservatorship realm for the enterprises and
that the Government is stating its intention that this is a
fully private activity or it is private with this amount of
support from the Government.
There are models out there. I think that as we have done in
other times, looked to the FDIC, which has certainly over its
history come up with various approaches to doing these sorts of
splits between institutions. That is one place that I would
look to for lessons on how actually one can go about
structuring these kinds of splits. But, honestly, Senator,
beyond that I am sorry to say that I have not thought through a
whole lot of the mechanics of this. I think I am a little too
focused on working with what we have got right now.
Senator Corker. So let me ask you, what--so you cannot walk
through the transition at the present. I hope you will help us
walk through that in our next meeting.
Mr. DeMarco. I would be glad to. Sure.
Senator Corker. What is it that a private entity that said,
hey, look, you know, these entities are going to sunset. We
know the oldco still has its various Government guarantees in
place. But what would a newco private entity--what are some of
the components that they would have to think about to, in
essence, take up the vacuum that the oldco was going to leave
on a go-forward basis?
Mr. DeMarco. So I think to get into details of where I
think we would need to go is we actually come up with a future
system.
One of the benefits of the current system is the
standardization of mortgage products. So if we create some new
companies and we get rid of the barriers to entry and exit so
that they are a non-Fannie or a non-Freddie entity that might
come into existence that also wants to participate in this
mortgage market, how do we go about appropriate standardization
of mortgages and mortgage documents so that no matter which
company we are talking about, we can continue to have the
benefit of that standardization to lower the costs to consumers
and to provide greater transparency to investors?
I think that we are going to need to think through how
exactly we make sure that happens with non-GSE entities that
are providing a mortgage securitization activity. It certainly
can be done, but, again, it is one of these things where all I
can do for you this morning, Senator, is note that these are
some of the issues I think we need to make sure we have
answered. And I am sure that there are answers there. I just do
not have them this morning.
Senator Corker. Mr. Chairman, thank you for the time, and,
Mr. DeMarco, for your service and testimony. I would like to
say that I would like--our office would very much like to be
involved in a step-by-step process with you as to how we unwind
oldco and move this function over the private sector. This is
really not that--housing loans are not that complicated. And,
in essence, by virtue of creating the huge entities that we
have, we really have taken away from community banks an
opportunity that exists for them to actually be able to make
money on something that is less complex than commercial loans
and other kinds of things where they are getting ready to take
a bath.
So I look forward to working with you, and I thank the
Chairman for having this Committee meeting.
Senator Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Thank you,
Director.
Let me ask you, in your testimony you have presented
challenges that your agency faces in regulating and monitoring
the progress of the GSEs. But the one thing I have heard time
and time again from critics is that Fannie and Freddie were the
catalysts of the mortgage collapse and not the unregulated
mortgage actors.
Is it fair to say that your own agency's data indicates
that Fannie and Freddie only held a small share of subprime
mortgages and never originated a single subprime mortgage?
Which is inconsistent with the explanation of what some people
are alleging the crisis is all about.
Mr. DeMarco. Senator, all the housing GSEs--Fannie,
Freddie, and the home loan banks--were clearly important
investors in subprime private label mortgage-backed securities,
so they clearly provided support to that market through their
purchases of it.
I think each enterprise had various programs in which they
purchased mortgages directly that one would say would have some
of the characteristics or features of subprime mortgages. So I
think that----
Senator Menendez. How big a share of them would they be?
Mr. DeMarco. Well, Senator, for their direct purchase, I do
not have those numbers directly.
Senator Menendez. If you could get that for the Committee,
I would like to see it, because my understanding is that they
held a rather small share of those subprime mortgages. I would
like to be able to quantify it.
Mr. DeMarco. Senator, we will get something for you.
Response: I am pleased to provide responses to questions you asked
me during October 8, 2009, Banking, Housing, and Urban Affairs
Committee hearing on the future of the mortgage market and the housing
enterprises. Your questions focused on historical information on the
participation by Fannie Mae and Freddie Mac in the market for subprime
single-family mortgages.
There is no common industry definition of a subprime mortgage, so
it is not possible to indicate the volume of subprime loans acquired by
the Enterprises. However, most industry participants would consider a
mortgage made to a borrower whose credit score is below 620 to be a
subprime loan. Both Freddie Mac and Fannie Mae have reported that, as
of September 30, 2009, loans to borrowers with credit scores below 620
comprised 4 percent of the unpaid balance of their respective
portfolios of conventional single-family mortgages. From 2002 through
2008, each Enterprise's acquisitions of such loans accounted for 3-6
percent per year of their total single-family acquisitions.
During the mortgage lending boom of the middle years of this decade
private-label mortgage-related securities often were backed by pools of
mortgages that issuers designated as subprime loans. The table below
provides information on issuance and Enterprise purchases of such
securities in 2002 through 2008. The data on securities issuance were
obtained from Inside Mortgage Finance Publications. The data on each
Enterprise's purchases in each year and combined Enterprise purchases
in 2006 through 2008 were obtained from the Enterprises and published
in FHFA's 2008 Report to Congress. The data on combined Enterprise
purchases for 2003 through 2005 were obtained from Inside Mortgage
Finance Publications and previously reported in annual research reports
published by the Office of Federal Housing Enterprise Oversight, one of
FHFA's predecessor agencies.
Table: Issuance and Enterprise Purchases of Private-Label Mortgage-Related Securities Backed by Subprime
Mortgages, 2002-2008
(dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
Issuance of Fannie Mae Freddie Mac Combined
Subprime -----------------------------------------------------------------------------------
Year Private-Label
MBS Purchases Share* Purchases Share* Purchases Share*
----------------------------------------------------------------------------------------------------------------
2002 $122,680.9 $5,143.9 4.2% n.a. n.a. n.a. n.a.
2003 194,958.5 25,768.6 13.2% n.a. n.a. $81,000.0 41.5%
2004 362,549.3 67,003.6 18.5% n.a. n.a. 176,000.0 48.5%
2005 465,036.3 24,468.8 5.3% n.a. n.a. 169,000.0 36.3%
2006 448,599.6 35,606.1 7.9% $74,761.0 16.7% 110,367.1 24.6%
2007 201,546.7 15,970.5 7.9% 43,667.0 21.7% 59,637.5 29.6%
2008 2,261.4 637.4 28.2% 106.0 4.7% 743.4 32.9%
----------------------------------------------------------------------------------------------------------------
n.a. = not available.
Sources: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications.
* Reported ``share'' is Enterprise purchases of subprime private-label MBS in each year expressed as a
percentage of total subprime MBS issued during the year. It cannot be assumed that the subprime private-label
MBS purchased by an Enterprise in a given year were issued in that year.
Mr. DeMarco. I think there has always been in this arena a
difficult definitional question of what constitutes a subprime
mortgage. The most traditional approach to this has been to
look at the lending channel through which the mortgage was
actually originated. But, in fact, there can be mortgages that
were originated through other channels. As I said, I used the
term they had some of the characteristics----
Senator Menendez. Well, you cannot have a universe of
people saying that Fannie and Freddie are the cause of the
crisis because they were the entities that created the mortgage
collapse and because they got largely involved in subprime
mortgages and not be able to quantify it. You know, so we have
to have some sense of being able to quantify it.
Mr. DeMarco. So we will be glad to do that, Senator.
One other thing I would point out, just because I think it
is germane to what you are asking me--and we will provide the
actual data to you, but I will just try to describe it--is to
look at the shifting share of secondary market activity with
mortgages over the course of this decade. You know, in the
early part of this decade, you see a real trend downward in
Fannie and Freddie's share of mortgage securitization activity,
because there was an increasing share of mortgage
securitization activity taking place through the private label,
private conduit system, and that is where most of the subprime
and the Alt-A and the other nontraditional mortgage activity
was taking place.
So there was a clear shift of market share away from the
enterprises and their normal underwriting through these other
channels. That has clearly and sharply reversed itself in the
last 2 years, such that today Fannie and Freddie are providing
the financing or mortgage guarantee on three out of every four
mortgages that are made in this country. But we will make----
Senator Menendez. But those are not subprime mortgages.
Mr. DeMarco. Those are not subprime mortgages, Senator.
Senator Menendez. OK. Just so we have the record clear.
Which of the policy options in the GAO report do you believe
are worthy of support in terms of the future of the GSEs? And
are any of the GAO options particularly troublesome to you?
Mr. DeMarco. Senator, I think GAO has done a very fair job
of presenting to the Committee three broad ways in which
policymakers and which the U.S. Congress can decide to go with
respect to not just Fannie and Freddie, but really in terms of
the secondary mortgage market and housing finance. This can
come more into the Government with a more direct Government
role. You can use the GSE model or various alterations to or
enhancements to the GSE model. Or you can move to something
that is more fully private.
I would offer two things about that. I do not have a
particular preference or recommendation to offer the Committee.
But I think that there are hybrids among each of these three
classes that GAO lays out. In my testimony, I tried to identify
three areas where I felt in particular policymakers needed to
think about what role they thought the Government ought to
have. That has to do with ensuring liquidity, credit backstop,
and affordable housing. But I think any of that can be worked
into any of these three models. Those issues can be addressed.
The one thing that I would caution against, as I have
earlier this morning, is this notion of trying to have it both
ways with an implicit guarantee where we say we want market
discipline, but, in fact, the Government is still standing
behind it there, because I think that creates a very difficult
position for the taxpayer.
If we want the Government to be providing credit support, I
think we ought to do it in a more sort of direct fashion and
say this is what we are doing, this is how we are limiting it,
this is how we are pricing for it, and so forth.
Senator Menendez. All right. Thank you.
Senator Johnson. Senator Vitter.
Senator Vitter. I think Senator Gregg may have been in
line.
Senator Johnson. Senator Gregg.
Senator Gregg. Thank you.
The way I look at this is it is sort of an inverted
pyramid, and you have got all this structure and everything
like that. But at the bottom of the pyramid is the person who
borrowed money on a house, and until you can get that done
correctly, until the underwriting of that loan is done
correctly, you are really not going to solve the problem.
So the Congress has set up a lot of incentives to lend to
that person even though the person may not be able to afford
the house. The guarantees are out there that say, well, maybe
the person cannot afford the house, but we are going to
guarantee the loan, anyway.
All of these create incentives for bad underwriting. Is
there some way to create some incentives for good underwriting?
Should we require recourse loan? Should we require a percentage
of--that there be 10, 15, 20 percent that cannot be loaned to,
such as they do in Australia? Should we have covered bonds?
Should we require covered bonds?
Is there something at that entry point in this process that
we can do that does not undermine the public policy, which is
that we want everybody in America to own a house? I mean, the
two conflict, right? Do you have any thoughts on that?
Mr. DeMarco. A couple, Senator. First, I believe in
diversification and diversity. I think that is one of the
things that impresses me in the work I do. Look at mortgage
lending, and on the one hand, there is a tremendous benefit
that American households get from standardization of mortgage
products. On the other hand, the American household is a very
diverse entity. It is different ages, different structures,
different income patterns, and so forth.
And so I would hope that whatever system we come up with, I
would actually not look for one answer, but, in fact, a market
system that is as robust as this country is which would allow
for--covered bonds might be an approach. There may be--recourse
lending is an approach. I would note that the Federal home loan
bank system, which we have not talked about, for a number of
years have had a mortgage purchase program. It is actually
shrinking a lot right now, but one mark of that program was, in
fact, the initial credit risk on the mortgage actually went
back to the original lender. And the mortgages in that
portfolio have performed better than sort of the average in the
country these past several years.
But I would look to more than one solution to this, because
I think that that we have got households in different
situations that have different needs. And the richness that I
think having multiple sort of conduits, if you will, between
capital markets and these individual lending transactions
allows for diversification of credit risk and allows for
greater opportunity for individual households.
Senator Gregg. OK. Accepting that--and I do accept that as
a very reasoned approach to this--you still have the problem
that we have created these massive incentives in our system to
undermine good underwriting. I mean, basically our guarantees
undermine good underwriting. This idea that the originator is
just out there for a fee really undermines good underwriting.
So what do you do to put back in the structure that does
some discipline on the underwriting side?
Mr. DeMarco. Senator, I think that is a very fair question,
and it is one we all have to grapple with. If I could in some
sense add to it with some additional information, we sent up to
the Congress a couple months ago a study that we were required
to do on guarantee fees by the enterprises, and one of the
striking things about that study is what it reflects about the
cross-subsidization of mortgage credit risk that was going on
with the GSEs' credit book. And so you have borrowers that are
in 15-year mortgages that are, in fact, effectively paying more
relative to their risk than someone in a 30-year mortgage. You
have someone that is a high credit quality borrower relatively
speaking paying more than a less creditworthy borrower.
Now, the model that was put out there that we have operated
under accepted and in some ways encouraged this sort of thing.
And yet when you do that, it does not create the best
incentives for people to have the most sound approach to taking
credit.
So I think, in fact, there are good incentives to have
credit risk properly priced to borrowers, and this gets
directly at your question, I think, about underwriting.
But while I would acknowledge and share your view that this
is something that needs to be addressed, I think that I do not
have a particular answer. I think the answer does lie somewhere
in the decisions that policymakers make about what kind of role
they want for the Government in the future operation of the
housing finance system.
Senator Gregg. Well, clearly, that is the problem. I was
sort of hoping you had a solution for it.
Thank you.
Senator Johnson. Senator Vitter.
Senator Vitter. Thank you very much, Mr. Chairman, and
thank you, Mr. DeMarco. And this sort of goes to Senator
Menendez's lines of questions.
On June 30th of this year, at a Banking Committee hearing
Secretary Geithner agreed that ``Fannie and Freddie were a core
part of what went wrong in our system.'' A core part. Would you
agree with that?
Mr. DeMarco. Clearly, Senator, the failure of these two
companies, the need to put them into Government
conservatorship, and the amount of taxpayer money that has been
injected into them to assure that they can continue to keep a
secondary market operating is a sign that their failure was a
central part, a key part of the broader financial crisis that
this country has been facing.
Senator Vitter. Well, I know you are not responsible for
any of these broad regulatory reform proposals, but given that,
don't you think it is odd that Fannie and Freddie reform is
nowhere on radar, basically no part of those broad proposals? I
am not saying they should be the only part or they are the only
problem, but isn't it logical for them to be a big part of that
discussion?
Mr. DeMarco. I clearly think, Senator, that the
Administration and the Congress need to deal directly with the
issues of Fannie and Freddie, their current status, and do that
in the context of the broader housing finance system.
With respect to regulatory reform, I may have said it
earlier this morning, but in any event, no matter what sort of
path reform takes and what sort of system or set of entities
that exists when Congress is done, whatever that looks like, it
strikes me as though there is still going to be multiple
Government agencies with key responsibilities for some aspect
of our housing finance system. And so I think that it would be
a prudent and wise thing to have arrangements whereby whatever
that collection of agencies is--and not just regulatory
agencies but places like HUD and the Veterans Administration
and so forth--that there be sort of a systematic way for
agencies with some responsibility for aspects of our housing
finance system to themselves be coordinated and be sharing
views on what is going on in the mortgage market, risks that
are out there, whether they have to do with financial risks to
investors or consumer protection issues where borrowers are at
risk.
So wherever that reform discussion goes, I hope that given
the huge size of the mortgage market as a particular credit
market and how important it is to so many households around the
country--and I would say not just homeowners. This is very
important to renters as well. So this covers all the American.
I think that we ought to be making sure we consider how we are
addressing that kind of coordination.
Senator Vitter. Right. Apart from Freddie and Fannie as
institutions, it seems to me that the sort of perverse
incentives in terms of safety and soundness that Senator Gregg
was describing was clearly part of the problem as well. Is that
fair to say?
Mr. DeMarco. Sure.
Senator Vitter. And, again, maybe I am missing something,
but it seems to me there is little to nothing addressing that
in these broad regulatory reform proposals. I know those
proposals are not from you. They are not your responsibility. I
am just asking for a reaction to that.
Mr. DeMarco. Well, the Administration has put forward a
regulatory reform proposal and has pledged to have its ideas on
the future of the housing GSEs early next year. So that really
is for the Administration to answer in terms of their thought
process on this. I am sure that they see the connections that
are here. But Secretary Geithner and the rest of the
Administration--I am not going to speak for them in terms of
the timing or staging of how they develop this.
I will say that this is a challenging--not as a challenging
issue, but there has been so much effort focused on trying to
get stability into the mortgage market right now and to assess
kind of where we are to give that a little time to figure out
where they want to go is, I suspect, part of what may be going
on.
Senator Vitter. Well, this is just a statement on my part.
It seems to me we are delving into regulatory reform and, in
doing so, in terms of the big proposals put forward, there are
a lot of things being proposed which, as I see it, have little
to nothing to do with what went wrong, and there are whole gaps
in the proposals, including Fannie and Freddie, where a lot of
what went wrong is not addressed, is not being changed in any
way, including the perverse incentive Senator Gregg was talking
about.
So I hope as the Committee works hopefully in a bipartisan
way on this, we sort of use as a starting point what the real
problems were that developed over the last several years.
Mr. DeMarco. Senator, if I may, just a couple of things
from the standpoint of my agency.
First we are working on developing and implementing the
authorities that were given to our agency last year in HERA, so
that is a step along the way. And I would just like to offer to
you, as I have offered to all the Members of the Committee, we
would be glad to continue to meet with you all individually and
collectively to have discussions along this way, as we are
working and having discussions with the Administration.
I mean, I do know the Administration cares deeply about
wanting to tackle this and are working on that, and we are
having discussions with them as well along the lines of the
things that I presented in my testimony this morning. But I
think at least we all can enter this sharing a sense that this
is a challenging but important issue for the country and we all
want to see it done right. And we are prepared to work with
you, Senator.
Senator Vitter. Great. Well, I thought the Administration
was virtually always for comprehensive reform. I guess that
breaks down when it comes to Fannie and Freddie in terms of
doing it together with these other pieces.
A final quick line of--one question. The CBO estimates that
the conservatorship will cost taxpayers $389 billion. Would you
roughly agree with that figure as of now?
Mr. DeMarco. Senator, I cannot comment on that. It was
actually just this morning that someone on my staff alerted me
that CBO had come up with some new numbers, and I have not had
any opportunity to look at them or assess what that is supposed
to reflect.
Senator Vitter. Whatever those numbers are, they clearly
are going to be very significant. What is the taxpayer exit
strategy from that type of liability?
Mr. DeMarco. Well, Senator, I think that is what we are
working on and what we are talking about right now. The
immediate strategy is to bring as much liquidity and stability
to the mortgage market today as we can, to try to prevent as
many avoidable foreclosures as we can, because those
foreclosures are only going to add to the tab. And so I think
that is where our immediate efforts are, to bring liquidity
back to the market and to try to stem this rising tide of
foreclosures so that we can keep individual homeowners
committed to their home, in their house, stabilize
neighborhoods, and start to see a curtailment in the credit
losses that are widespread in our housing finance system right
now. So that is where the immediate focus is.
Senator Vitter. But beyond that, shouldn't there be a
strategy for exiting out of that type of liability for the
taxpayer in the future?
Mr. DeMarco. Yes, Senator, there should, and I think that
is very much what we are talking about when we are talking
about the future of the housing finance system and the post-
conservatorship framework for Fannie and Freddie. How do we
exit and how do we then create a structure that is more robust
so that we do not end up in this kind of a situation again. I
would agree entirely. And that is what I hope my agency has
been able to contribute in some way to that this morning, and
we very much look forward to continuing the dialogue so that we
can achieve just that, Senator.
Senator Vitter. Great. Thank you.
Senator Johnson. Thank you, Mr. DeMarco, for your public
service. I appreciate your thoughtful testimony and welcome
Members to submit additional questions for the record. You may
be excused.
Mr. DeMarco. Thank you very much, Mr. Chairman.
Senator Johnson. The second panel will take its place.
[Pause.]
Senator Johnson. Mr. Shear, will you proceed?
STATEMENT OF WILLIAM B. SHEAR, DIRECTOR, FINANCIAL MARKETS AND
COMMUNITY INVESTMENT, GOVERNMENT ACCOUNTABILITY OFFICE
Mr. Shear. Mr. Chairman, Members of the Committee, I am
pleased to be here this morning to discuss the results of our
recently issued report on options for restructuring Fannie Mae
and Freddie Mac. This report provides information on the roles,
benefits, and risks associated with the enterprises' activities
over time. Our intent is to help inform forthcoming
deliberation on their future structures.
Here I will discuss our first three objectives: first, to
summarize the enterprises' performance in achieving key housing
mission objectives; second, to identify various options for
revising the enterprises' long-term structures; and, third, to
analyze these options in terms of their potential capacity to
achieve key housing mission and safety and soundness
objectives.
With respect to key housing mission objectives to support
the secondary mortgage market, the enterprises' contributions
include the establishment of standardized underwriting
practices for conventional mortgages that in turn helped to
develop a liquid MBS market. However, it is not clear to what
extent the enterprises have been able to support a stable and
liquid secondary mortgage market during periods of economic
stress, nor whether enterprise efforts to facilitate mortgage
credit opportunities for targeted groups have materially
benefited such groups.
Over the years, we have been particularly concerned with
how the enterprises' structures as for-profit corporations with
Government sponsorship undermined market discipline and
provided incentives to engage in potentially profitable but
risky business practices that did not necessarily support their
public missions. Given this concern, we have consistently
called for establishing a single regulator for the housing GSEs
with all the regulatory oversight and enforcement powers
necessary to address unsafe and unsound practices, assess the
extent to which the GSEs' activities benefit home buyers and
mortgage markets, and otherwise ensure that the GSEs comply
with their public missions.
Given the mixed records of the enterprises, researchers and
others believe a range of options for the enterprises'
structure could better achieve housing objectives, help ensure
safe and sound operations, and minimize risks to financial
stability. Basically, these options generally fall along a
continuum, with some overlap among key features and include,
first, establishing a Government corporation or agency; second,
reconstituting the enterprises as for-profit GSEs in some form;
and third, privatizing or terminating them.
Here I would like to draw attention to the section
beginning on page 9 of my statement, particularly to Table 2 on
pages 10, 11, and 12, where tradeoffs are summarized.
Let me highlight one challenge associated with each
proposed reform option. If a Government corporation or agency
is adopted, it could face greater challenges than private
sector entities in obtaining the human and technological
resources needed to manage complex processes, or it might lack
the operational flexibility to do so.
With reconstituted GSEs, the incentive concern I raised
would be reestablished, which in turn could lead to even
greater moral hazard and safety and soundness concerns and
increase systemic risk. While we recognize that FHFA is in a
better position to effectively regulate the enterprises than
its predecessors were, its role in this function has not been
tested.
And with respect to privatization, privatization could lead
to a situation where the resulting mortgage finance entities
are considered too big to fail.
Finally, regardless of any enterprise structural reforms
that are adopted, we urge Congress to continue to actively
monitor the progress of such implementation and to be prepared
to make legislative adjustments to ensure that any changes are
as effective as possible. And we stand ready to assist this
Committee and the Congress in its oversight capacity and in
evaluating the progress that is being made in implementing any
changes.
It is a pleasure to be here. I would be pleased to answer
any questions.
Senator Johnson. Mr. Wallison.
STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN
FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE
Mr. Wallison. Thank you, Senator. Fannie and Freddie are
now central to the housing finance system in the United States.
This is especially true since the advent of the financial
crisis. Because of the collapse of the securitization market,
other sources of financing--jumbo loans, available through
banks or private label securitization--are very expensive, and
that is holding down recovery in markets that Fannie and
Freddie cannot access.
For this reason, any reforms that make private credit
sources more expensive will create pressure for Fannie and
Freddie, as GSEs--or as Government agencies, if that is what
ultimately happens to them--to remain in existence and
eventually to take over the entire housing finance market. I
believe that the ultimate solution to the housing finance
question is a private one. However, there is a very difficult
transition problem here.
Realistically, for a long while, Fannie and Freddie will
continue to exist, and any comprehensive financial reform
adopted now must take into account how a private housing
finance system will be able to develop as long as Fannie and
Freddie continue to operate.
As GAO suggests, there are really only three likely
outcomes for Fannie and Freddie: nationalization,
privatization, or a return to GSE status. I discuss these
issues, the pros and cons--mostly cons, I might say, about
nationalization and GSE status--in my prepared testimony.
However, GAO did not consider how current regulatory reform
proposals will affect how Fannie and Freddie, while they exist,
will compete with and impede the development of the private
sector financial system.
As an example, the Administration has proposed that both
originating lenders and securitization sponsors retain some
interest in securitized mortgages. Banks will also be required
to hold more capital. These proposals may improve mortgage
underwriting and financial soundness. But they will also
increase the cost of private credit, especially for securitized
mortgages.
As long as Fannie and Freddie exist in the conservatorship,
they will not be subject to the new capital and securitization
rules. Accordingly, there will be a very large gap in cost
between mortgages securitized by these Government agencies and
mortgages securitized in the private sector.
The housing market will be seriously bifurcated in this
case, and pressure will develop for Fannie and Freddie to
securitize all mortgages, including jumbo mortgages. The same
thing will certainly be true if Fannie and Freddie are
ultimately nationalized.
Similarly, if Fannie and Freddie are allowed to survive as
GSEs, they will be subject--or they may be subject, or not, to
new securitization rules and capital requirements. If so, if
they are subject to those requirements, we will have authorized
them again to hold a portfolio of interests in mortgages, this
time the retained interests in securitizations. And that in
turn will require them to borrow more with the Government's
backing and to hold substantial capital in order to protect the
taxpayers against losses.
If they will not be subject to the new securitization rules
and capital requirements--and that will be true as long as they
are in the conservatorship--the bifurcation of markets problem
will arise again, and again there will be pressure to let them
securitize mortgages of any size. If this happens, they will
likely assume the credit risk of virtually the entire mortgage
system.
Then there is the question of whether the GSEs or a
Government agency will have an affordable housing mission.
Their former regulator noted that, in retrospect, their
affordable housing goals caused them to do things they should
not have done. When Fannie and Freddie were taken over, they
held or had guaranteed $1.6 trillion of subprime and Alt-A
mortgages, about 85 percent of which met the goals set by HUD.
These loans are now defaulting at unprecedented rates and will
probably cost the taxpayers somewhere between $200 and $400
billion.
There is little doubt that Fannie and Freddie bought and
guaranteed these mortgages and mortgage-backed securities
because of HUD's affordable housing regulations and because of
demands that, as GSEs, they had to ``lead the market'' in
increasing home ownership. These weak loans were a major part
of the housing bubble, the mortgage meltdown, and ultimately
the financial crisis.
The problems associated with nationalization or renewed GSE
status suggest to me that the best long-term solution is
privatization. This means that if the securitization system is
improved and investor confidence returns to the securitization
market, Fannie and Freddie should be privatized. I do not
believe that a Government-backed structure and a private system
can coexist. The Government system, as Fannie and Freddie have
shown, will always drive out private competitors because of its
financing advantages. Accordingly, if the Committee wants to
retain any role for private sector financing in the housing
system, it will have to consider the future of Fannie Mae and
Freddie Mac and how they will eventually be privatized.
Thank you.
Senator Johnson. Thank you.
Dr. Wachter.
STATEMENT OF SUSAN M. WACHTER, RICHARD B. WORLEY PROFESSOR OF
FINANCIAL MANAGEMENT, WHARTON SCHOOL OF BUSINESS, UNIVERSITY OF
PENNSYLVANIA
Ms. Wachter. Thank you, Mr. Chairman and Members of the
Committee. I appreciate the invitation to testify at today's
hearing on the ``Future of the Mortgage Market and the Housing
Enterprises.'' It is my honor to be here.
Historically, home ownership for Americans has served as
bedrock of social prosperity. As we consider the future of the
mortgage market, we need to step back and understand the
sources of the global financial debacle. This is essential as
we evaluate the broad options before us of nationalization,
privatization, and a public/private system.
While Federal support of the mortgage system is now
necessary, nationalization I do not believe is a long-run
solution as it ultimately expands taxpayer exposure, while
privatization without a stabilizing public role also leads to
the inevitable socialization of risk, as this crisis has
demonstrated.
This crisis resulted from the explosion of risky mortgages,
made in the USA, the result of a lethal race to the bottom for
short-term profits, enabled by regulatory failure. This
explosion can be traced to the issuance of private label
securities. These private label securities were neither
standardized nor transparent; they were not traded, and,
therefore, they were not subject or accountable to private
sector forces of market discipline. The common-sense-defying
loans they funded, including interest only, negative
amortization, zero equity, and teaser rate ARMs, were not
designed to be affordable when full rates came into effect; and
these loans drove housing markets to an episode of irrational
exuberance of historic proportions that have brought down the
entire financial system.
As these loans were pushed into the market, overall
household debt to GDP rose, with the increase coming from
mortgage debt and these risky loans.
As nonstandard mortgages proliferated, the market share of
traditional mortgages declined. From 2000 to their peak in
2006, nontraditional mortgages grew in origination market share
from 10 percent in 2000 to almost 50 percent at their height in
2006. In particular, the housing enterprises' share of the
market dropped, as did the market share of the long-term
standard fully amortized fixed-rate mortgage that they fund,
which I note protects borrowers against interest rate risk, a
risk which is likely to be rising.
The fundamental problem in the proliferation of these
nonstandard loans was the lack of accountability to the long-
run risks they generated. Due to the illiquidity of markets,
private label mortgage-backed securities did not trade. Because
they did not trade, this meant that market discipline could not
prevail. They continued to be supplied, eroding mortgage
lending standards and artificially pushing up housing prices.
Before private label securities, securitization did work
well, supporting sustainable home ownership. Historically, the
GSEs were regulated to support sound underwriting. Contrary to
popular misconception, they were not allowed to securitize
subprime or Alt-A mortgages. After they started losing market
share to private label securities, however, shareholder and
other pressures led them to purchase private label securities
backed by nonstandard mortgages for their portfolio. To be
clear, they did not create the risky mortgage-backed securities
that caused the crisis, but they did become a burden to the
taxpayer because they were allowed to purchase them for their
portfolio after private institutions had manufactured them. My
fellow panel member Peter Wallison elsewhere has documented how
several GSE observers suggested Congress put limits on the
portfolios, but to no avail.
To ensure the safety and long-term sustainability of a
reenvisioned mortgage finance system, we should pursue policies
that embody three principles.
First, policies and procedures are needed to identify and
prevent out-of-control housing asset bubbles and systemic risk.
Loan-to-value ratios, in particular, must be maintained over
time.
Second, borrowers must have effective, informed choice:
safe mortgages should be the presumed mortgage vehicle for
borrowing. The standard mortgage must be a safe mortgage, and
mortgage regulation should favor safe products. Consumer choice
is inconsistent with heterogeneous nonstandard options that
cannot be compared by the consumer.
Third, we need a structure that promotes and provides safe
and standard mortgages through liquidity and standardization.
Effective borrower choice is impacted by the structure of the
system. Standard mortgages should be the cost-efficient
mortgage. Liquidity in funding sources can assure this.
Securitization should be the way to bring liquidity and
cost efficiency to bear on the provision of safe, transparent,
and standard 30-year fixed-rate mortgages which banks cannot
fund. This can assure effective choice and support for a
mortgage system that once again becomes the bulwark of
sustainable home ownership in the U.S.
Thank you for the opportunity to be here today, and I will
be pleased to answer questions.
Senator Johnson. Thank you.
Mr. Jakabovics.
STATEMENT OF ANDREW JAKABOVICS, ASSOCIATE DIRECTOR FOR HOUSING
AND ECONOMICS, CENTER FOR AMERICAN PROGRESS ACTION FUND
Mr. Jakabovics. Thank you, Mr. Chairman and other Members
of the Committee, for giving me the opportunity to share a
series of principles that describes the essential functions of
the housing finance system that it must serve, and several of
which were touched upon by Chairman Dodd in his opening
remarks.
I also want to take this opportunity to touch upon
important lessons to be learned from the subprime crisis in an
effort to prevent us from drawing the wrong lessons from it. In
short, the systemic failures we have seen stemmed from the
proliferation of poorly underwritten mortgages channeled
through the so-called ``shadow banking system'' of unregulated
private label securities.
Any discussion of the housing finance system's future
should start from a clear sense of what we expect the system as
a whole to accomplish. But if the Committee restricts its
analysis of the past and prescriptions for the future simply to
the GSEs, it will miss the most significant points of origin of
the current crisis, leading possibly to a system that is
inadequate to support the essential role of housing finance in
our economy. The real question for the Committee's
consideration should be what the goals of the system are and
what combination of public, private, and hybrid arrangements,
if any, will deliver those objectives.
I want to note that the core principles that I will lay out
are the result of collaborative efforts and discussions of a
group of experts and stakeholders in mortgage finance convened
by the Center for American Progress that have been meeting for
more than a year, which we call our ``Mortgage Finance Working
Group.'' And while we have benefited tremendously from those
members' insights and expertise, my remarks this morning should
not be construed as their personal or institutional endorsement
of my testimony, and any errors, of course, are my own.
I point you to my written testimony where I go into the
principles in greater detail, but the key principles to
consider are access to credit and liquidity,
countercyclicality, risk management and oversight,
standardization, transparency, and accountability, systemic
stability, and consumer protection.
The first concern of policymakers in contemplating any
redesign in the U.S. mortgage finance system must be ensuring
sufficient credit liquidity at all times to meet the Nation's
housing needs. In thinking about liquidity, two important
aspects must be considered: first, the need for consistent
credit liquidity through booms and busts; and, second, the need
for broad availability of credit across places and housing
types, including multifamily housing, which is not easily
securitized or underwritten as single-family mortgages are, and
in which the GSEs have played a critical role, particularly in
times of stress.
Reform efforts must consider the importance of ensuring
sufficient credit liquidity during down times and who might
provide that liquidity. Private mortgage securitization
certainly played a procyclical role during the bubble years,
but institutions with the capacity and responsibility for
countercyclical activity are a requirement for a well-
functioning system. This countercyclical role is one that will
require some measure of Government backing as the private
sector has proven itself unable or unwilling to independently
provide sufficient and necessary capital during periods of
retrenchment.
Consumers, including in underserved communities, must
continue to be able to receive access to credit on terms that
reflect their actual not perceived credit risk and not on
predatory terms. We should be careful to ensure that tightened
underwriting standards are based on criteria empirically tied
to credit risk while remaining sensitive to the true costs of
providing that credit.
Level playing fields are necessary, particularly when it
comes to affordable credit provision. Safe, affordable, and
well-underwritten loans must compete against unregulated exotic
mortgage products priced without regard to underlying asset
value or risk marketed by brokers with misaligned incentives,
and the results have been disastrous, both for homeowners and
the larger economy. Parallel systems must not again emerge that
put soundly underwritten loans in competition with unregulated
and nontransparent products.
Susan Wachter has already mentioned the importance of
consumer protection in a well-designed system and
standardization closely linked to it, so I refer you to my
written testimony for those points.
But exotic products should have a higher not lower
obligation for transparency and consumer protection, both at
the point of origination as well as securitization.
Finally, there are principles of risk management and
systemic stability to consider. It is clear that the
unregulated private securitization markets caused this crisis
through poor underwriting and misaligned incentives that
ultimately because toxic MBS whose losses infected seemingly
invincible institutions. And so we believe that any efforts to
reform the housing finance system that focus exclusively on the
GSEs or maintain unregulated private securitization markets are
destined for failure. We must ensure a level playing field.
All modern banking systems have a prudential oversight
regime, but when regulators fail to use their authorities or
loopholes are created that allow certain products and market
participants to avoid oversight, the stability of the entire
system is threatened. The problem of regulators being
philosophically opposed to regulation was an even more critical
failing in light of the problem of misaligned incentives
throughout the system. Put simply, virtually none of the
participants in the private mortgage securitization process had
the incentive to originate and sell loans that were viable over
the long term.
The unregulated private MBS market, free from any direct
safety and soundness supervisory oversight, was held as a
paradigm for efficient markets, with the result that the
regulatory playing field was tilted to the advantage of private
securitization, with the lack of regulation allowing the shadow
banking system to enjoy cost advantages over other sources of
housing finance, allowing it to dominate the marketplace and
bring it to the point of collapse.
A reformed system must ensure that all market participants
play by the same rules. My written testimony offers a
suggestion for how this may be accomplished, but the key take-
away from this hearing should be the principles I laid out as a
metric for evaluating any proposals.
I urge the Committee to ask of any proposal coming forth:
Will institutions of any size in any market have access to
capital and liquidity in all markets at all times? How well
will it do in ensuring a steady supply of 30-year fixed-rate
mortgages, in ensuring a steady supply of financing for
affordable housing, specifically multifamily? Will it support
and speed innovation, encourage transparency? Will all
communities, especially those devastated by this particular
crisis, have access to credit on fair and nondiscriminatory
terms? And, finally, how can we transition to a new system
without disruption?
I thank you for your time and look forward to taking your
questions.
Senator Johnson. Thank you. Mr. Shear, how would each
option that you suggest affect borrowing costs? Could there be
a geographical disparity in unavailability or cost under any of
these proposals?
Mr. Shear. You raise a very good question, because
historically when the GSEs were established, we had large
regional disparities in mortgage rates because of the nature of
unit banking and other aspects of our financial services
industry.
The GSE structure addressed that, and now we have more of a
financial system where you have very large, diverse, nationwide
types of financial service firms. So the return with either
privatization or a Government corporation or with reconstituted
GSEs, a return to regional disparities in interest rates that
are not related to risk, we think would be unlikely to occur.
In terms of just affordability, part of the question--I
will pose it in terms of just going back even a decade ago when
we were addressing the privatization question. Government
support for Fannie Mae and Freddie Mac did cause mortgage
interest rates to be slightly lower on conforming conventional
mortgages than other mortgages, such as jumbo mortgages. But
what we pointed out, there were benefits to borrowers and there
were risks to other entities, including the Federal taxpayer.
We still have that dichotomy today. Part of the question
for this Committee and the Congress is what you want to
achieve, how much risk you are willing to take to achieve a
certain outcome.
So I think that answer is consistent with what we were
saying a decade ago.
Senator Johnson. Thank you.
Mr. Jakabovics, in the Chicago Sun Times article this
summer, you noted that at the end of last year, half of all
seriously delinquent mortgages were improperly issued mortgage-
backed securities, despite being only 15 percent of the
outstanding mortgages. By way of comparison, Fannie Mae and
Freddie Mac had a combined 56-percent market share, but only 20
percent of the delinquencies.
Are there tools at the Administration's disposal to address
this disparity in refinanced or modified mortgages held in
private label securities?
Mr. Jakabovics. I think that there are two aspects to that,
and one is focusing, I think, on the efforts that this
Committee in particular led to establish the Hope for
Homeowners program and other modification efforts, where
working with the owners of--or the servicers of mortgages both
controlled by Fannie Mae and Freddie Mac as well as those
serviced on behalf of private entities, an effort to bring
those mortgages more in line with payment standards that the
existing borrowers can make or to refinance borrowers out of
loans that are unsustainable or underwater into a mortgage--
refinance into a mortgage that is, in fact, sustainable because
they are originated based on the current value of the property.
A lot of the problems that we have seen have been a function of
the fact that house price declines have been severe, and so
borrowers who may otherwise be creditworthy lack the ability to
refinance into safer loan products.
Senator Johnson. Dr. Wachter, would the market be able to
maintain the 30-year fixed-rate mortgage without the
enterprises?
Ms. Wachter. There are very few countries in the world that
have access to 30-year fixed-rate mortgages without prepayment
penalties. The only other two that have systems that do provide
it, Germany and Denmark, have a securitization system which is
heavily regulated by their governments. And, in fact, only
Denmark has a system where you have a prepayable mortgage, and
their system has regulations over time which maintain
underwriting and which maintain standardization of the mortgage
system.
So much of the world has a banking system supported
adjustable--and they support adjustable-rate mortgages. Our
trading partners--U.K., Australia--all have adjustable-rate
mortgages. And while adjustable-rate mortgages are, in fact,
useful mortgages for some people, they do expose borrowers to
interest rate risk and, indeed, the entire economy to interest
rate risk, which I am at this moment very concerned about going
forward.
So your question is: Can you have a 30-year fixed-rate
mortgage without GSEs? GSEs are a particular securitization
entity which achieves standardization. In that respect, I
believe the answer is if the entities that replace GSEs or
carry on the mission of GSEs are similar to the GSEs in
offering standardized mortgage-backed securities as well as
standardized 30-year fixed-rate mortgages, the answer is yes.
If indeed we have securitization which requires banks to
keep securities on their portfolios, that is a risk to the
banks, to the banking payment mechanism, and to the stability
of the overall economy, and that I do not believe is consistent
with the long-term provision of the 30-year fixed-rate
mortgage.
Senator Johnson. Thank you.
Mr. Wallison, you have been a strong supporter of
privatizing the enterprises. Could you discuss the transparency
available to investors in the private label MBS?
Mr. Wallison. Yes, Senator. In a private label structure,
the investors should get quite a lot of information if they ask
for it. There is no reason why the transparency of a private
label system should not be as complete as the transparency that
occurs in any securities market--particularly in our securities
markets--as overseen by the SEC. So I do not see any
inconsistency between a private label system in terms of its
transparency and a system that uses a Government structure for
doing securitizations. The difference turns out to be that in
the Government system, I believe, whether it is through a
nationalized structure or a GSE-type structure, a lot of risk
will be taken by the Government, which, as we have seen through
Fannie Mae and Freddie Mac, ultimately comes back to the
taxpayers.
So to have a realistic kind of system, one that is
practical and one that is not ultimately causing losses to the
taxpayers, I think we must go with a private system of some
kind. Securitization might not be the only system we might
have, but it should be a private system.
Senator Johnson. Thank you. I have been handed a note. The
leadership has called a 12:15 vote. Keep that in mind.
Senator Bunning.
Senator Bunning. Thank you, Chairman.
Mr. Wallison, you have made a very clear point on the GSEs,
and you have outlined three different alternatives. How do we
get the GSEs out of business? How? I mean, we are in to them,
according to the prior panel, about $97 billion. At least that
is the preferred stock that we own. Now, how do we get them out
and get into a private sector situation?
Mr. Wallison. Well, there are really two questions, I
think, in what you have asked. One is what we do with the GSEs
in terms of the losses they already have embedded in their
portfolios or in their----
Senator Bunning. Do we have to eat them?
Mr. Wallison. Oh, yes, the taxpayers are going to have to
eat those losses, and it is just a question of whether we use a
good bank/bad bank kind of structure--move all those things
over to a bad bank--and then have the Treasury pay off the
creditors who would be holding the bag there. But it is clear
that the U.S. Government has always been willing to and had to
stand behind the GSEs, and so the taxpayers are going to have
to take losses.
This is very regrettable. Many people tried to change this,
but it never happened.
On the----
Senator Bunning. I just want you to realize that we are at
$12 trillion and counting.
Mr. Wallison. Yes, understood.
Senator Bunning. $12 trillion and counting. Now we are
going to be asked to increase the debt ceiling very shortly.
There comes a time when my 40 grandkids are going to get tired
of paying for our excesses. Even though it is a laudable goal
that everybody own a house, certain people just cannot afford
to own a house.
Mr. Wallison. Yes, and, Senator, that is another problem
with a Government-run system. It is subject to political
manipulation. That is one of the reasons why we had affordable
housing requirements and other requirements which have caused
the tremendous losses that Fannie and Freddie will be
suffering.
Senator Bunning. There is no question that the Congress
pushed Freddie and Fannie to make these loans.
Mr. Wallison. No question in my mind.
Senator Bunning. I mean, it was clear.
Mr. Wallison. It was actually through the Department of
Housing and Urban Development, which had affordable housing
guidelines. Those began in the mid-1990s and were gradually
ratcheted up over time so that by 2005--and we are talking
about two Administrations here, the Clinton administration and
the Bush administration--the affordable housing requirements
required that 55 percent of loans the GSEs bought had to be
affordable housing loans. Within the 55 percent, had to be to
low-income people, not just people who were at or below median
income.
So it became very difficult for Fannie and Freddie to find
those loans unless they gave up on downpayments and they gave
up on blemished credit and they reduced their underwriting
standards, which they did. Now----
Ms. Wachter. Senator, when you are complete--I do not want
to interrupt, but when you complete, this is not the problem.
This was not the cause of our crisis.
Mr. Wallison. If I can----
Ms. Wachter. I apologize.
Mr. Wallison. But let me just finish my point, because
there was a second part of your question, and that is, what do
we do now with Fannie and Freddie? How do we turn them into
privatized entities?
Senator Bunning. How do we get out?
Mr. Wallison. I do think there is a relatively simple way
to do that, and that is to gradually lower the conforming loan
limit over time. Once the securitized market returns and
investors are confident again about what a AAA security might
mean, then it is possible to reduce the conforming loan limit.
And as you do that, the private sector will move into that
market and begin to take up more and more of it. And, finally,
the GSEs will be reduced to zero, and the private market will
take it over.
So I think that is a simple way to accomplish
privatization.
Senator Bunning. Dr. Susan, you brought up the Danish
system. Can that ever work in the United States? I mean, I did
not know that a lot of people knew about that, but my staff
did.
Ms. Wachter. Yes, I do believe a version of the Denmark
system could work in the United States. I think we have some
misunderstandings of the Denmark system. Actually, the Danish
system is very much supported by regulation, with standards
that are maintained over time.
Senator Bunning. Absolutely.
Ms. Wachter. And with securitization that does not allow
nonstandard private label mortgage-backed securities to----
Senator Bunning. But it also allows you to go and preclude
and buy--if the bond goes down, you can go into the market and
buy at a discount and reduce your rate.
Ms. Wachter. Senator, you are absolutely right. What is
required in the Danish system is prepayment options and
prepayment optionality on both sides of the deal. So unlike our
private label securitization, which were not subject to
requiring prepayment options, the Danish systems require
prepayment options and optionality on both sides.
Senator Bunning. But let me just bring up the fact that in
1994 we gave the Federal Reserve the responsibility to regulate
all mortgages, both by banks and by mortgage brokers. And it
was 14 years before they wrote a regulation. Now, I mean, it
was the second year of Ben Bernanke's tenure as Chairman of the
Federal Reserve.
Now, you stated from 2000 to 2006 all these different types
of sophisticated mortgages came in, and there were no
regulations against them. My question is: Should there have
been? Should there have been regulations to prevent these
sophisticated interest-only type things and putting people into
houses that they should not be put in?
Ms. Wachter. Absolutely, Senator. Absolutely, the answer is
yes. Ned Gramlich pushed for this. It did not happen. But it is
a difficulty. There is actually a significant difficult that I
think we all must face, which is the following: Do we preclude
anybody from ever using one of these niche products? Or do we
allow them to be niche products? And I do think that is the
difficulty we must face, that the standard mortgage should be a
safe mortgage. For sophisticated borrowers with special needs,
we can do something differently.
So how do we get there? We can get there by having a
playing field that is supportive of the standard mortgage, a
playing field where the standard mortgage is funded liquidly so
that the standard mortgage is the cost-efficient mortgage. And
that comes through standardization.
My concern about the private sector is that private sector
entities do not automatically standardize the products they
offer. Quite to the contrary. Private sector entities will want
to differentiate their product not only from their competitors,
but even within their own entities. So we will get----
Senator Bunning. Well, but if they are going to bust the
bank, if they are going to blow the housing and the market
right out of sight, then we as regulators or as policymakers
have got to prevent that.
Ms. Wachter. Absolutely, but the way to prevent it cannot
simply be to preclude these mortgages altogether, I believe, in
the United States because, in fact, they are--some will want
them, and appropriately so. Therefore, there needs to be as a
cost advantage standardization for what we regard as the safe
mortgage, which fortunately for the U.S. historically has been
the 30-year fixed-rate mortgage.
Senator Bunning. Thank you very much. My time has expired.
Senator Johnson. Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank each
of you for your testimony. I wish there were more people here
to hear it. I think it was all very good.
To GAO, Mr. Shear, I want to say especially the analysis
you gave was very good, and I guess at the end of the day,
regardless of where the costs are, there is a cost associated
with loaning money out to people. And so, you know, one of the
things that is fascinating about all this is that aside from
the fact that an entity, maybe a Government entity, can have a
tax advantage, there are still going to be costs. And so if you
take risk, somebody at some point is going to bear the cost of
that risk. And so the question I guess one would have to start
with--or the assumption is that that is a fact. And, second, is
there a reason for us in this country to assume risk at the
Government level as it relates to residential mortgages?
Mr. Shear. First, thank you for the compliment for the work
that we do. We have some great people at GAO.
In terms of the question you ask, it is a great question
because it is a question of what the priorities are of this
Committee, of the Congress, and as a Nation of what we think is
the appropriate Federal role to achieve certain mission
requirements. We, meaning those of us from GAO, are not here to
make those value judgments. But I think referring to our work
and when we discuss these different options and the continuum
of them, what we are trying to point out is: What are some of
the safety and soundness concerns? What are some of the
concerns in terms of reaching out?
And when you look at this as a whole, some of the issues
that have come up at this hearing, such as regulatory arbitrage
or when you have capital requirements that are lower for some
pipelines compared with others, there will be a tendency for
risk to move to where it is in a sense taxed or where the
regulatory requirements are the least. And this is, I think,
part of the challenge of what we are dealing with here.
So one of the things that I would hope would come out our
work is that we have to be careful of what we ask for, because
none of this comes free.
Senator Corker. And I think that is a point that, as we
move through this reg reform process, we need to understand
that somebody at the end of the day is going to pay for the
cost. And if the risk is high, the cost is probably going to be
absorbed down the road by someone else.
Dr. Wachter, I would assume, based on your comments--and I
thought they were very good--that you would also agree that if
we are going to deal with regulatory reform, certainly we need
to deal with the issues we have talked about in this panel
meeting and to leave out--as you mentioned, I mean, the GSEs in
many ways moved toward things--under two Administrations, I
might add, and I think a lot of folks on the other side of the
aisle are defensive sometimes about the GSEs. But, in fact, the
Bush administration pushed the GSEs to purchase subprime
mortgages to meet quota requirements. They did. And as you
mentioned, that was not necessarily the problem because it was
originating of those loans that I think you are alluding to as
being the problem in the first place, creating loans that
really did not meet appropriately the needs of the people they
were being loaned to.
But I guess you would agree that if we are going to do
regulatory reform, this area that we are talking about today
needs to be a big part of that.
Ms. Wachter. My understanding is that that is just what
these discussions are about, and I am very pleased to have been
invited to be part of them. I do think we have to build the
understanding of the deeply interrelated parts of the systems
as we move forward. There is no way that we are going to be
able to move to a new system in the short run. We are reliant
now on Federal support for the system, and I believe we will be
for some time to come, which is unfortunate. But, on the other
hand, there is time to do this right, and we must do it right.
Senator Corker. There is time to do it right, but it is all
very related to each other, isn't it? I mean, it would be
difficult to do regulation to try to deal with the systemic
risk we just had and not deal with this area simultaneously.
Would you not agree? Because it is so synchronized.
Ms. Wachter. Well, I personally do believe that there are
components that are commonsensical and obvious that we can
begin to put into place as we deal with the entire system, yes.
Senator Corker. Since Mr. Wallison and I tend to agree so
much, I am not going to ask him many questions. I am just going
to get him to come back to our office as we work this through.
But is there a reason that we should have loans to home buyers
that are nonrecourse? Dr. Wachter? I came up here just a fairly
sophisticated--fairly sophisticated--business person and
borrowed lots of money on a recourse basis and nonrecourse.
Every home mortgage I have ever had, I guess because, you know,
was recourse, and I actually was stunned to realize that there
are so many mortgages in this country that are nonrecourse--
almost all now. And I do not know what the Danish system is
like, but should we have loans in the first place that are
nonrecourse to residential buyers?
Ms. Wachter. An important question, Senator, and, by the
way, thank you so much for your kind comments about my
testimony.
The recourse, it is true that in Denmark those loans are
recourse loans. In the United States, this is a State-by-State
determination. Many States have recourse. Many States do not.
The difficulty is that even with recourse loans, it is
difficult in actuality to get recourse. You would then have to
go through bankruptcy, so it is a complicated situation. Legal
recourse and actually effective recourse are two separate
issues.
Senator Corker. But along with recourse, it does make some
degree of difference when the borrower asks for the loan, does
it not? I mean, there is just a different sense of obligation
when it is a recourse loan.
Mr. Jakabovics. If I may actually touch upon that, in
California, for example, there is recourse, but you only have
access to the recourse if you go through judicial foreclosure.
Most servicers in California do not avail themselves of
judicial foreclosure because they find they would rather simply
get the property in whatever condition they can faster, and
then get themselves out of the loan. And so while they have the
opportunity for recourse, in almost all instances they do not
choose to pursue it.
So I think that sort of focusing specifically on whether a
particular loan might be recourse or nonrecourse, again,
setting aside the fact that there is, in fact, great variation
in State laws, lenders and servicers seem not to have availed
themselves of recourse because, in fact, at the end of the day
when most borrowers find themselves in default and there is
insufficient amount of value in the property itself, the
borrower is usually not in the position to make up the
difference as well. And so the availability of recourse at the
end of the day has little material impact.
Senator Corker. Let me get back to the cost issue, and by
the way, if anybody needs to leave, I promise you I will not do
anything mischievous if you need to go.
Senator Johnson. One more question.
Senator Corker. OK. Since there is a cost with everything--
I mean, you cannot create a fixed-rate loan and there not be a
cost associated with that. There is a cost.
So back to Dr. Wachter. Should there not be--why isn't
there a prepayment penalty? If somebody is going to give you a
fixed-rate loan for 30 years and you pay it off in advance of
30 years, there is a loss that that organization has in making
that loan and tying those funds up. Why isn't there a
prepayment penalty? I think that is a perfectly ridiculous
notion that there is not prepayment penalties associated with
paying a loan off early. Why would that be a good public policy
because it artificially lowers rates?
Ms. Wachter. You are absolutely right that one could do
this. One can have all sorts of options, and they could be
priced. The problem is what is a standard option that is pro-
home-ownership and pro-building of wealth for families. The
prepayment penalty, while for some people is, in fact, a good
option, for many households who wish to--or need to move, let
us say, because they need to get a job in another part of the
country, they have lost a job, if they had to pay a prepayment
option, might find that their loan-to-value ratio in their home
was such that there would not be enough funds to do so. Their
only alternative would be to default.
So, in fact, this is a complicated decision whether from a
borrower's perspective it is optimal to have a prepayment
option or not. And for those who are sophisticated, this is a
good choice, and I do not think that we should preclude them
from the marketplace. However, we should have a standard
mortgage with standard features that borrowers understand.
Senator Corker. Mr. Chairman, thank you for the additional
time and certainly all of you for your testimony. My sense is
that there is a way to create some of the standardization that
has been discussed but do so on the private sector side. And I
guess I asked the question, and I will ask it continually
through. I do not know why we artificially do things to
stimulate the housing industry. I know the Chairman mentioned
early on wealth creation. You mentioned it again. I think the
things we have done artificially to stimulate the housing
market have lowered household wealth in our country over the
last year hugely. And my sense is that if we had not
artificially done that, our country as a whole would be in a
much--the world would be in a much more stable situation.
So thank you, Mr. Chairman.
Senator Johnson. I thank the witnesses for your testimony,
and this hearing is adjourned.
[Whereupon, at 12:16 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD
Good morning. Today, we meet to discuss the Government-Sponsored
Enterprises--Fannie Mae and Freddie Mac--and the role they will play as
we seek to restore normalcy to the mortgage market.
But let's not forget what we're really talking about.
We're talking about whether responsible homeowners will have the
access to the home loans they need to realize their American dreams.
Last year, when the mortgage market collapsed, the Director of the
Federal Housing Finance Authority put Fannie Mae and Freddie Mac into
conservatorship.
At the same time, Secretary Paulson exercised the authority he was
given by last year's bipartisan Housing and Economic Recovery Act to
provide back-up funding for the two companies, ensuring that they could
continue financing mortgages during the housing crisis.
Today, we consider where we need to go from here.
Now is the time to look forward. But with so much damage done by
this financial crisis, the role of the GSEs in that crisis is still
hotly debated.
Let me just say: Fannie and Freddie were neither the villains that
caused the crisis, as some claim, nor the victims of that crisis, as
others would make them out to be.
They didn't create the subprime and exotic loan market--but they
did chase it to generate profits.
And, like many of the supposedly private financial institutions
that ended up becoming equivalent to GSEs, Fannie and Freddie enriched
their shareholders and management, while the public took the losses.
We can't let that happen again.
As we look forward, we must start by setting benchmarks to
determine whether the mortgage market is healthy, so that American
families can once again begin to build wealth--not the kind of wealth
that buys mansion and yachts, but the kind of wealth that sends kids to
college and ensures a comfortable retirement.
First: the mortgage market must remain liquid and stable,
especially in times of stress. Otherwise, rates are driven up, prices
are driven down, and American families lose.
Second: we must encourage product standardization, such as the
widespread availability of the 30-year, fixed-rate mortgage without
prepayment penalties. This helps both borrowers and lenders.
Third: mortgage credit must remain consistently available and
affordable. Home ownership remains part of the American dream. That
dream should be accessible to everyone--and sustainable for everyone.
Today, the market is meeting these tests--but only through massive
Government intervention.
The Federal Reserve, for example, has committed to pumping more
than $1 trillion into the mortgage market. That can't go on
indefinitely.
Therefore, it is time to begin the conversation about how we can
re-create a functional market that stands on its own two feet, and to
decide what role, if any, the GSEs should play. I want to start that
conversation by posing a number of questions:
Can the market function with no Government involvement?
Should, on the other hand, the Government completely and explicitly
take over the job previously done by Freddie and Fannie?
Do we want a model where there is some private capital at risk, but
only under strict Government control, like a utility?
These are important questions. The answers are critical to ensuring
the American dream. And I look forward to considering these questions
with our distinguished panel today.
Before turning to Senator Shelby, I want to quickly add that I am
hopeful that the higher GSE and FHA loan limits, which we first
established in HERA, will be extended again in the HUD appropriations
bill currently being negotiated. These higher loan limits are helping
many borrowers purchase homes or refinance their mortgages. I think we
need to keep this support in place.
I'd now like to recognize Senator Shelby.
______
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
Thank you Mr. Chairman.
As we consider the future of the GSEs, we would be wise to remember
the disastrous consequences that poorly regulated GSEs can have on our
financial markets.
Just 1 year ago, Fannie Mae and Freddie Mac were placed into
conservatorship when they could not cover billions of dollars in
losses. Despite repeated warnings by me and others about the risks the
GSEs presented, they were allowed to accumulate more than $5 trillion
in financial obligations with only minimal amounts of capital.
The Congressional Budget Office now estimates that resolving the
GSEs will cost American taxpayers $389 billion. We must ensure that
this never happens again.
This hearing, therefore, comes at an opportune time as this
Committee is considering financial regulatory reform. There is no doubt
that the failure of Fannie and Freddie was a significant factor in the
financial crisis because their activities touched nearly every aspect
of our financial system.
In addition, their debt is among the most widely held in the world.
They are also major counterparties to our most prominent financial
institutions. Accordingly, regulatory reform must involve the GSEs.
Unfortunately, the Administration made no effort to include the GSEs in
its financial regulatory reform proposal. Instead, the Administration
has said that it will not propose how to deal with GSEs until next
year.
I believe that this is a grave mistake that will make it more
difficult to reform our financial system and that will potentially
expose taxpayers to even greater losses. What we need is a clear plan
that addresses both the GSEs' ongoing financial difficulties and the
role the GSEs should play in our economy going forward.
I fear that the longer we wait, the more it is going to cost the
American taxpayer.
Certainly, the question of what to do with the GSEs is difficult
and complex. Yet, it is a question that we ignore at our peril.
Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF EDWARD J. DeMARCO
Acting Director, Federal Housing Finance Agency
October 8, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
thank you for the opportunity to testify on the current condition of,
and challenges facing, the Nation's housing Government-sponsored
enterprises (GSEs)--the Federal National Mortgage Association (Fannie
Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the
12 Federal Home Loan Banks (FHLBanks).
The Federal Housing Finance Agency (FHFA) just completed its 14th
month of existence, Fannie Mae and Freddie Mac (the Enterprises) have
been in conservatorship for 13 months, and I have just completed my
first month as FHFA's Acting Director. During its short existence, FHFA
has been involved in many of the Federal Government's efforts to
respond to the crisis in the Nation's housing and housing finance
markets. I will begin this morning by briefly reviewing FHFA's key
activities and accomplishments. I will then describe the financial,
managerial, and operational challenges facing the housing GSEs and
their efforts to respond to those challenges while bringing liquidity,
stability, and affordability to the housing market. In closing, as
requested, I will offer some thoughts on the future of the housing
finance system.
FHFA--A Brief Review
FHFA came into existence on July 30, 2008, upon enactment of the
Housing and Economic Recovery Act of 2008 (HERA). To create FHFA,
Congress combined the Office of Federal Housing Enterprise Oversight
(OFHEO) and the Federal Housing Finance Board (FHFB), and added certain
staff from the Department of Housing and Urban Development. FHFA was
given safety and soundness and mission oversight responsibilities for
the housing GSEs, including safety and soundness authorities that had
been lacking at OFHEO.
In the midst of all the market turmoil of the past year, FHFA has
devoted long hours to working through the housing crisis and its
implications for all the housing GSEs we oversee. Among our
accomplishments:
We conducted examinations and targeted supervisory reviews
at both Enterprises and all 12 FHLBanks to assess their safety
and soundness and their support for housing finance and
affordable housing.
We are serving as conservator of the Enterprises--Fannie
Mae and Freddie Mac--even as we continue to oversee them as
their regulator.
We have been working with the housing GSEs regarding the
valuation of their private-label mortgage backed securities
(PLS) and appropriate recognition of other than temporary
impairment (OTTI) of those PLS. In particular, we worked with
the FHLBanks on their adoption of a common platform for
accounting for the impairment of their PLS.
FHFA staff worked with the Obama administration and others
to address foreclosure prevention and borrowers with
``underwater'' mortgages with the aim of keeping people in
their homes whenever possible.
We set new, more feasible affordable housing goals for 2009
for Fannie Mae and Freddie Mac and are working on a new housing
goal framework for the Enterprises and the FHLBanks for 2010.
We combined the personnel and financial systems of two
separate organizations and established an infrastructure for
FHFA, including systems, procedures, and policies that serve as
the foundation for accomplishing the mission of the agency.
We published our first strategic plan, our first human
capital plan, our first Performance and Accountability Report,
and our first annual Report to Congress.
We issued numerous regulations, guidances, and reports to
Congress as required by HERA.
We remain committed to the effective supervision of the housing
GSEs with the objective of promoting financially safe and sound
operations and ensuring operations consistent with their housing
finance mission, which includes supporting a stable and liquid mortgage
market. In that context, I see three priorities for the housing GSEs,
and hence three supervisory priorities for FHFA.
First, as the country continues to work through the housing market
collapse, I am looking to all the housing GSEs to provide ongoing
support to the mortgage market, consistent with their mission and
charters. For the Enterprises, this means continuing to provide a
secondary market outlet for mortgages, including mortgages that meet
the Enterprises' affordable housing goals. For the FHLBanks, this means
making advances to member institutions collateralized principally by
mortgage loans and carrying out their responsibilities to support
affordable housing and community investment programs.
Second, the housing GSEs must remediate identified weaknesses and
further strengthen their operations and risk management practices that
have been stressed in this housing crisis. As financial institutions
focused on housing finance, they must address their direct and indirect
exposure to serious mortgage delinquencies. Our oversight of their
response to these conditions is core to our mission and our assessment
of their safety and soundness.
Third, as part of their overall housing finance mission, the
housing GSEs each have important roles to play in preventing avoidable
foreclosures and providing programs that assist the housing market
recovery. The Enterprises are implementing the loan modification and
refinance programs under the Administration's Making Home Affordable
program. The FHLBanks are implementing troubled homeowner refinance
assistance available through our recent Affordable Housing Program
(AHP) regulation.
Current Financial Conditions of the GSEs
Let me now address the current financial conditions at the housing
GSEs.
Fannie Mae and Freddie Mac. In the first 2 full years of this
housing crisis--from July 2007 through the first half of 2009--combined
losses at Fannie Mae and Freddie Mac totaled $165 billion. In the first
half of 2009, Fannie Mae and Freddie Mac together reported net losses
of $47 billion. The Enterprises' financial performance continues to be
dominated by credit-related expenses and losses stemming principally
from purchases and guarantees of mortgages originated in 2006 and 2007.
Since the establishment of the conservatorships, the combined
losses at the two Enterprises depleted all their capital and required
them to draw $96 billion from the U.S. Treasury under the Senior
Preferred Stock Purchase Agreements. With continuing uncertainty
regarding economic conditions, employment, house prices, and mortgage
delinquency rates, the short-term outlook for the Enterprises remains
troubled and likely will require additional draws under the Senior
Preferred Stock Purchase Agreements.
Beyond the preferred stock purchases, the Treasury Department and
the Federal Reserve have made other, sizeable purchases of housing GSE
securities to instill confidence in their securities, provide stability
to mortgage markets, and lower mortgage rates. Treasury has purchased
approximately $192 billion of the Enterprises' mortgage-backed
securities (MBS). The Federal Reserve has purchased $831 billion worth
of Enterprise MBS and $134 billion in debt issued by Fannie Mae,
Freddie Mac, and the FHLBanks. This combined support from the Federal
Government exceeds $1 trillion and has allowed Fannie Mae and Freddie
Mac to continue providing necessary liquidity to the mortgage markets.
Federal Home Loan Banks. The FHLBanks have not been immune from
mortgage-related credit losses. The most important financial
development among the FHLBanks in 2009 is the deterioration of the PLS
portfolios held by the FHLBanks. As of June 30, 2009, the FHLBanks held
$56.6 billion worth of PLS with an estimated fair value of $46.3
billion, down from a December 31, 2008, carrying value of $73.0 billion
and a fair value of $53.7 billion. The decline in the carrying value
reflects impairment charges of almost $8.2 billion and principal
payments and prepayments of $8.9 billion. However, a change in
accounting rules resulted in only $953 million charged against income.
Net income was $1.4 billion in the first half of 2009, compared to
$1.2 billion for all of 2008. The apparent improvement reflects new
accounting rules from the Financial Accounting Standards Board for
other-than-temporary impairment on PLS.
The FHLBanks ended the first half of 2009 with assets of $1.1
trillion, down $201 billion, or 15 percent, since the end of 2008.
Advances, which had peaked at $1.0 trillion at the end of September
2008, fell to $739 billion by the end of June 2009 and $659 billion as
of September 30. The 35 percent decline in advances in just 12 months
is largely due to a rise in deposits at member banks, decreased loan
demand, the emergence of new or expanded Federal liquidity programs,
increased use of the Fed's discount window, and some return of
liquidity in financial markets. The expansion and contraction of
FHLBank advances demonstrates that the FHLBanks' capital structure has
the ability to meet demands for liquidity on the part of member
financial institutions while leaving the FHLBanks with the portfolio
flexibility to shrink without untoward consequences.
At the end of June, total regulatory capital for the FHLBanks was
$60.6 billion, or 5.3 percent of assets. Total retained earnings were
$6 billion, but negative accumulated other comprehensive income (AOCI)
exceeded retained earnings at the six FHLBanks with the greatest PLS
exposure.
Conservatorship of the Enterprises
FHFA placed Fannie Mae and Freddie Mac into conservatorships on
September 6, 2008. This action was a result of substantial
deterioration in the housing markets, rapidly rising credit expenses,
and the inability of the Enterprises to raise new capital and access
debt markets in their customary way.
At that time, FHFA along with Treasury and the Federal Reserve
recognized that Fannie Mae and Freddie Mac would be unable to fulfill
their mission of providing liquidity and stability to the housing
market without substantial Government support. Uncertainties remain
about the future structure of the Enterprises, but one thing is clear:
the conservatorships have accomplished their objective of ensuring that
the Enterprises continue to provide a secondary market outlet for new
mortgages.
Despite unprecedented market events, both Enterprises have been
able to maintain a significant presence in the secondary market. The
Enterprises' combined market share of mortgages originated in the
second quarter of 2009 was 74 percent, up from 54 percent in 2007 and
37 percent in 2006. Most other loans this year have been guaranteed by
the Federal Housing Administration (FHA).
FHFA has also sought to align the Enterprises' housing goals with
safe and sound practices and market realities. This summer we finalized
the affordable housing goals for 2009 and are working on a new housing
goal rule for 2010 as directed by HERA. FHFA meets monthly with each
Enterprise to review its progress against the goals.
We recognize that FHFA's duties as conservator means just that,
conserving the Enterprises' assets. These two companies have $5.3
trillion in mortgage exposure. Given the Enterprises' importance in the
mortgage market, Enterprise activities to stabilize the housing and
mortgage markets are closely linked to conserving assets. Over the long
term, effective mortgage modifications, refinancings, short sales, and
other loss mitigation activities assist homeowners and neighborhoods
and will save the Enterprises billions of dollars.
Challenges the Enterprises Face
I would like to turn my focus now to some of the challenges the
Enterprises face and the steps they have taken during conservatorship
to strengthen and improve safety and soundness.
1. Executive Leadership/Management and Staff Retention. Both
Enterprises have filled significant vacancies at the executive
management level. Since conservatorship, each company's CEO position
has turned over twice and most executive vice-presidents at each
company have changed. These changes have included individuals most
responsible for the problems that led to conservatorship and have
improved each company's ability to appropriately focus on key business
strategies given conservatorship and the problems in the housing
market. We have also replaced the majority of both boards of directors.
The new boards are now actively overseeing the affairs of the
Enterprises. However, personnel risk at both Enterprises remains a
major challenge and risk going forward. Several key officer vacancies
remain below the executive levels. Moreover, uncertainties about the
future of the Enterprises keep staff retention a key concern. As we see
improvements in the economy, opportunities for employees and officers
to seek other employment will increase, adding to the current retention
challenge. Both Enterprises, along with FHFA, are working on available
options to manage personnel risk.
2. Credit Risk and Loss Mitigation. The size and credit
characteristics of Fannie Mae and Freddie Mac's mortgage books of
business remain supervisory concerns. While a few positive signs of
recovery in housing have begun to emerge, we remain concerned and
recognize the risk associated with increasing numbers of seriously
delinquent loans, higher forecasted foreclosures, and the uncertain
path of the market's recovery. In particular, we are concerned with the
continued increase in serious delinquency rates, even among prime
mortgages.
More than one in four subprime mortgages today is seriously
delinquent. Among subprime adjustable-rate mortgages, nearly 40 percent
are seriously delinquent. While mortgages in the prime market are
performing better, the numbers are still very high. The serious
delinquency rate is 3.1 percent at Freddie Mac and 4.2 percent at
Fannie Mae. These rates are disturbing both in their magnitude and in
the fact that they continue to increase. Currently the Enterprises are
managing a real estate owned (REO) inventory of almost 100,000
properties, a number expected to grow. Certainly rising unemployment
has contributed to defaults as people have lost incomes and the
employment situation adds to the uncertainty regarding future
delinquencies.
On a positive note, both Enterprises are devoting significant
resources to programs aimed at reducing default rates and preventing
avoidable foreclosures. Credit underwriting practices during
conservatorship have been strengthened, resulting in higher quality
mortgage purchases.
In addition to the stress in the single-family mortgage market, the
multifamily market is experiencing declining property values and record
vacancy rates. As of midyear 2009, rental vacancy rates hit their
highest level since the U.S. Census Bureau began tracking vacancy rates
in the 1950s. Still, the Enterprises are working to support the
multifamily market while adhering to clear and consistent credit risk
management principles. As of June of this year, the Enterprises'
combined multifamily portfolios had grown to $357 billion, and their
market share has increased substantially, growing from 34 percent in
2006 to 84 percent last year.
Going forward, we are looking to Freddie Mac and Fannie Mae to
continue to provide liquidity to the multifamily sector while ensuring
safety and soundness. For instance, in setting the housing goals for
2009, FHFA lowered all of the single-family goals but actually raised
the special affordable multifamily goal. We recognize that this will be
a challenge for each company given the depressed environment for
multifamily lending, but we expect each Enterprise to remain focused on
this sector and bring prudent approaches to enhancing their support for
this market.
3. Market Risk. The Enterprises' investments in mortgage assets
expose them to market risk. Given the uncertainties in the marketplace,
managing market risk continues to be a challenge.
4. Operational Risk. Both Enterprises are addressing operational
risk weaknesses. The systems and models upon which the companies have
relied in the past have been greatly stressed in this market
environment and the new management teams are working on appropriate
remediation. The implementation of the new consolidation accounting
standard, which will require the Enterprises to bring off-balance-sheet
mortgage backed securities onto their balance sheets beginning next
January, is a substantial operational challenge, one that has required
significant resources at each company.
Foreclosure Prevention/Making Home Affordable
I have already reviewed the substantial credit risk to the
Enterprises from mortgage delinquencies in their own books of business.
Because the Enterprises own or have guaranteed securities backed by
about 58 percent of the residential mortgages in this country, it is
fair to say that activities that bring stability to housing markets
generally are of direct financial benefit to the Enterprises. It is in
that context that I would like to discuss the Enterprises' current
efforts to support foreclosure prevention and, more generally, their
activities under the Obama administration's Making Home Affordable
program.
The Enterprises are applying the Home Affordable Modification
Program (HAMP) to their own mortgage books, and as agents of the
Treasury Department they are extending the program to mortgages in PLS
and in bank portfolios. Fannie Mae is the administrator of the program
and Freddie Mac has responsibility for overseeing program compliance.
The loan modification initiative is a critical effort to combat the
slide into foreclosure facing the many households that are seriously
delinquent on their mortgages. It represents a serious response to help
those homeowners dedicated to preserving their home if given the
opportunity through a more sustainable mortgage payment.
Under the umbrella of the Administration's Making Home Affordable
program, the Home Affordable Refinance Program (HARP) is an effort by
FHFA with the Enterprises to enhance the opportunity for homeowners to
refinance. For homeowners today who have mortgages owned or guaranteed
by Fannie Mae or Freddie Mac, and who are current on those mortgages,
HARP provides the opportunity for those homeowners to reduce their
monthly mortgage payment by taking advantage of the low mortgage rates
in the market today.
While a 5 percent mortgage rate creates an inviting opportunity to
refinance, in today's environment many homeowners have been unable to
do so. The decline in house prices has raised the current loan-to-value
ratio for many, and for some, put them underwater on their mortgage.
Combined with the limited availability of private mortgage insurance in
the marketplace today, many homeowners have been unable to qualify for
a refinance.
HARP has been designed to address these barriers. Fannie Mae and
Freddie Mac today will refinance mortgages they currently hold, even up
to a current loan-to-value of 125 percent. For homeowners with a
current loan-to-value ratio between 80 and 125 percent, the Enterprises
will refinance those mortgages without requiring additional private
mortgage insurance. If there already is mortgage insurance on the
existing mortgage, that coverage will carry forward to the new
mortgage. If the existing mortgage did not have mortgage insurance, it
will not be required in the new mortgage. This program recognizes that
the Enterprises already have the credit risk on their books for these
mortgages. Enhancing the ability of these homeowners to refinance their
mortgage improves the credit quality of the loan.
FHFA has been reporting monthly to Congress and the public on the
Enterprises' loss mitigation activities, including those under HAMP and
HARP, in our Federal Property Managers Report.
Challenges the FHLBanks Face
While much attention remains focused on the Enterprises, the
FHLBanks have challenges of their own that warrant the Committee's
attention. The FHLBanks have served their core statutory function of
bringing liquidity to member institutions holding mortgage assets. From
June 2007 to September 2008, advances to members increased from $640
billion to more than $1 trillion. When liquidity sources for many large
and small banks were drying up, the FHLBanks provided much needed
liquidity. I have already described the subsequent decline in advances
since last Fall.
The FHLBanks face several important challenges, two of which I
would like to note:
1. Private Label Securities. Working through the impairments and
fair value losses associated with their investments in private label
mortgage backed securities is an immediate and ongoing challenge for
the FHLBank System and the potential for losses on those securities
poses a serious problem for several FHLBanks.
2. Concentration Risks. The failure or consolidation of System
members has shifted business volumes among the FHLBanks and increased
concentration of ownership by, and advances to, a select number of
large institutions. This raises long-term structural questions
regarding the FHLBank System.
Future of the Housing GSEs and Mortgage Finance System
With that Mr. Chairman, let me move to the final topic that you
asked me to address: my views about the future of the mortgage market
and the role of the GSEs. To properly consider the future of the
housing GSEs, one should first consider the goals policymakers have for
the U.S. housing finance system and specifically the secondary mortgage
market.
In its broadest terms, the housing finance system is comprised of a
set of institutions and financial arrangements that connect capital
markets to local mortgage lending transactions. The mortgage market is
a $12 trillion market ($11 trillion in single-family mortgages and $1
trillion in multifamily mortgages). This market is one of the largest
individual credit markets in the world, nearly the size of all domestic
nonfinancial corporate borrowing and 65 percent greater than the
Federal debt held by the public. Yet this massive size is attained
through millions of individual transactions that have an average size
of $200,000. Today, the Enterprises, the FHLBanks, FHA, private
mortgage insurers, and portfolio lenders are among the primary
participants in our housing finance system.
For many years, Fannie Mae and Freddie Mac have been the two
leading conduits that connected capital markets to individual mortgage
transactions. Given the extraordinary losses to these companies and the
need for financial support from the Federal Government resulting from
the present mortgage crisis, to say nothing of the toll on individual
households and communities, we as a Nation need to ask and answer some
hard questions about what we want out of our housing finance system
going forward. In particular, we need to clearly define the proper
public policy objectives and the degree and characteristics of
Government involvement in this housing finance system to best serve
those objectives.
We might begin with the following simple purpose statement: To
promote the efficient provision of credit to finance mortgages for
single-family and multifamily housing. An efficient system of credit
allocation would typically have a number of characteristics:
Allows Innovation. Financial technology, products, and risk
management tools and understanding all evolve over time. An
efficient housing finance system should be constantly striving
to innovate. Competition is the natural generator of market
innovation yet the GSE structure limits competition by the
grant of exclusive charters to a few firms. At the same time,
regulation is necessary in many cases to protect the financial
system and other Government interests. The key is a regulatory
approach that accomplishes the latter without hindering the
former.
Provides Consumer Choice. A Nation of 50 million plus
homeowners is not likely to be well-served by a one-size-fits-
all approach to mortgage availability. Given the wide array of
household structures, income patterns, wealth, age, financial
sophistication, other assets, and so on, a robust housing
finance system should be able to cater to varying demands and
to suitably customize its product offerings.
Provides Consumer Protection. The costs to individual
households of the current record delinquencies and foreclosures
reminds us of the need to have a housing finance system that
appropriately protects households. Even for households with a
substantial degree of financial sophistication, mortgage
transactions are not an everyday occurrence and pitfalls and
blind spots may exist. Transparency and basic fairness in the
lending process need to be assured. Consumer responsibility
should also be a goal tied to strong disclosure and financial
education.
Facilitates Transparency. Investors in and guarantors of
mortgages and mortgage-related securities need clear, timely
information on the mortgages in which they invest in order to
make optimal investment decisions and to properly manage the
risks of those investments. Market mechanisms that are
transparent are more attractive to investors. They also
facilitate Government oversight of institutional and systemic
risk.
While the characteristics described above provide a broad framework
for thinking about the future of the housing finance system, there are
a number of specific areas related to the current activities of the
housing GSEs that deserve special attention. In particular, some key
decisions that policymakers will have to address include what role the
Federal Government should have in the following key areas of the
housing finance system: ensuring that the mortgage market has adequate
sources of liquidity; absorbing credit risk; and promoting the
availability of mortgage credit.
Briefly, ensuring liquidity in this context addresses the concern
that periodic disruptions in credit markets cause investors to
temporarily exit from holding, or purchasing new, mortgage-related
instruments. For example, during periods of interest rate volatility,
the heightened uncertainty makes it difficult to judge mortgage
prepayment and default risks, so investors may depart that sector.
Likewise, the extreme credit stress of the current mortgage crisis
would have caused severe disruptions in the flow of mortgage credit
were it not for the establishment of Government support programs.
During such episodes, do we need to ensure there is a balance sheet of
last resort?
Second, up to the present crisis, arguably the markets relied upon
an implicit Government guarantee of Enterprise securities. Going
forward, a threshold question is what level of Government credit
support is needed to have a mortgage market that operates efficiently.
As opposed to more broadly expanding Government guarantees, one
approach to consider is having the Government take a more limited
catastrophic credit insurance position backing mortgage assets. Another
approach could be a combination of enhanced private sector market
discipline and regulatory oversight to get a more economically accurate
market price of mortgage credit risk.
Third, for many decades the Federal Government has sought to affect
housing finance in ways that promoted the availability of credit for
low-and moderate-income homeowners and renters. Under the current
structure, the many subsidies granted the Enterprises were exchanged
for various requirements, including housing goals, to ensure the
Enterprises did not ignore these segments of the marketplace. Going
forward, policymakers may consider alternative approaches to defining
and targeting subsidies to achieve public policy objectives. For
instance, subsidies intended to support the financing of affordable
rental units or to assist first-time homebuyers could be more
efficiently targeted through down payment assistance or other measures
than by a general subsidy provided to all types of mortgage credit.
As policymakers deliberate the future of the housing finance
system, it is important to keep in mind the benefits that the secondary
mortgage market provides. Notable among those benefits are
standardization in the terms of conventional mortgages and a highly
liquid forward market for mortgage backed securities that allows
applicants to lock in interest rates when they are planning to buy a
home or refinance an existing loan. We should strive to maintain those
benefits while addressing the significant challenges we face.
Mr. Chairman, I believe we are in the early stages of an important
national discussion about them, one that I know the Administration has
committed to addressing in the coming months. There are options
available to us. The GAO, which will testify at the next panel, has a
broad framework setting forth some of these options. I have hoped to
add a few elements to the discussion here. I believe that private
capital, properly regulated, has a critical role to play in the housing
finance system of the future. But to do so, we must clearly articulate
the rules of the road before private risk capital will fully return to
this market sector. As for the Enterprises and the FHLBanks, they each
may have important roles to play in this future system. But the place
to begin the discussion is outside the existing framework of
institutional arrangements.
Thank you for the opportunity to appear here today. I would be glad
to answer any questions.
PREPARED STATEMENT OF WILLIAM B. SHEAR
Director, Financial Markets and Community Investment, Government
Accountability Office
October 8, 2009
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
______
PREPARED STATEMENT OF PETER J. WALLISON
Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise
Institute
October 8, 2009
Chairman Dodd, Ranking Member Shelby, and Members of the Committee:
I very much appreciate this opportunity to testify before this
Committee. The role and structure of Government sponsored enterprises
(GSEs), and particularly Fannie Mae and Freddie Mac, has been an
interest of mine since I was General Counsel of the Treasury in the
early 1980s.
While most of the attention to the GAO report in today's hearing
will focus on the agency's analysis of the options for their future,
the report contains a lot of useful background about Government housing
policies in general that the Committee should take into account. Table
1, for example, records the large number of housing programs that the
U.S. Government now pursues, beginning with the establishment of the
Federal Home Loan Bank System in 1932, the Federal Housing
Administration in 1934, and Fannie Mae in 1938, and extending through
the many programs for direct outlays currently run by HUD and the tax
subsidies that are enjoyed by most homeowners today. The sheer number
of these programs is a reminder that there will still be plenty of
Government support for housing and home ownership in the United States,
even if Fannie Mae and Freddie Mac are ultimately privatized or
liquidated.
Unfortunately, the table does not include or describe the system of
savings and loan associations (S&Ls), originally operated and regulated
by the Federal Home Loan Bank Board (FHLBB). The Board was the
predecessor of the Office of Thrift Supervision, which now regulates
the S&Ls that are a vestige of the much larger system that collapsed in
the late 1980s. One of the reasons for abolishing the FHLBB was that
its mandate included the promotion of housing, and that was deemed to
be inconsistent with the responsibility of a regulatory agency. As I
will discuss in this testimony, the same issue of conflict in missions
occurs in the case of Fannie and Freddie and severely impairs their
effectiveness. Indeed, for more than just this reason, the example of
the S&L system has great relevance to what the Committee is considering
today--both the future of Fannie Mae and Freddie Mac and the wider
issue of new regulations that are intended to prevent the recurrence of
the financial crisis we are now experiencing.
The Lesson of the S&Ls
The S&L system was established in 1932 to provide housing finance.
At the time, this was only the latest in many Government efforts during
the 20th century to increase home ownership in the United States. For
good reason, Americans believe in home ownership. It has many indirect
benefits--better housing, better neighborhoods, better family
conditions, less delinquency, and others--that are worthy of Government
support if they do not occur through operation of the market alone. But
recalling the history of the S&Ls and their collapse as an industry is
important for understanding what we should do with Fannie Mae and
Freddie Mac today.
This is true for two major reasons. First, the S&Ls were an attempt
by Congress to use a financial mechanism--a depository institution--to
achieve a social purpose, an increase in home ownership. S&Ls were
limited to making housing loans, which meant that they were locked into
a structure in which they were compelled to carry long-term assets with
short-term liabilities--a prescription for depository institution
failure if there ever was one. Commercial banks also carry long-term
assets with short-term deposits, but they have many more short-term
assets they can acquire. Fannie and Freddie were initially developed
simply to make the secondary mortgage market function more effectively
by purchasing mortgages from banks and S&Ls, thus making these long-
term assets more liquid. However, after the S&L industry failed,
Congress adopted another way to increase home ownership. In this case,
Congress gave Fannie and Freddie an additional responsibility--an
affordable housing ``mission''--intended to direct housing finance
resources to certain groups that were thought to be underserved in the
normal credit markets. This effort worked too well. The loans made to
the borrowers Congress designated, borrowers who did not have the
financial resources or the credit standing necessary to meet their
obligations, were largely responsible for Fannie and Freddie's
insolvency. Accordingly, the failure of both the S&Ls and the GSEs
should tell us that attempts to manipulate financial institutions in
order to achieve a particular social purpose are likely to end badly.
Second, the S&Ls failed because the system was not flexible enough
to survive in a market where interest rates were set by supply and
demand. This is important, and bears on many of the issues raised by
the financial crisis. The S&Ls remained a stable source of housing
finance only during a unique time--when the deposit interest rates at
banks and S&Ls were controlled by regulation and depositors had nowhere
else to go. Under what was known as the Fed's Regulation Q, banks could
not pay more than 5 percent interest on deposits and S&Ls could not pay
more than 5\1/4\ percent.
This created a very stable banking system for many years, and many
of the advocates of greater regulation today point to this period--
roughly from the end of World War II through the end of the 1970s--as a
period of ``great moderation'' when we didn't have many banking crises.
The implication is that we should have more regulation now. What the
proponents of regulation don't mention is that during this period we
had many very serious recessions and housing finance crises when there
was insufficient liquidity in the economy because the banks and S&Ls
could not raise sufficient funds for lending when money market rates
exceeded what Regulation Q permitted them to pay for deposits. After
the deregulation of deposit rates in the early 1980s, we really did
have a great moderation, with only two mild recessions until the early
2000s, when the Dot-Com bubble deflated. Even that recession did not
implicate the banking system, which remained reasonably strong from the
time of the S&L collapse (when almost 1600 commercial banks also
failed) until the current crisis.
The lesson of the S&L collapse is that it was a serious policy
error to impose a rigid regulatory structure on an institution that is
supposed to be operating in a market where the cost of its principal
raw material--i.e., money--is subject to the law of supply and demand.
The policy worked for a while, as long as the general public had no
other choices, but with the advent of ordinary money market mutual
funds, people could get access to higher rates and safe short-term
investments in the money markets and withdrew their funds from banks
and S&Ls. These institutions were forced to replace these fleeing
depositors with funding sources that required them to pay higher rates,
and the losses that resulted (paying more for funds than the assets
that they were holding were yielding) caused the collapse of the whole
industry. It is important to recognize that Regulation Q penalized the
public and trapped them in low-paying deposit accounts. In effect, they
were freed by technological changes--primarily the advent of
computers--that made it possible for mutual funds to calculate their
net asset value at the end of every day.
The S&L analogue at Fannie and Freddie is that no financial
institution can serve two masters. Government-sponsored enterprises--to
the extent that they are owned by shareholders but also have a
Government ``mission''--are living contradictions. They were set up to
achieve two Government purposes--creating a more liquid and efficient
secondary mortgage market and reducing the interest rates on mortgage
loans. But they are also private, shareholder-owned companies, and
their managements have a fiduciary duty to maximize value for the
shareholders. Just as the S&Ls' rigid structure could not survive in a
market where their depositors had alternative investments, Fannie and
Freddie could not serve both their Government purpose and their
shareholders at the same time. In the end, the shareholders come
first--if only because in serving the shareholders the managements
could assure themselves of rich rewards by exploiting the Government
franchise they had been given. This is part of the story of Fannie and
Freddie, and why they did not actually reduce mortgage interest rates
for the great middle class of the United States. As the GAO points out,
Fed studies showed that the interest rate reductions attributable to
their operations actually amounted to only 7 basis points.
One of the reasons that they achieved only this paltry sum for home
buyers is their affordable housing mission, which was adopted by
Congress in 1992. This created another inherent conflict of interest in
their charter. In this case, Fannie and Freddie were required to devote
a substantial portion of their resources to purchasing loans made to
home buyers at or below the median income. When HUD first began to
implement this mandate, the requirement was 30 percent, but it was
ratcheted up over time, and by 2005 HUD's affordable housing
regulations required that 55 percent of the loans Fannie and Freddie
purchased had to be loans to home buyers at or below the median income,
including 25 percent to low-income home buyers. Of course, the HUD
regulations said that these loans were to be prudent, but Fannie and
Freddie were also importuned to be ``flexible'' in their standards, and
that resulted in their looking for and buying loans that had been made
to people with blemished credit or limited ability to make
downpayments. By the early 2000s, Fannie and Freddie were buying loans
which involved no downpayment at all. The result is clear today. At the
time Fannie and Freddie had to be taken over by the Government, they
held or had guaranteed 10 million subprime and Alt-A loans, with a
total value of $1.6 trillion. These loans are defaulting at
unprecedented rates, and when it is all said and done, cleaning up the
mess at Fannie and Freddie will probably cost the American taxpayers
$200 to $400 billion.
The losses that finally overwhelmed Fannie and Freddie were hidden
for a long time in the huge profits that the two companies were able to
earn from exploiting their Government franchise. It looks today as
though the allocation of those profits was pretty much as one would
expect--first to the management, then to the losses incurred in their
affordable housing mission, then to the shareholders in the form of
dividends, and finally 7 basis points of benefit to home buyers. Of
course, the embedded losses were reserved for the taxpayers, who never
had an opportunity to reject the honor.
There are certainly good policy reasons for the U.S. Government to
encourage home ownership, but imposing the burden on companies that are
supposed to be shareholder-owned and profit-making is not the way to do
it. A Government program that provides downpayments for people who
can't afford them would make a lot more sense. Then the losses, if any,
would be visible and could be balanced against the gains from
increasing home ownership. But requiring Fannie and Freddie to perform
this mission--to find an increasing number of ``prudent'' loans that
met HUD's requirements--was a mission impossible, and the result is the
insolvency of the two companies and huge eventual losses for the
taxpayers.
The Future of Fannie Mae and Freddie Mac
What do these two lessons say about the future of Fannie and
Freddie? First, I think the GAO's conclusions about the options
available to Congress are correct. The realistic options are only
nationalization, privatization, or a return to GSE status, but there
are some ideas that are refinements of these general categories. For
example, the Mortgage Bankers Association has proposed a well thought-
out proposal that falls somewhere between privatization and GSE status.
In addition, the Treasury under Hank Paulson published a plan for a
covered bonds structure that might get the Government completely out of
the mortgage market. An evaluation of these ideas as substitutes for
Fannie and Freddie is beyond the scope of this testimony. Instead, I'd
like to review each of the possibilities raised by the GAO, beginning
with a return to GSE status.
Fannie and Freddie as GSEs
From what I have said above, a return to GSE status would the worst
choice, especially if Fannie and Freddie were to continue to have an
affordable housing mission. That mission seems unnecessary when FHA's
activities could be expanded to achieve the same result, and if the
objective is to increase home ownership, a program that provides
downpayments for prospective homebuyers with otherwise good credit
records is likely to be more effective. At least such a downpayment
subsidy program would be transparent, which Fannie and Freddie's
affordable housing losses certainly were not.
But even if Fannie and Freddie are no longer required to support
affordable housing, and even if their activities are limited to
securitizing mortgages (so that they are prohibited from holding
portfolios of mortgages and mortgage-backed securities), it would be a
mistake for them to be set up again as GSEs. The GSE form is a
prescription for moral hazard. If there had ever been any doubt that
GSEs are backed by the Federal Government, the Federal takeover of
Fannie and Freddie in 2008 removed it. If they are again set up as
GSEs, creditors will assume that the Government will rescue them again
if they get into trouble. There will be no market discipline, no
market-based restraint on their risk-taking. They and their supporters
will argue that strong regulation will prevent substantial risk-taking,
but this is an error. Since FDICIA was adopted in 1991, in the wake of
the S&L crisis, we have relied on the strongest regulation we could
think of to make sure that insured banks were safe and sound. Yet,
today, we have the worst banking crisis since the Great Depression.
Accordingly, it seems clear that strong regulation cannot overcome the
incentives of management--indeed their fiduciary obligations as
managers of shareholder-owned companies--to exploit the GSE franchise
to the maximum possible degree. No regulator will be able to tease out
the myriad ways in which the management of a future GSE will be able to
take risks in order to enhance the returns with which they and the
shareholders will be rewarded. Risk-taking is appropriate for private
companies--they should take risks for profit--but not when companies
are operating with the taxpayers' credit card. Yet that is exactly what
we will be doing if Congress accepts the facile argument that strong
regulation will prevent serious risk-taking and losses.
I should add here that if Fannie and Freddie return as GSEs, and
creditors assume that their liabilities are backed by the Federal
Government, the potential losses on their activities will be greater
than the potential losses to the Government arising out of the FDIC's
insurance on bank deposits. Bank deposits are only insured up to
$250,000, but all of Fannie and Freddie's debts will be covered in the
event of another failure in the future. So the stakes will be high for
the taxpayers if Fannie and Freddie are returned to GSE status.
Nationalization of Fannie and Freddie
The next question, then, would be whether nationalization would
solve this problem. In other words, if Fannie and Freddie were combined
into a single Government institution, could they more effectively
perform their secondary market role without a danger of excessive risks
to the taxpayers? In effect, the new entity would be doing what Ginnie
Mae is doing, but for a broader range of mortgages. Because a
Government agency would have no profit motive and no capital
requirement, it could, in theory, offer less expensive mortgages.
Again, the question arises whether the new entity would have an
affordable housing mission, and whether that obligation would require
them to take on the excessive risks that Fannie and Freddie seem to
have taken on in pursuit of that mandate. In addition, while there is
little incentive for a Government entity to take risks, there is also
little incentive to be careful about the credit risks they might be
taking on inadvertently. Unless the agency can pay the salaries
necessary to attract high-quality employees, its staff may not be able
to understand the complexity of the mortgages that might be created in
the future. As we saw with Fannie and Freddie, these risks can build up
over a long period and not come to light. When they do, the losses can
be substantial, in this case for the account of the Government. In this
connection, the Government entity could be securitizing trillions of
dollars in mortgages, and only small errors in risk management could be
very costly over time.
The GAO report does not consider the budgetary impact of
nationalizing Fannie and Freddie. Fannie was originally turned into a
private company in order to take it out of the budget process. As the
housing market grew, Fannie's purchases of mortgages were larger than
the revenues it received on the sale or refinancing of the loans, and
this added to the budget deficit. The same problem would appear to
arise if Fannie and Freddie were now to be nationalized. Even if they
are no longer permitted to accumulate portfolios of mortgages, their
purchases of mortgages will precede the sale of these loans to trusts
or other special purpose entities in the securitization process, and
this will add to the deficit. This phenomenon will be more pronounced
in a growing housing market, when the size of the GSEs purchases will
precede the proceeds of sale in a securitization.
The Nexus Between Fannie and Freddie and the Administration's Reform
Proposals
At this point, it is worthwhile to consider the nexus between the
issues that concern the future of the GSEs and the issues that arise in
connection with the Committee's consideration of various proposals to
prevent a repeat of the financial crisis. The GAO did not address these
issues, but they should be of concern. As part of its effort to prevent
another financial crisis, the Administration has proposed that in the
future banks hold more capital and the securitization process be
revised so that both loan originators and securitization sponsors
retain some portion of the credit risk associated with the securitized
mortgages. These proposals have important implications for the
restructuring of Fannie and Freddie--whether they are reestablished as
GSEs or merged into a single Government entity. The new capital
requirements and securitization rules, if they go into effect, will
increase the costs of securitization-based credit. This seems to be
acceptable to the Administration, apparently because it believes it
will reduce or eliminate the risk of another financial crisis.
But these new capital requirements and securitization rules will
have major implications for Fannie and Freddie as GSEs or as a
consolidated nationalized entity performing a secondary market
function. In both cases, explicit Government backing--or its equivalent
in the case of the GSEs--would have the potential to substantially
reduce the cost of the mortgages that go through a securitization
process run by a GSE or a Government entity. At the same time, the new
capital and securitization requirements for private sector operators
would substantially increase their costs. The gap between the cost of
mortgages in the two systems--Government and private--could be very
wide. Mortgages that fall within the conforming range for Government or
GSE securitization would have major advantages over those that do not,
and this could distort investment in the housing market. This will
substantially increase pressure for the Government or the GSEs to take
over all secondary market securitization. The usual groups--
homebuilders, realtors, and others in the business of constructing or
selling homes--will press Congress to cover all mortgages, not just
those that are at or below some maximum permitted size. If Congress
accedes to this pressure, it will significantly increase the amount of
mortgage debt that becomes a Government risk. For this reason, when the
Committee gets to a consideration of the Administration's proposals for
reform of bank capital and the securitization process, it should weigh
these in light of their effects on the future role of Fannie and
Freddie in the housing finance system.
In addition, if Fannie and Freddie survive as GSEs, there is a
question whether they will be subject to the both the new
capitalization and securitization requirements. If we assume that they
will be, then we are starting down the track of allowing Fannie and
Freddie again to accumulate a portfolio of interests in mortgages. To
carry these interests, they will be required to borrow, and if they
borrow they will be required to hold more capital in order to protect
the Government against losses. However, the Government's potential
exposure would grow over time, and could get quite large if the GSEs
take on growing numbers of mortgages for securitization.
Privatization
The previous discussion suggests that there are serious flaws and
taxpayer risks associated with both the GSE and the Government agency
structures. Ideally, Congress and the Administration should be
considering new and better ways to finance residential housing in the
United States, but there is no indication that any effort is being made
to address this issue. Under these circumstances, the Committee should
consider the privatization of Fannie and Freddie as a better policy
than the two flawed approaches we have previously discussed.
There is no reason in principle why mortgages cannot be securitized
through solely private sector activity, like any other asset that
creates a cash flow. Car loans, boat loans, insurance premiums, credit
cards, and many other assets have been securitized without problems.
The difficulties in the mortgage market come primarily from Government
interventions to promote home ownership in ways described above.
Indeed, the current freeze-up in the asset-backed securities market was
caused by investors' loss of confidence in mortgages and rating
agencies after unexpected losses appeared in pools of subprime
mortgages that had been rated AAA. The resulting losses to investors
caused the entire asset-backed market to shut down in 2007, and it has
remained largely closed since then. The right kind of reforms--simple
requirements, such as downpayments for mortgages and transparency for
the underlying rationale of the rating it received--will encourage a
return of investor confidence, although it will take time.
There are many advantages to a fully private housing finance
market--some of which were clear in the lessons of both the S&L
collapse and the failures of Fannie and Freddie. Principal among these
advantages is the fact that the taxpayers are unlikely to suffer any
losses on a fully privatized mortgage finance system. Failures in
today's mortgage financing system are increased, not reduced, by
Government backing. Government support creates moral hazard; creditors
don't pay attention to risk-taking because they believe the Government
will ultimately bail them out, and regulators regularly fail to prevent
excessive risk-taking. All these factors increase the risk of failures.
In a fully private system, however, creditors will not lend to a Fannie
or Freddie if they believe the company is undercapitalized or taking
excessive risks. If the mortgages are securitized through structured
arrangements, investors will insist on full disclosure concerning the
nature and risks of the securities they purchase, and, given the recent
track record of rating agencies, will want to know how a rating on a
particular tranche in the structure was established. This will mean
that the taxpayers will not again be burdened with hundreds of billions
of dollars in losses by Government-backed vehicles that were able to
take unreasonable risks because of their Government support.
In addition, a private system will encourage more innovation,
efficiency, and competition; with many other players joining the
secondary mortgage market, competition should bring down mortgage
rates. Privatized entities would have the flexibility to react to
changes in the economy and the financial markets, and the incentives to
do so. Finally, privatized companies are not likely have an obligation
to provide affordable housing financing to targeted groups--a mission
that was responsible for Fannie and Freddie's overwhelming losses. This
mission would be assigned to Government agencies such as FHA, so the
losses--if they occur--will be transparent.
Privatization can be achieved relatively easily after investor
confidence in securitization returns. The simplest way would be to
gradually reduce the size of the loans that Fannie or Freddie are
permitted to buy. This will gradually move them out of the market and
make room for new private sector entrants. It will also probably
stimulate the development of new ways of financing mortgages, such as
covered bonds, or the MBA's recent proposal, which--although designed
to use a Government guarantee--could work as a fully private sector
structure. If at any time the reduction in the GSEs' role is
interfering with the orderly financing of mortgages, the process can be
stopped. In current market conditions, it would not be good policy to
reduce conforming loan levels--investors are still too nervous about
the private securitization process--but as investor confidence returns,
and in the absence of any new thinking on how to finance housing in
this country, this approach would be the best way to prevent future
taxpayer losses while creating a viable housing finance system.
To conclude, the choices available to the Committee are rather
limited. Both the GSE and nationalization option have serious flaws
that probably make them unworkable. That leaves some form of
privatization. There are many good reasons to adopt a privatization
strategy as the future of Fannie and Freddie, but the best is that as
private entities without an affordable housing mission, they will not
create losses for the taxpayers. Ultimately, however, we must develop a
better system of financing housing in the United States, and it is an
unpleasant fact that no serious thinking along these lines appears to
be going forward in Congress or the Administration.
______
PREPARED STATEMENT OF SUSAN M. WACHTER
Richard B. Worley Professor of Financial Management, Wharton School of
Business, University of Pennsylvania
October 8, 2009
Chairman Dodd, Ranking Member Shelby, and other distinguished
Members of the Committee: Thank you for the invitation to testify at
today's hearing on the ``Future of the Mortgage Market and the Housing
Enterprises.'' It is my honor to be here to discuss the future of the
mortgage market in the United States. Historically home ownership for
Americans has served as bedrock of social prosperity. Given recent
history, we must ask ourselves how to envision a safe, sound mortgage
market for sustainable home ownership going forward.
As we consider the future of the mortgage market, we need to step
back and understand the sources of the global financial debacle.
Treasury Secretary Geithner correctly points out: we need to get this
phase right in order to minimize future crises. Understanding the
crisis and its sources is essential as we evaluate the broad options
before us of nationalization, privatization, and a public/private
system. While Federal support of the mortgage system is now necessary,
nationalization is not a long-run solution as it ultimately expands
taxpayer exposure, while privatization without a stabilizing public
role also leads to the inevitable socialization of risk, as this crisis
has demonstrated.
This crisis resulted from the explosion of risky mortgages, made in
the USA, the result of a lethal race to the bottom for short term
profits, enabled by regulatory failure. This explosion can be traced to
the issuance of private-label securities (PLS). These privately issued
securities were neither standardized nor transparent; they were not
traded, and, therefore, they were not subject or accountable to private
sector forces of market discipline. The common sense defying loans they
funded including, interest only, negative amortization, zero equity,
and teaser-rate ARMs, were not designed to be affordable when full
rates came into effect; and these loans drove the market to an episode
of irrational exuberance of historic proportions, causing the housing
bubble and inevitable bust. As these loans were pushed into the market,
overall household debt to GDP rose, due to mortgage debt, with the
increase coming from these risky loans.
As nonstandard mortgages proliferated, the market share of
traditional mortgages declined. From 2000 to their peak in 2006,
nontraditional mortgages grew in origination market share from 10
percent to almost 50 percent at their height (Wachter 2009b). In
particular, the housing enterprises' share of the market dropped, as
did the market share of the long-term fully amortized fixed rate
mortgage that they fund, protecting borrowers from the interest rate
risk which can undermine sustainable home ownership. The result of the
tsunami of debt was not an immediate disaster; rather, the initial
impact was an artificial house price bubble. As financial institutions
loaded up balance sheets on the upswing (Pavlov and Wachter, 2009a and
2009b), they were brought to their knees on the downswing, triggering
the liquidity crunch and subsequent foreclosures and the now far-
reaching and ongoing economic crisis.
Incentives of mortgage issuers were negatively aligned with the
production of safe, sound loans or even loans with a likelihood of
payback. Riskier mortgages were more profitable in the short term, even
though in the long term they brought down the system. Their greater
margin was due to highly inflated fees, which uninformed borrowers paid
without realizing their divergence from the norm. Fees drove the demand
for securitization at every stage of production: Banks received fees to
originate and distribute, the secondary market received fees to bundle
mortgages, and rating agencies received fees to rate pools. At each
stage, entities were able to book fees without exposure to long run
risks. Ultimately investors purchased MBS. But investors could hedge
their risk also. With the purchase of newly available credit default
swaps (CDS), their positions could be insured against possible loss.
There was counterparty risk to be considered, but if this was
evaluated, investors might have concluded that these instruments had to
be backed up or the entire system would fail. The providers of the
credit default swaps perhaps would have been viewed as--and certainly
in the event were--``too big to fail.''
The fundamental problem, then, was the lack of accountability in
the system to the long-run risks being generated. Due to the
illiquidity of their markets, mortgage backed securities and related
derivatives traded infrequently, and short-selling these assets was not
feasible--this unbalanced market dynamic led to further overpricing for
MBS. Without short-selling pressure or frequent trading, prices were
driven to high levels that could not be sustained. The result was that
artificially inflated asset prices increased further as credit
underwriting eroded, which meant that financial institutions' balance
sheets were also artificially inflated (Pavlov and Wachter, 2009a and
2009b). In summary, as these balance sheets grew, the assets reflected
ever-eroding standards for mortgage issuance. In the short term, cash
flowed in through fees, but each fee that was accounted for represented
one more mortgage that did not account for the lack of qualifications
of the borrower.
For 25 years, securitization worked well and supported sustainable
home ownership in the U.S. The GSEs were strictly regulated. Contrary
to popular misconception, they were not allowed to securitize subprime
or Alt-A mortgages. After they started losing market share to PLS,
however, shareholder and other pressures led them to purchase PLS
backed by nonstandard mortgages for their portfolio. To be clear, they
did not create the risky mortgage-backed securities that caused the
crisis, but they did become a burden to the taxpayer because they were
allowed to purchase them after private institutions had manufactured
them. My fellow panel member Peter Wallison has documented how several
GSE observers suggested Congress put limits on the portfolios, but to
no avail.
More generally, financial regulators did not do their part in
tracking or preventing systemic risk. With the profusion of mortgage
instruments it was exceedingly difficult to determine in real time the
amount and type of debt that was being issued. The extent of the asset
bubble being generated by this debt explosion was also difficult but
not impossible to detect. In a forthcoming paper (Pavlov and Wachter
2009b), we trace the identifiable impact of the debt on asset prices
across America, especially in the bubble States, where such loans
aggressively expanded.
The most striking aspect of this story is that it never should have
happened. While trading partner countries experienced house price
increases as interest rates fell from the mid-1990s on, housing price
inflation accelerated in the U.S. but not elsewhere, even with the
increase in interest rates, in 2003, as nonstandard mortgages and PLS
securities issuance took market share in the U.S. The increases in 2003
and 2004 occurred with the dramatic rise in the issuance of private
label securities and the aggressive lending they supported. Colleagues
and I have separately detailed the regulatory competition and
regulatory failure that enabled the profusion of unsafe loans by
institutions that were supposed to be regulated for safety and
soundness by the Federal Government. While the opportunity for
extraordinary compensation, in the short run, drove these markets,
regulators were complicit. They failed to hold the suppliers to the
long-term consequences of their actions. Federal Reserve Governor Ned
Gramlich, and others, warned us as this was occurring.
To ensure the safety and long term sustainability of a reenvisioned
mortgage finance system, we should pursue policies that embody three
principles. First, policies and procedures are needed to identify and
prevent out-of-control asset bubbles and systemic risk, under the
supervision of a risk regulator. Proactive measures to warn and protect
against asset bubbles must be in place in order to assure sustainable
home ownership. Loan-to-value ratios, in particular, must be maintained
over time. This will require specific analytics for the identification
and monitoring of risks and controls to prevent the procyclical
production of risk.
Second, borrowers must have effective, informed choice: safe
mortgages should be the presumed mortgage vehicle for borrowing. The
standard mortgage must be a safe mortgage and mortgage regulation
should favor safe products. To this end, it is important to create a
dedicated agency, such as the proposed Consumer Financial Protection
Agency. Consumer choice is inconsistent with nonstandard options that
cannot be compared or priced.
Third, we need a structure that promotes and provides safe and
standard mortgages through liquidity and standardization. Effective
borrower choice is impacted by the structure of the system. Standard
mortgages must be cost efficient. Liquidity in funding sources can
assure this.
I would also like to draw your attention to a feature of today's
mortgage market that we all take very much for granted, namely that a
borrower can lock-in a rate in advance of closing, which means that the
borrower can come into the closing knowing what the mortgage rate will
be. This is possible only because of the forward or ``To Be Announced''
(TBA) market. In the TBA market, the originator enters into a forward
contract with the GSE issuer, in which the originator promises to
deliver in the future a package of loans meeting the GSE's requirements
in exchange for GSE MBS to be identified in the future. This is
possible because GSE MBS of the same type, coupon, and maturity are
interchangeable, unlike private-label MBS, each of which is unique in
terms of credit risk and interest rate risk. The interchangeability of
GSE MBS is a function of a large degree of standardization. This
standardization produces sufficient liquidity to support a TBA market,
which benefits consumers with guaranteed rate quotes and prevents bait-
and-switch mortgage offers. Because the originator is able to resell
the loan to the GSE for a guaranteed rate before closing, the
originator is not exposed to interest rate fluctuations between the
time it quotes a rate and closing. Without the TBA market, originators
would have to bear the risk that the market value of the loan would
change before closing due to fluctuations in market rates. Because of
the liquidity in GSE MBS, a TBA market is possible that allows
originators to offer borrowers locked-in rates in advance of closing.
This is of course key to the ability of a borrower to choose a mortgage
that in fact the borrower will receive at closing.
More generally, securitization should be the way to bring liquidity
and cost efficiency to bear on the provision of safe and standard 30-
year fixed-rate mortgage. This can assure effective choice and support
for a mortgage system that becomes the bulwark of sustainable home
ownership in the U.S.
Bibliography
Abraham, Jesse M., Andrey D. Pavlov, and Susan M. Wachter, ``Explaining
the United States' Uniquely Bad Housing Market'', Wharton Real
Estate Review XII, pp. 24-41, Fall 2008.
Bostic, Raphael, Kathleen Engel, Patricia McCoy, Anthony Pennington-
Cross, and Susan M. Wachter, ``State and Local Anti-Predatory
Lending Laws: The Effect of Legal Enforcement Mechanism'', Journal
of Economics and Business, Vol. 60, Issue 1-2, pp. 47-66, 2008.
Bostic, Raphael, Souphala Chomsisengphet, Kathleen C. Engel, Patricia
A. McCoy, Anthony N. Pennington-Cross, and Susan M. Wachter,
``Mortgage Product Substitution and State Anti-Predatory Lending
Laws: Better Loans and Better Borrowers?'' University of
Pennsylvania, Institute for Law and Economics Research Paper;
Suffolk University Law School Research Paper, Working Paper 2009,
http://ssrn.com/abstract=1460871.
Calem, Paul, Marsha Courchane, and Susan M. Wachter, ``Sustainable Home
Ownership'', Working Paper 2009, http://ssrn.com/abstract=1365436.
Green, Richard, Roberto S. Mariano, Andrey D. Pavlov, and Susan M.
Wachter, ``Misaligned Incentives and Mortgage Lending in Asia'',
Financial Sector Development in the Pacific Rim, eds. Takatoshi Ito
and Andrew K. Rose, Chicago: University of Chicago Press, pp. 95-
116, 2009.
Green, Richard, and Susan M. Wachter, ``The American Mortgage in
Historical and International Context'', Journal of Economic
Perspectives, Vol. 19, No. 4, pp. 93-114, Fall 2005, http://
ssrn.com/abstract=908976.
Levitin, Adam, and Susan M. Wachter, ``The Future of Housing Finance:
Secondary Markets and Systemic Stability'', Working Paper 2009.
Levitin, Adam, Andrey Pavlov, and Susan M. Wachter, ``Securitization:
Cause or Remedy of the Financial Crisis?'' Georgetown Law and
Economics Research Paper; University of Pennsylvania, Institute for
Law and Economics Research Paper, Working Paper 2009, http://
ssrn.com/abstract=1462895.
McCoy, Patricia, Andrey Pavlov, and Susan M. Wachter, ``Systemic Risk
Through Securitization: The Result of Deregulation and Regulatory
Failure'', Connecticut Law Review, Vol. 41, p. 493, 2009, http://
ssrn.com/abstract=1367973.
Pavlov, Andrey, and Susan M. Wachter, ``Mortgage Put Options and Real
Estate Markets'', Journal of Real Estate Finance and Economics,
Vol. 38, No. 1, 2009a, http://ssrn.com/abstract=1285517.
Pavlov, Andrey, and Susan M. Wachter, ``Subprime Lending and House
Price Volatility'', Institute for Law and Economics Research Paper,
Working Paper 2009b, http://ssrn.com/abstract=1316891.
Pavlov, Andrey D., and Susan M. Wachter, ``Systemic Risk and Market
Institutions'', Yale Journal on Regulation, Vol. 26, No. 2, 2009c,
http://ssrn.com/abstract=1462360.
Pavlov, Andrey, and Susan M. Wachter, ``The Inevitability of Market-
Wide Underpriced Risk'', Real Estate Economics, Vol. 34, No. 4, p9.
479-496, 2006.
Wachter, Susan M., ``Bad and Good Securitization'', Wharton Real Estate
Review XIII, pp. 23-34, Fall 2009a.
Wachter, Susan M., ``Understanding the Sources and Way Out of the
Ongoing Financial Upheaval'', International Real Estate Review,
Working Paper 2009b, http://ssrn.com/abstract=1464791.
______
PREPARED STATEMENT OF ANDREW JAKABOVICS
Associate Director for Housing and Economics, Center for American
Progress Action Fund
October 8, 2009
Any discussion of the housing finance system's future should start
from a clear sense of what we want the system as a whole to accomplish.
The recent GAO report considers the range of roles historically played
by the housing enterprises, specifically Fannie Mae and Freddie Mac.
But if the Committee restricts its analysis of the past and
prescriptions for the future to simply the GSEs, it will miss the most
significant origins of the current crisis and produce a system that is
inadequate to support the essential role of housing finance in our
economy. The real question for the Committee's consideration is what
are the goals of the system and what combination of public, private,
and hybrid arrangements, if any, will deliver those objectives.
My goal for today's testimony is to therefore lay out a series of
principles that describes the essential functions that the housing
finance system must serve. In short, the specific principles are:
access to credit and liquidity, countercyclicality, risk management and
oversight, standardization, transparency and accountability, systemic
stability, and consumer protection. I hope that these principles are
useful as a starting point for reform of the housing finance system,
particularly with respect to the secondary market and its
participants--both public and private. I will also touch upon important
lessons to be learned from the past so that we do not learn the wrong
lessons from the subprime crisis, as some may be inclined to do. In
short, the systemic failures stemmed from the proliferation of poorly
underwritten mortgages channeled through the so-called ``shadow banking
system'' of unregulated private label securities.
The principles that I present today are the result of the
collaborative efforts and discussions of a group of experts and
stakeholders in mortgage finance convened by the Center for American
Progress that have been meeting for more than a year. The group is
known as the Mortgage Finance Working Group, or MFWG. These principles,
which are available on the Center for American Progress's Web site, \1\
were publicly released at an event in March. While we at CAP have
tremendously benefited from MFWG members' insights and expertise over
the past year, my remarks this morning should not be construed as their
personal or institutional endorsement of my testimony. Needless to say,
any errors herein are my own.
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\1\ See, http://www.americanprogress.org/issues/2009/03/pdf/
mortgage_finance_principles.pdf.
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Looking at any proposal that is made going forward, based on these
principles, the Committee should ask the following questions:
Will institutions of any size in any market have access to
capital and liquidity in all markets at all times?
How well will it do in ensuring a steady supply of 30-year
fixed-rate mortgages?
How well will it do in ensuring a steady supply of finance
for affordable multifamily house?
Will it support and speed innovation?
Will it support and encourage transparency?
Will all our communities, especially those devastated by
this crisis, have access to credit on fair and
nondiscriminatory terms?
How can we transition to a new system without disruption?
With these questions in mind, policymakers can design a regime that
not only sets the policy framework for the primary and secondary market
actions of purely private entities and public credit enhancement
agencies and provides carefully designed Government backing only for
those select activities of private actors that are determined to be
necessary to ensure that there is credit available to support all the
Nation's housing needs.
Liquidity Across Products and Time
The first concern of policymakers in contemplating any redesign the
U.S. mortgage finance system must be ensuring sufficient credit
liquidity at all times to meet the needs of U.S. homeowners. American
borrowers have shown a strong preference for long-term, fixed-rate,
self-amortizing loans that have allowed them to build assets and plan
loan repayment. Most investors, on the other hand, seek short-term,
liquid investments. Mortgage markets in the United States in recent
decades have done a remarkable job of intermediation between those
different needs. (As Susan Wachter has mentioned, no other housing
finance system provides long-term, fixed-rate mortgage lending as well
as the American system.)
What do we mean by liquidity? An investor needs to know that there
will be a market for their assets--in the context of mortgage-backed
securities, their particular share of loans made to individual
homeowners--at all times. If an investment is not liquid, investors
will charge more, if they make the capital available at all. If they
don't, a new homebuyer cannot get a loan and an existing owner may be
unable to sell.
In thinking about liquidity, two important aspects must be
considered: first, the need to have consistent credit liquidity through
booms and busts; and second, the need to have broad availability of
credit across places and housing types, Each is of paramount importance
in thinking about the future of U.S. housing finance.
Broad demands for liquidity must be consistently met over time. In
the most recent housing cycle, we saw too much credit flow into the
U.S. housing markets during the boom, creating a housing price bubble
that misallocated trillions of dollars of capital. Private mortgage
securitization played an unquestionably procyclical role during these
bubble years. Conversely, during the aftermath of the housing bust,
there has been a notable drying up of credit liquidity, one which has
only been filled by the housing enterprises, Fannie Mae and Freddie
Mac, both before and particularly after being placed in
conservatorship, and FHA/Ginnie Mae. If not for these governmental and
Government-backed sources of housing finance, the downturn would have
been much more severe, and no one would be talking about the
possibility that we've seen a bottom, either for the housing market or
the broader economy.
Any housing finance reform efforts must consider the importance of
ensuring sufficient credit liquidity during down times, and who might
provide that liquidity. Institutions with the capacity and
responsibility for countercyclical activity are a requirement for a
well-functioning system. This countercyclical role is one that will
require some measure of Government backing, as the private sector has
proven itself unable or unwilling to independently provide sufficient
and necessary capital during periods of retrenchment.
Credit liquidity must also be deep in addition to being broad.
Policymakers must consider how a revised system will succeed in
maintaining the confidence of domestic and international investors to
continue directing their capital into U.S. housing markets. This
confidence has been shaken, most particularly with respect to the
primary lenders and secondary market institutions that are at the heart
of mortgage finance today. Perhaps the biggest question policymakers
face is whether U.S. housing finance can attract sufficient capital to
meet its needs without a significant Government role, particularly in
the wake of massive failures in the private securitization market which
have caused the global investment community massive losses on U.S.
mortgage securities. I believe the answer to the question is that there
remain critical roles for Government to play in the provision of
mortgage finance liquidity.
Beyond the issue of constant and deep liquidity, U.S. housing
finance must provide liquidity across geographies to support the
acquisition and refinancing of a wide range of housing types, from the
single-family suburban home to the high-rise apartment building, from
double-wide manufactured housing to triple-decker row homes. An
emphasis on ensuring the availability of mortgage finance to support
home ownership remains appropriate, even in the aftermath of the
housing crisis, as home ownership is still the key route to economic
mobility and wealth accumulation for large segments of the American
populace.
But home ownership is not appropriate for everyone at every point
in their lives. If the reformed housing system fails to provide
sufficient financing for the production and maintenance of affordable
rental housing, the system will fail to serve the needs not only of a
large and sometimes vulnerable segment of the population, but also of
the rest of us. Not only have almost all of us rented at some time in
our lives, but the lack of quality affordable rental housing affects
the fabric of our entire economy and society.
The idea of ensuring sufficient credit liquidity translates for
most Americans into ensuring a supply of capital flowing to originators
of single-family mortgages. But policymakers should also be careful to
consider the needs of multifamily housing as well. In the context of
the secondary mortgage market, providing liquidity for multifamily
housing in particular will be a challenge to policymakers going
forward. Because multifamily housing is not as easily securitized or
underwritten as single-family mortgages are, ensuring constant
liquidity is more difficult. In periods of significant to stress to the
banking system during the past two decades, permanent financing for
multifamily housing was predominantly financed by the GSEs, both
through their direct efforts as well as through their role as an active
purchaser of the tax credits that helped finance the equity portions of
multifamily housing deals. Research by the National Multi Housing
Council highlights the critical role the housing enterprises played
during the S&L crisis, providing $9 billion for multifamily housing at
a time when savings and loans were responsible for $43 billion of
disinvestment in the sector. Similarly, between October 2007 and
September 2008, the GSEs provided a combined 82 percent of the $83
billion in net new multifamily financing. \2\
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\2\ Mark Obrinsky, ``NMHC Research Notes: The GSEs' Role in
Multifamily Finance'', National Multi-Housing Council. February 3,
2009; Available at http://www.nmhc.org/Content/
ServeContent.cfm?ContentItemID=5039. See also Paul Weech, ``More than
Home Ownership: The Role of the Housing GSEs in Multifamily Housing
Finance'' (Forthcoming from the Center for American Progress).
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Demographic changes coupled with the fallout from the housing
crisis make it a certainty that demand for rental units will soar in
the near future, and much of that demand will be for affordable rental
housing in places with access to decent job opportunities. During the
height of the boom, much of the multifamily construction took the form
of condominiums and higher-end developments. \3\ Any reformed housing
finance system will need to meet the demand for financing multifamily
housing across the range of price points; this will likely require a
range of delivery channels for deeply subsidized, narrowly subsidized,
and unsubsidized units.
---------------------------------------------------------------------------
\3\ Joint Center for Housing Sudies, ``America's Rental Housing:
The Key to a Balanced National Policy.'' Harvard University, 2008.
http://www.jchs.harvard.edu/publications/rental/
rh08_americas_rental_housing/rh08_americas_rental_housing.pdf.
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Fair and Affordable Access to Credit
We should expect private capital to provide consumers with access
to credit on profitable but fair terms. In particular, underserved
communities should receive access to credit on terms that reflect their
actual, not perceived, credit risk and not on predatory terms. These
are the communities that have been hardest hit by the housing and
economic crisis and will need the most capital to rebuild. While an
emphasis on better risk management is likely to lead to tighter
underwriting standards, policymakers should be careful in ensuring that
those changes are based on criteria empirically tied to credit risk--
while remaining sensitive to the true costs of providing that credit--
rather than on ideological or discriminatory assumptions about the
credit profiles of certain communities. Stronger underwriting should
ultimately lead to a more careful allocation of credit within all
communities, not a deprivation of credit to underserved communities.
It is worth noting that the modern long-term fixed rate mortgage,
where the homeowner does not bear interest rate risk, such as the 30-
year fixed-rate mortgage that we all take for granted, is actually an
affordable housing financial product created by Government policy. In
the 1920s and early 1930s, private-sector mortgages were short-term,
nonamortizing bullet loans--many of same features found in the most
toxic of the toxic mortgages originated at the height of the bubble.
The Home Owners' Loan Corporation was created in 1933 at the height of
the depression to refinance distressed borrowers into stable, long-
term--then 15-year--mortgages at up to 80 percent loan-to-value. FHA
followed the HOLC offering these innovative long-term products. The
adoption of the self-amortizing, fixed-rate mortgage by the private
sector was a reflection of a need to compete on the best terms with
public entities--in contrast to the race to the bottom among lenders we
have witnessed over the past several years.
Long-term, fixed rate loans are a unique feature of the American
system. As a policy matter we should want to ensure their continued
availability, because they remain essential to creating wealth/asset
building opportunities for consumers. Moreover, unlike adjustable-rate
mortgages, these loans shift interest rate risk away from homeowners,
the party with the least ability to manage that risk, onto institutions
and individuals with greater risk-management capacity.
Absent a policy intervention to ensure the availability of these
long-term mortgages, they probably will not exist, a point implicitly
acknowledged by Wells Fargo CEO John Stumpf in a recent call for the
GSEs to be given permission to purchase jumbo mortgages as a way to
``help revive the moribund market for big mortgages.'' \4\
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\4\ http://www.ft.com/cms/s/0/85c9c1c8-a258-11de-9caa-
00144feabdc0.html?nclick_check=1.
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Another important goal is the provision of affordable housing
finance products to all communities, not just the middle and upper
class, but also to those underserved traditionally by decent and fair
financial products and sources. Unfortunately, many have taken the
wrong lessons from this crisis about the ability of low and moderate
income people to be homeowners.
And while society has sometimes overemphasized home ownership over
the last two decades at the expense of rental housing, we should not
learn the wrong lesson. The current high rate of default on subprime
mortgages does not mean that home ownership is inappropriate for low-
and moderate-income households. Indeed, from 1998 to 2006, only 9
percent of subprime mortgages went to first-time homebuyers, with 62
percent being used to refinance existing homes. \5\ As I will discuss
shortly, the lesson policymakers should be taking away from the crisis
is that level playing fields are necessary, particularly when it comes
to affordable access to credit. When safe, affordable, and well
underwritten loans must compete against unregulated exotic mortgage
products priced without regard to underlying asset value or risk and
marketed by brokers with misaligned incentives, the results are
disastrous, both for homeowners and for the larger economy. We must
ensure that parallel systems cannot again emerge that put the soundly
underwritten loans in competition with unregulated and nontransparent
products.
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\5\ http://www.responsiblelending.org/mortgage-lending/research-
analysis/Net-Drain-in-Home-Ownership.pdf.
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Many nonprofit, CDFI, and other innovators such as the Self-Help
Credit Union were finding compelling and sound ways to lend to lower
income families that proved to be far more successful than the track
record of subprime product. \6\ The originations and servicing of these
successful Self-Help mortgages were by banks motivated by CRA, with the
liquidity provided by Fannie Mae. The Ford Foundation provided a
guarantee and Self-Help provided management. In other words, this model
presents a partnership that relied on Government incentives and
provided safe loan products to consumers at no risk to the originating
lender. The real lesson of these loans is that standard, well
underwritten, low downpayment mortgages to low-wealth, low-income
borrowers just like those offered through myriad CRA lending programs
offered a safe and durable alternative to subprime products.
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\6\ http://www.self-help.org/secondary-market.
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It is important to understand that affordable housing finance for
lower income and minority families was at a marked disadvantage in
competing with predatory subprime product that was irrationally priced,
poorly underwritten, and/or marketed with predatory practices. In 2005,
55 percent of borrowers given subprime loans that were sold into
private label securities qualified for prime loans at the time of
origination. \7\ Good affordable lending was driven out--a perfect
example of Gresham's law, ``Bad money drives out good.''
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\7\ Rick Brooks and Ruth Simon, ``Subprime Debacle Traps Even Very
Credit-Worthy'', Wall Street Journal, December 3, 2007. http://
online.wsj.com/article/SB119662974358911035.html.
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We need to ensure that all the money in the game is available under
the same rules. This doesn't mean that lenders should not differentiate
between legitimate credit risks and price their offerings
appropriately, but recent CAP research found that even among borrowers
earning at least twice area median incomes, African-American and
Hispanic borrowers were about three times as likely as whites to be
given higher-priced mortgages. This is hardly a characteristic found in
a system that ensures equal access to fairly priced credit.
We must reestablish such efforts to allocate capital on fair but
economically viable terms, particularly through innovation, not shy
from doing affordable home ownership right.
Consumer Protection
There has been a lot of discussion about the merits of consumer
protection in the context of the Administration's proposal for a
Consumer Financial Protection Agency, so I won't go into great detail
here to explain CAP's support for that proposal. Rather, I will make a
few brief points about the importance of consumer protection to an
effective system of housing finance and vice versa--points that have
been absent from the broader conversation to date.
First, it is worth noting that to a large extent, consumer
protection--i.e., efforts to prevent predatory lending and encourage
the origination of safe and sustainable loans--is really also a means
to protect investors as well. If loans are originated with aligned
incentives, consumers should tend to receive sustainable, well-
underwritten loans, which benefits investors by making their
investments safer. What we saw in the last market cycle was mortgage
brokers and originators with misaligned incentives to sell
unsustainable, high-fee mortgages because compensation was immediate
and risks were divested.
At the origination level, brokers and originating lenders had no
incentives to make sustainable loans, and typically had perverse
compensation incentives to sell high-risk, high-fee mortgages over
safer products. Subprime and Alt-A mortgages, mainstays of private
label securitization, were a particular problem, as we all know.
Originating lenders like Countrywide paid originators more if they sold
higher risk mortgages such as option ARMs and interest only loans.
(They also got paid more for higher interest rate loans, which has led
to our suggesting the need for greater scrutiny of whether there had
been fair lending violations at the height of the housing bubble.) \8\
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\8\ See, http://www.americanprogress.org/issues/2009/08/
tarp_lending.html.
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With such misaligned incentives, it is not surprising that there
have been rampant reports of origination fraud, and more importantly,
that the mortgages composing private-label MBS were across the board
poorly underwritten with historically astronomical default risks. For
example, 44 percent of subprime mortgages, and 9 out of 10 Alt-A option
ARMs, originated in 2005 were made without full income documentation.
\9\
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\9\ Wei Li and Keith Ernst, ``Do State Predatory Lending Laws
Work?'', Housing Policy Debate, Vol. 18, Issue 2 at p. 361 (2007),
available at http://www.mi.vt.edu/data/files/hpd%2018.2/6.hpd_wei-
ernst_web.pdf.
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At all levels of the shadow banking system, the incentives for
market actors, including credit rating agencies, were to generate as
much volume as possible, with no regard for credit risk and often
perverse incentives to generate higher cost, higher risk loans. Because
the costs generated by their poorly underwritten mortgages were not
ultimately borne by the key market actors in the private securitization
process, but were instead borne by others (including the taxpayer)--an
externality--their incentives were all aligned towards generating high
short-term fees and payments, and away from the long-term viability of
the underlying mortgages.
In thinking about these problems, one potential solution stems from
greater transparency and standardization. It's a lot easier to shop for
a product where you can do comparison shopping, so to the extent that
the current system encourages the mass availability of certain standard
mortgage products (15/30yr FRM in particular), it empowers the
consumer. This is not to say that certain innovative mortgage products
should be excluded entirely from the marketplace; borrowers with unique
circumstances should not be forced to accept a standard product that is
unsuitable for them. Nevertheless, even in these instances, terms
should be easily understood and presented in a fashion that allows for
consistent comparisons across offerings.
The benefits of standardization accrue to the consumers of
securitized mortgages--investors--as well. As we have seen, securities
with the same AAA rating have performed very differently over time.
Transparency in MBS down to the loan level is often available only to
market participants with very deep pockets, leaving other investors to
guess how much future impairment is already priced into the security.
MBS and collateralized debt obligations trade without TRACE
requirements, which also impede market participants' ability to
accurately price securities that may have been sliced and diced
multiple times over.
The secondary market ultimately drives the standardization that
benefits consumers. Investors who innovate with exotic products should
have a higher, not lower, obligation for transparency and consumer
protection. Products with transparency that allows for ease of
comparison across offerings in both the primary and secondary mortgage
markets provide much greater efficiency and stability for individual
participants and for the system as a whole.
These consumer protection considerations are essential not only for
primary market regulation. The secondary market plays a key role as
well.
Risk Management and Oversight Creates Transparency
Finally, there is the principle of risk management. In
contemplating the reform of the housing finance system, most
policymakers have understandably focused on the need to restore
stability and sufficient risk oversight to the housing finance system.
But those who would focus primarily on GSE reform are missing the
bigger picture. After all, it is clear that the unregulated private
securitization markets caused this crisis through poor underwriting and
misaligned incentives that ultimately became the toxic MBS whose losses
infected seemingly invincible institutions. And so we believe that any
efforts to reform the housing finance system that ignore the private
securitization markets are destined for failure. We must ensure a level
playing field.
In discussing the crisis that hit the housing finance system, it is
critical that the difference between GSE-conforming MBS and private-
label MBS is understood. This is something that is clearly not well
understood by many.
GSE-conforming MBS have been around since at least the 1970s and
involve a guarantee from one of the Government sponsored entities
Fannie Mae or Freddie Mac on the timely payment of principal. This
guarantee was thought to carry the implied backing of the Federal
Government, something which was confirmed in the recent crisis, when
the Federal Government took over the GSEs in a conservatorship and
near-explicitly guaranteed their obligations. GSE-guaranteed MBS are
securities based upon ``conforming mortgages,'' which typically are
safe and standard mortgages--such as the 30 year FRM--with strong
underwriting requirements. The GSEs also purchased ARMs, Alt-A, and
even subprime mortgages, but even in those cases, the quality of those
loans were mostly better than what was securitized through PLS, in part
because the terms of the loans contained fewer predatory features. \10\
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\10\ See, https://www.efanniemae.com/sf/mortgageproducts/pdf/
armmatrix.pdf for the types of adjustable rate mortgages that Fannie
Mae would purchase. Note that the factors that determine the interest
rates (index plus margin) are generally favorable to the borrower and
prohibit negative amortization and no lifetime floors.
---------------------------------------------------------------------------
GSE-conforming mortgages, in large part due to the standards set by
the GSEs themselves and the requirement of private mortgage insurance
on loans in excess of 80 percent of the property's value, have
historically performed very well. Even in this historically
unprecedented housing downturn, GSE-conforming mortgages have seen
default rates that are small relative to PLS. In fact, serious
delinquency rates for PLS are considerably higher than Fannie Mae or
Freddie Mac's portfolios (including their held Alt-A and subprime
mortgages) as of the end of the second quarter of 2009. PLS make up 13
percent of the outstanding single-family first mortgages but account
for 35 percent of the serious delinquencies. The housing enterprises,
in contrast, collectively hold 57 percent of those mortgages but only
26 percent of the serious delinquent mortgages. \11\ In other words,
there are more than one-third more delinquent mortgages in PLS than
owned by the GSEs, despite the GSEs' market share being more than three
times the size.
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\11\ http://www.freddiemac.com/corporate/company_profile/pdf/
fm_housing_crisis.pdf.
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The Housing and Financial Crisis Originated in ``Toxic'' Private-Label
MBS
Having laid out the principles that describe the essential
functions of the housing finance system, I would like to also touch
upon the key points of failure of the existing system.
Specifically, the rapid expansion of a ``shadow banking system''
consisting of private label securities and their complex derivatives
distorted the secondary mortgage market and chased safer loan products
out. The proliferation of PLS comprised of loosely underwritten
mortgages was made possible by a lack of prudential oversight and
misaligned incentives throughout the origination and securitization
processes.
The unregulated private MBS market, free from any direct safety and
soundness supervisory oversight, was hailed as a paradigm for efficient
markets, with sophisticated private actors and cutting-edge
quantitative analysis efficiently managing and allocating risk, whose
complexities were boiled down into a series of letter grades issued by
credit rating agencies who were paid handsomely by those packaging
mortgages into securities. Despite the inherent conflicts of interest
in ratings agencies' business model, belief that the ``shadow banking
system'' could manage its own risk while providing strong returns was
nearly universal. Thus, the regulatory playing field was tilted to the
advantage of private securitization, as regulators and legislators
alike were reluctant to regulate a market that seemed to be functioning
efficiently without regulation. The lack of regulation allowed the
shadow banking system to enjoy cost advantages over other sources of
housing finance, which allowed it to dominate the marketplace.
Because private securitization had relatively little regulation but
the near-universal belief that its products were safe--AAA ratings
coupled with expectations of perpetual house price appreciation--global
capital flooded into the shadow banking system, and thus the U.S.
housing markets, during the Bush administration. Private-label MBS have
been created and sold for more than two decades, but their expansion
was dramatic in the earlier part of this decade, expanding almost nine-
fold from $135 billion 2000 to almost $1.2 trillion in 2005. \12\
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\12\ http://www.fdic.gov/bank/analytical/regional/ro20063q/na/
2006_fall01_chart02.html.
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The U.S. PLS share of MBS went from 12 percent in 2002 to nearly 50
percent in 2006, which had the effect of distorting the overall
economics of the U.S. housing market. Coupled with low interest rates,
this flood of capital caused massive appreciation in housing prices
that was unsupported by the underlying economic trends. By the end of
2007, U.S. housing prices had seen an inflation-adjusted 86 percent
increase since 1996, even as household income stagnated. \13\ The PLS-
induced housing bubble burst and has today left approximately one in
three mortgages underwater, \14\ and that number could rise to nearly
50 percent by 2011, according to a recent study from Deutsche Bank.
\15\
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\13\ http://www.responsiblelending.org/mortgage-lending/policy-
legislation/congress/senate-testimony-10-16-08-hearing-stein-final.pdf.
\14\ First American CoreLogic.
\15\ http://www.bloomberg.com/apps/
news?pid=20603037&sid=ac9y1xr7yNhQ.
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The growth in mortgages originated for private securitization
displaced the so-called ``plain vanilla'' mortgage products offered by
the GSEs, FHA, and portfolio lenders. GSE conforming mortgages shrank
to less than 30 percent in 2006, down from 50+ percent in the 1990s.
2005 was the first year in which PLS originations outstripped mortgages
originated for agency MBS--including GNMA. Unsurprisingly, 2005 also
marked the year in which mortgage lending standards deteriorated
markedly, based on the proportion of loans where the intersection of
credit score and LTV ratios had historical lending precedents. \16\
``By June 2006,'' notes Whitney Tilson based on loan performance data
presented by Amherst Securities Group, ``mortgage lending standards had
collapsed, even for the best loans.'' \17\
---------------------------------------------------------------------------
\16\ http://www.moremortgagemeltdown.com/download/pdf/
T2_Partners_presentation_on_the_mortgage_crisis.pdf.
\17\ Ibid.
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This unprecedented market share of the ``shadow banking system,''
which performed the basic functions of bank lending but without the
risk oversight imposed on banks, was tied to the belief that these
market players could self-regulate their own risk, and therefore this
process of private securitization didn't need regulation for safety and
soundness. As Alan Greenspan noted:
Deregulation and the newer information technologies have joined
. . . to advance flexibility in the financial sector. Financial
stability may turn out to have been the most important
contributor to the evident significant gains in economic
stability over the past two decades . . . . Recent regulatory
reform, coupled with innovative technologies, has stimulated
the development of financial products, such as asset-backed
securities, collateral loan obligations, and credit default
swaps, that facilitate the dispersion of risk. \18\
---------------------------------------------------------------------------
\18\ http://www.federalreserve.gov/boarddocs/speeches/2005/
20051012/default.htm.
In hindsight, this was clearly a tremendously flawed assumption,
but one which enjoyed huge support at the time.
Private-Label MBS Imploded Because of a Lack of Prudential Oversight
and Misaligned Incentives
All modern banking systems have a prudential oversight regime, but
when regulators fail to use their authorities, or loopholes are created
that allow certain products and market participants to avoid oversight,
the stability of the entire system is threatened.
At the origination level, the Federal Reserve, which had
specifically been tasked by Congress to develop guidance on subprime
mortgages, ignored this obligation for more than a decade. And when
State-level regulators sought to provide much-needed guidelines for
products and institutions operating within their borders, the Bush
administration's Office of the Comptroller of the Currency sued them
arguing that national banks were already subject to Federal regulation,
despite the OCC's determined unwillingness to protect consumers from
dangerous loan products. The former attorney general of North Carolina,
Roy Cooper, was led to remark, the OCC ``took 50 sheriffs off the job
during the time the mortgage lending industry was becoming the Wild
West.'' \19\
---------------------------------------------------------------------------
\19\ Robert Berner and Brian Grow, ``States Warned About Impending
Mortgage Crisis'', BusinessWeek, October 12, 2008. http://
www.msnbc.msn.com/id/27121535.
---------------------------------------------------------------------------
The problem of regulators being philosophically opposed to
regulation was an even more critical failing in light of the problem of
misaligned incentives throughout the system. Put simply, virtually none
of the participants in the mortgage securitization process had the
incentive to originate and sell loans that were viable over the long
term.
At the securitization level, loan underwriters had no incentives to
verify the underwriting of the loans they were pooling, or to take
measures to ensure that defaults were limited. Instead, they merely
needed to attain a AAA rating for as high a volume of securities as
possible.
Credit rating agencies were tasked with assessing the risk
associated with these private label MBS. As Chairman Dodd, Vice
Chairman Shelby, and Senator Schumer, among others, have described,
these rating agencies faced inherent conflicts of interest, as they
were paid by the MBS issuers, and paid more for higher volumes of new
issues.
Indeed, we have begun to see renewed activity among re-REMICs,
wherein previously downgraded MBS are reorganized into new securities
with better ratings, even as the underlying impaired mortgages are left
untouched. This alone should put pause to anyone claiming that the
market has learned its lesson (once burned, twice shy) and the worst
excesses of originators and the PLS market are unlikely to return.
Similarly, some who have put forth proposals that ignored the
possibility of a reinvigorated PLS market and therefore saw no need to
develop a regulatory structure for it are inviting a return of these
distortions on the conventional market.
One possibility we at CAP are considering to ensure that whatever
PLS market emerges competes on fair and transparent terms with future
conventional mortgage lending would be to require all those who
securitize residential mortgages to obtain a license that brings with
it certain duties to transparency, risk management, and a
countercyclical market presence. There are advantages and disadvantages
to this model, but it is worth exploring further.
The Costs of Excessive Risk Taking by Private MBS Market Participants
Were Borne by Others
In 2007, Fed Chairman Ben Bernanke famously stated that the damage
from the subprime mortgage crisis had been contained. In fact, as we
now know, this was terribly incorrect, as the excessive defaults from
subprime and Alt-A securities, as well as those caused by the
depreciation of housing markets artificially inflated by the surge of
global capital into U.S. housing, became so great that they paralyzed
our entire global financial system, necessitating massive injections of
public funds into private Wall Street financial institutions and the
housing enterprises.
By 2007, all of the world's largest financial institutions had
assumed enormous exposure to the U.S. private-label MBS market. As a
result, when these securities began to see higher defaults as a result
of their poor mortgage origination practices and the overall inflation
of U.S. housing prices, the resulting losses impacted areas of the
financial markets far beyond private mortgage origination. Financial
institutions as disparate as Citigroup (primarily a bank holding
company regulated by Federal banking regulators), AIG (primarily an
insurance company regulated by State insurance regulators), and Bear
Stearns (primarily an investment bank and broker-dealer regulated by
the SEC) experienced losses related to their private label MBS exposure
that were so severe that it impacted their other financial activities.
Ironically, the housing enterprises also experienced enormous
losses as a result of the private-label MBS market. This occurred
through losses on their guarantee book of business as well as through
more profound losses on the private-label securities they themselves
had bought in an effort to boost profits in response to lost market
share from the vary same PLS.
Conclusion
In summation, the housing finance system as a whole must offer
access to credit and liquidity, countercyclicality, risk management and
oversight, standardization, transparency and accountability, systemic
stability, and consumer protection. A robust system will likely require
a combination of public, private, and hybrid entities to deliver all of
these objectives. It is instructive to look back at the rapid expansion
of the PLS market at the expense of conventional lending to identify
the failures of the past as we begin to consider how to reform the
housing finance system to achieve the principles we have laid out.
Appendix
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
FROM EDWARD J. DeMARCO
Q.1. Availability of Mortgage Capital-- Mr. DeMarco, a witness
on our second panel will testify that ``Perhaps the biggest
question policymakers face is whether U.S. housing finance can
attract sufficient capital to meet its needs without a
significant Government role, particularly in the wake of the
massive failures in the private securitization market . . . ''
What is your answer to this question--Will the United States be
able to attract the capital necessary to meet our housing needs
if the U.S. Government does not play such a role?
A.1. In responding, I assume that the Federal Government
continues to provide direct credit support to the mortgage
market through its existing programs such as FHA and VA
mortgage insurance. Thus, I take the question to be in
reference to attracting private capital to support the
conforming, conventional market. In the long run, I believe the
answer to that question is yes and I hope that policymakers
will seek institutional and regulatory structures aimed at such
an outcome. In the near-term, however, with the Enterprises in
conservatorship and much uncertainty in the marketplace today
regarding housing in the United States, I believe that some
continued Government support is important to maintaining market
stability. It may also be a necessary component of a
transitional period as we move to a post-conservatorship set of
structures for the secondary mortgage market.
Q.2. Enterprises and Foreclosure Prevention-- Mr. DeMarco, to
date, the loan modification effort has focused largely on
payment modifications rather than principal reductions. At the
very least, I believe principal reductions may be necessary to
prevent foreclosures for borrowers who are deeply underwater.
Is there more that Fannie Mae and Freddie Mac can do to
encourage principal forgiveness? Is this the kind of thing you
are prepared to explore?
A.2. As an alternative to a principal write-down, the Home
Affordable Modification Program (HAMP) program incorporates
principal forbearance as the final step in the waterfall--in
the event it's needed to create an affordable payment. However,
with the other features of the program--interest rate reduction
to 2 percent and term extension--there are few cases when
principal forbearance is needed.
The impact of principal forbearance is comparable to a
principal write-down in that the amount of principal subject to
forbearance is not amortized and is not subject to interest.
However, it is due and payable at the time the loan is paid off
and is included in the payoff quote. If at payoff the value of
the property is less than the payoff quote, the servicer can
forgive some or the entire principal forbearance amount. This
accomplishes several things. First, it minimizes the potential
for moral hazard. Second, it allows the investor to recover
some or the entire amount of principal forbearance, if the
housing market recovers. Third, it's more acceptable to the
investor community as an option. There are investors and other
industry stakeholders who take a very strong position against
principal write-downs.
Where principal forgiveness may be a viable strategy is
with addressing the needs of borrowers with option ARMs who may
not have understood the product and how it worked, and have
seen the principal balance of their loans increase due to
negative amortization. Many would say this is the most logical
and justifiable scenario for a principal write-down. It is one
that's being considered.
Finally, I would note that any borrower has an obligation
to repay their debt even if that debt is backed by an asset
that has declined in value. Borrowers with an ability to pay
should be expected to make their payments without regard to
declining house prices.
Q.3. The Affordable Housing Mission of the Enterprises-- In his
testimony, Mr. Wallison argues that enterprise purchases of
both subprime and Alt-A loans were driven by their affordable
housing mandate imposed in the law. However, my understanding
from talking to FHFA staff is that the Alt-A book of business,
which is responsible for 40 to 45 percent of the enterprises'
losses, was not really used to meet the housing goals. You
seemed to indicate during the hearing that this is your
understanding as well. Is that correct?
A.3. FHFA assumed responsibility for setting affordable housing
goals--previously set by HUD--upon enactment of the Housing and
Economic Recovery Act of 2008 (HERA) on July 30, 2008. The
decisions by Fannie Mae and Freddie Mac to purchase certain
loans with layers of risks, e.g., subprime and Alt-A loans,
were influenced by several factors, including a desire to
preserve market share and to achieve the anticipated higher
yield on such, as well as the affordable housing goals. The
purchase of Alt-A loans, which has contributed significantly to
losses at both enterprises, had the effect of making it more
difficult for the enterprises to meet their income-based
affordable housing goals, because, by definition, such loans
often lacked information on borrower income. Purchase of such
loans did have a modest positive impact on enterprise
performance on the underserved area goals.
Q.4. You suggest in your testimony that, rather than creating
housing goals, it might be more efficient to provide more
targeted subsidies. Senator Reed, with my strong support,
included in HERA a provision that requires the enterprises to
contribute to a National Housing Trust Fund, assuming they
return to profitability. Is that the kind of targeted subsidy
you think makes sense?
A.4. HERA established a Housing Trust Fund to increase and
preserve the supply of rental housing for extremely low and
very low income families, including homeless families, and to
increase home ownership for extremely low and very low income
families. This approach might well be more effective than the
housing goals. Currently, because of the financial condition of
the companies, Enterprise contributions have been suspended. As
a general matter, my view about subsidies is that taxpayers
should clearly see the cost and the delivery mechanism should
ensure that the subsidy gets to the intended beneficiaries.
Q.5. Liquidity and Standardization-- Mr. DeMarco, you note, as
I did, that we need a market to ensure standardization and
liquidity, particularly in times of stress. In your view, is
some sort of a Federal role necessary to achieve these goals?
If not, how would we be assured that product standardization
would result from a purely private marketplace?
A.5. Taking each goal separately, I do not believe that a
direct Government role is necessary to ensure the
standardization necessary to create a deep and liquid secondary
mortgage market in normal times, but a Government role probably
is necessary if we want depth and liquidity during a period
like we have experienced recently. Standardization can be
achieved in several ways. It can be imposed by the Government;
it can be achieved through a self-regulated organization or
trade association such as the stock exchanges or the Securities
Industry and Financial Markets Association (SIFMA); or it can
be imposed by dominant firms (think of video formats or
computer operating systems). With respect to market liquidity,
it seems unlikely that private market-makers will be large
enough to ensure liquidity in the secondary mortgage market
during crises. Therefore, some sort of Government buyer of last
resort authority maybe necessary to avoid severe periods of
illiquidity in this market.
Q.6. Portfolios Under Conservatorship-- Under the
conservatorship, FIIFA has directed the GSEs to begin shrinking
their portfolios beginning in 2010. With the Federal Reserve
announcing it does not intend to extend its MBS purchase
commitment beyond the current $1.25 trillion limit, does FHFA
intend to maintain its requirement that the enterprises shrink
their portfolios? If so, please assess the market outlook for
agency MBS in the absence of either enterprise or Fed portfolio
purchases. What impact do you project this outlook will have on
mortgage rates?
A.6. The portfolio limits referenced are a part of the
Treasury's Preferred Stock Purchase Agreement with the
Enterprises. In the absence of any change in the current Senior
Preferred Stock Purchase Agreements and the Federal Reserve's
MBS purchase program, it seems reasonable to expect there could
be a gradual, modest increase in mortgage rates over time.
Still, the market is well aware of these pending changes yet
mortgage rates remain very low and, in fact, have declined
since the Federal Reserve announced its intention to terminate
new purchases by March 31, 2010.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM EDWARD
J. DeMARCO
Q.1. What were Fannie and Freddie's respective shares of the
total mortgage market from 2003 to the present? Did Fannie and
Freddie lose market share to subprime and nontraditional
markets during those years? What share of Fannie and Freddie's
business were subprime mortgages as defined at the time?
Nontraditional mortgages as defined at the time? Which of these
types of mortgages caused the most significant losses for
Fannie and Freddie?
A.1. Table 1 below shows total originations of single-family
mortgages in 2003 through 2008 and combined Enterprise
acquisitions of such mortgages during that period. The decline
in the share of total originations represented by combined
Enterprise acquisitions in 2004 through 2006 resulted both from
the boom in subprime and nontraditional lending during those
years and a reduction in the volume of Enterprise acquisitions,
as some mortgages that the Enterprise would likely have
acquired in previous years were financed through private-label
securitization.
Table 1. Originations of Single-Family Mortgages and Fannie Mae and Freddie Mac Single-Family Mortgage
Purchases, 2003-2008
(dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
Single-Family Mortgage Fannie Mae and Freddie Mac Fannie Mae and Freddie Mac
Year Originations Combined Purchases Share of Originations
----------------------------------------------------------------------------------------------------------------
2003 $3,945.0 $2,023.7 51.3%
2004 2,920.0 942.9 32.3%
2005 3,120.0 918.7 29.4%
2006 2,980.0 875.6 29.4%
2007 2,430.0 1,125.4 46.3%
2008 1,500.0 940.5 62.7%
----------------------------------------------------------------------------------------------------------------
Sources: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications.
There is no common industry definition of a subprime
mortgage, so it is not possible to indicate the volume of
subprime loans acquired by the Enterprises. However, most
industry participants would consider a mortgage made to a
borrower whose credit score is below 620 to be a subprime loan.
Both Freddie Mac and Fannie Mae have reported that, as of
September 30, 2009, loans to borrowers with credit scores below
620 comprised 4 percent of the unpaid balance of their
respective portfolios of conventional single-family mortgages.
From 2002 through 2008, each Enterprise's acquisitions of such
loans accounted for 3-6 percent per year of their total single-
family acquisitions.
During the mortgage lending boom of the middle years of
this decade, private-label mortgage-related securities often
were backed by pools of mortgages that issuers designated as
subprime loans. Table 2 provides information on issuance and
Enterprise purchases of such securities in 2002 through 2008.
The data on securities issuance were obtained from Inside
Mortgage Finance Publications. The data on each Enterprise's
purchases in each year and combined Enterprise purchases in
2006 through 2008 were obtained from the Enterprises and
published in FHFA's 2008 Annual Report to Congress. The data on
combined Enterprise purchases for 2003 through 2005 were
obtained from Inside Mortgage Finance Publications and
previously reported in annual research reports published by the
Office of Federal Housing Enterprise Oversight, one of FHFA's
predecessor agencies.
Table 2. Issuance and Enterprise Purchases of Private-Label Mortgage-Related Securities Backed by Subprime
Mortgages, 2002-2008
(dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
Issuance of Fannie Mae Freddie Mac Combined
Subprime -----------------------------------------------------------------------------------
Year Private-Label
MBS Purchases Share* Purchases Share* Purchases Share*
----------------------------------------------------------------------------------------------------------------
2002 $122,680.9 $5,143.9 4.2% n.a. n.a. n.a. n.a.
2003 194,958.5 25,768.6 13.2% n.a. n.a. $81,000.0 41.5%
2004 362,549.3 67,003.6 18.5% n.a. n.a. 176,000.0 48.5%
2005 465,036.3 24,468.8 5.3% n.a. n.a. 169,000.0 36.3%
2006 448,599.6 35,606.1 7.9% $74,761.0 16.7% 110,367.1 24.6%
2007 201,546.7 15,970.5 7.9% 43,667.0 21.7% 59,637.5 29.6%
2008 2,261.4 637.4 28.2% 106.0 4.7% 743.4 32.9%
----------------------------------------------------------------------------------------------------------------
n.a. = not available.
Sources: for issuance data 2002-2008 and combined data 2003-2005, Inside Mortgage Finance; Fannie Mae and
Freddie Mac for all other data.
* Reported ``share'' is Enterprise purchases of subprime private-label MBS in each year expressed as a
percentage of total subprime MBS issued during the year. However, it cannot be assumed that the subprime
private-label MBS purchased by an Enterprise in a given year were issued in that year.
Defining a nontraditional mortgage is even more problematic
than defining a subprime loan, since the use of the former term
varied widely across lenders and over time. For that reason, it
is not possible to indicate the volume of nontraditional
mortgages originated or acquired by the Enterprises.
Information is available on issuance and Enterprise purchases
of private-label mortgage-related securities backed by
Alternative-A (Alt-A) mortgages. Table 3 provides such
information for 2002 through 2008. The data on securities
issuance were obtained from Inside Mortgage Finance
Publications. The data on each Enterprise purchases were
obtained from the Enterprises and published in FHFA's 2008
Annual Report to Congress.
Alt-A mortgages acquired by Fannie Mae and Freddie Mac have
contributed disproportionately to each Enterprise's credit
losses. In Fannie Mae's earnings statement for the second
quarter of 2009, the Enterprise reported $18.8 billion in
credit-related expenses. Alt-A mortgages accounted for 9.8
percent of Fannie Mae's total single-family mortgage portfolio
at that time, but 41.2 percent of the Enterprise's credit-
related expenses in that quarter. Freddie Mac reported $5.2
billion in credit-related expenses in the second quarter of
2009. The Enterprise stared that Alt-A mortgages accounted for
9 percent of its single-family mortgage portfolio at that time,
but caused 45 percent of its credit losses in the first half of
the year.
Data on single-family mortgages that are seriously
delinquent--past due 90 days or more--sheds additional light on
how nontraditional mortgages are contributing to Enterprise
credit losses. As of September 30, 2009, the serious
delinquency rate on Fannie Mae's conventional single-family
mortgage portfolio was 4.72 percent; the comparable rate on
Alt-A loans acquired by Fannie Mae was 73.97 percent. On that
date, the serious delinquency rate on Freddie Mac's single-
family mortgage portfolio was 3.43 percent; the comparable
rates on Alt-A, Interest-Only, and Option adjustable-rate
mortgages acquired by Freddie Mac were 10.94 percent, 15.52
percent, and 15.55 percent, respectively.
Table 3. Issuance and Enterprise Purchases of Private-Label Mortgage-Related Securities Backed by Alt-A
Mortgages, 2002-2008
(dollars in millions, unpaid principal balance)
----------------------------------------------------------------------------------------------------------------
Issuance of Alt- Fannie Mae Freddie Mac Combined
Year A Private-Label -----------------------------------------------------------------------------------
MBS Purchases Share* Purchases Share* Purchases Share*
----------------------------------------------------------------------------------------------------------------
2002 $53,462.7 $1,756.0 3.3% n.a. n.a. n.a. n.a.
2003 74,151.0 8,104.0 10.9% n.a. n.a. n.a. n.a.
2004 158,585.8 21,999.0 13.9% n.a. n.a. n.a. n.a.
2005 332,323.2 16,109.0 4.8% n.a. n.a. n.a. n.a.
2006 365,675.8 11,973.0 3.3% $30,546.0 8.4% $42,519.0 11.6%
2007 249,610.0 5,288.0 2.1% 10,008.0 4.0% 15,296.0 6.1%
2008 1,854.7 175.0 9.4% 618.0 33.3% 793.0 42.8%
----------------------------------------------------------------------------------------------------------------
n.a. = not available.
Sources: Fannie Mae, Freddie Mac, Inside Mortgage Finance Publications.
* Reported ``share'' is Enterprise purchases of Alt-A private-label MBS in each year expressed as a percentage
of total Alt-A MBS issued during the year. However, it cannot be assumed that the Alt-A private-label MBS
purchased by an Enterprise in a given year were issued in that year.
Q.2. We know that a large percentage of delinquent borrowers
eligible for the HAMP program are either not responding to
servicer requests or returning incomplete documentation.
Freddie has initiated a program to reimburse servicers who hire
qualified third-parties to help reach out to borrowers. Why are
GSEs not doing this to help more struggling borrowers, and
could you launch a pilot program to see whether in person
outreach would improve the effectiveness of the loan
modification programs?
A.2. Both Freddie Mac and Fannie Mae are testing the concept of
reaching out to borrowers with third parties who go door-to-
door to initially solicit borrowers for modifications and/or to
follow-up on outstanding documentation required by HAMP. Early
results indicate in-person contact is effective. It mirrors the
face-to-face contact that occurred when many of these borrowers
took out their loans and needed individual guidance and to be
educated. Fannie Mae and Freddie Mac continue to evaluate the
successes and shortcomings of the current programs to look for
additional means of addressing shortfalls and reaching more
borrowers. The Enterprises will continue to work with FHFA and
the Administration on cost-effective ways of reaching out to
borrowers and improving the overall effectiveness.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR KOHL
FROM EDWARD J. DeMARCO
Q.1. Currently, the GSEs own more than half of the mortgages
across the country. For a period of time, Fannie and Freddie
started to purchase more exotic and riskier mortgages while no
additional safeguards put in place. The GSEs, have before,
required that homeowners who meet a certain criteria receive
prepurchase counseling. Additionally, Fannie Mae recently
reinstated a homebuyer education piece for the
MyCommunityMortgage. Finally, it has been proven that
homeowners who have received prepurchase counseling have a
lower default rate and should they get in trouble, they have
the information on where to get help.
Do you support expanding a homebuyer education requirement
to first-time homebuyers who will have their loan guaranteed by
the GSEs? Do you think this will be an effective tool to help
better protect the GSE's investments?
A.1. Recent studies have found that households that receive
prepurchase counseling have slightly lower default rates and,
if they do default, are likely to seek help from the entity
that counseled them. Such studies cannot control for
differences in the quality of counseling services provided by
different firms or in different jurisdictions, however, so that
it is not clear that requiring prepurchase counseling for all
first-time homebuyers whose mortgages were acquired by Fannie
Mae and Freddie Mac would lower default rates on those loans.
In addition, default losses would not necessarily go down,
since there is no evidence that lenders incur smaller average
losses on defaulted loans whose borrowers were precounseled and
seek help when they become delinquent. Further, the current
market counselors who are certified to provide prepurchase
counseling are very busy working with servicers to assist
distressed homeowners modify their delinquent mortgages. There
are also shortages of counselors in nonurban areas.
For all those reasons, at this time I do not favor
requiring prepurchase counseling for all first-time homebuyers
whose loans are acquired by the Enterprises. Still, in view of
how many homebuyers in the past few years got into mortgages
they did not understand or could not manage, it seems logical
that prepurchase counseling should be encouraged for certain
classes of homeowners and required in certain specified
circumstances.
Q.2. Fraudulent and inaccurate appraisals have been identified
as one of the problems that caused the housing bubble. Steps
have been taken to create a firewall between appraisers, real
estate agents and mortgage lenders. While it is a good first
step in trying to ensure that there is not a conflict of
interest and the homebuyer is getting a fair and accurate
appraisal of the property, there might be other safeguards that
can be put in place?
How often does the Agency review and update appraisal
standards for the mortgages that the GSEs guarantee? Do the
GSEs ever ask for a second opinion on appraisals that they
might find questionable? Does the Agency feel that the new
reforms for appraisers and lenders will be strong enough to get
more accurate appraisals?
A.2. Fraudulent and inaccurate appraisals were a contributor to
the rapid run-up in home prices and have resulted in
significant problems for lenders and homeowners. Safeguards now
appear to be adequate and numerous; the critical issue turns on
enforcement. State regulators--entrusted with authority to
administer appraisal rules--admit to being underfunded and
understaffed. Registration of appraisers may help. However,
strong education and ethical standards work most effectively
when supported by real enforcement.
FHFA does not update appraisal standards; that is the work
of the GSEs. FHFA examines the GSEs to assure that their
guidelines are being carried forward in dealing with their
seller servicers. The recently adopted Home Valuation Code of
Conduct will expire next year in November and new rules will
add to or amend that code. Further, at any time, the GSEs may
add to their appraisal guidelines in response to market
conditions.
There has been some indication that appraisals have
improved. This may be a combination of appraisal standards by
the Enterprises and stronger underwriting and appraisal
requirements by lenders. For example, Freddie Mac recently
stated that appraisals received had improved some 15 percent,
when tested against the automated valuation models they employ
for quality control.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR CORKER
FROM EDWARD J. DeMARCO
Q.1. How is FHFA overseeing the way in which Fannie Mae,
Freddie Mac, and the Home Loan Banks are managing credit risk?
A.1. Fannie Mae and Freddie Mac--FHFA is keenly focused on
credit risk at Fannie Mae and Freddie Mac. Examiners and
analysts in the Division of Enterprise Regulation, with the
support of other offices within FHFA, continuously assess the
drivers of credit risk for single- and multifamily mortgages
owned and guaranteed by the Enterprises. We also assess the
creditworthiness of a wide range of counterparties to which the
Enterprises are exposed, including loan originators and
servicers, mortgage insurers, bond guarantors and derivatives
counterparties. The Enterprises are also exposed to credit risk
from private-label mortgage-backed securities that they have
purchased or guaranteed in structured products, and FHFA
continuously evaluates the performance of these securities.
Our staff assesses mortgage credit performance, as well as
the processes used by the Enterprises in assessing their own
performance, by reviewing a wide range of performance metrics,
including delinquency statistics, loss severity upon
disposition of real-estate owned (i.e., properties acquired
through foreclosure), losses incurred through foreclose
alternatives such as short-sales and deeds-in-lieu of
foreclosure, and redefault rates on modified mortgages. FHFA
personnel also assess credit metrics gauging the performance of
mortgages by various categories, including credit score, year
of origination, original and current loan-to-value ratios,
geographic locale, product type and originating lender, among
others.
In addition to continuously monitoring credit performance,
we assess the quality of the models used by the Enterprises to
underwrite and price mortgages, as well as models used to
forecast credit expenses. We also assess a wide range of
operational processes that directly affect the amount of credit
risk that ultimately is realized, including processes for
quality control, fraud prevention and remediation, mortgage
repurchases and the disposition of real estate acquired through
foreclosure. Further, we work closely with both Enterprises and
the Department of Treasury to evaluate controls surrounding the
Making Home Affordable program, which has a direct effect on
ultimate credit losses.
Federal Home Loan Banks--Structurally, the Federal Home
Loan Banks (FHLBanks) face limited credit risk in their
advances portfolios. The principal source of their credit risk
is in their holdings of private-label mortgage-backed
securities (MBS), which constitute approximately 5 percent of
their aggregate asset portfolio, or $56.6 billion, as of June
30, 2009.
Sixty-four percent of FHLBank assets are advances to
members. By law, all advances must be collateralized by
residential mortgage loans, deposits in an FHLBank, Treasury
and agency securities, or ``other real estate-related
collateral.'' No FHLBank has ever incurred a credit loss on an
advance to a member.
Seven percent of their assets are whole mortgage loans.
These nonjumbo, fixed-rate loans, principally from 2004 and
before, have high FICO scores and low loan-to-value ratios.
They were written to traditional underwriting standards, and
the originating member retains some credit risk on these loans.
At June 30, 2009, only 0.35 percent of these loan balances were
90 or more days delinquent and not accruing interest.
Fifteen percent of assets are non-MBS investments, mostly
prime money market investments and Federal agency securities.
Approximately half of these money market investments have an
overnight maturity. The FHLBanks face regulatory limitations on
the amount of investments with any counterparty based on the
capital levels of both the FHLBank and the counterparty as well
as the credit rating of the counterparty.
Mortgage-backed securities are the remaining 14 percent of
the portfolio. Of these, $56.6 billion were private-label MBS
and 594.4 billion were agency MBS. By regulatory policy, an
FHLBank may currently invest in MBS up to six times its
capital, but any investments in excess of three times its
capital must be agency MBS.
FHFA examiners review credit risk at each examination, and
each FHLBank receives a credit risk component rating at each
examination. The rating reflects the amount of credit risk at
the FHLBank and the quality of its credit risk management. The
FHFA is also completing a targeted review of credit risk across
all 12 FHLBanks, and will release a report on that review
within several months.
The targeted review focused on collateral operations and
private-label MBS. The principal credit risk stems from the
private-label MBS. While all these investments were rated
triple-A at the time of purchase, the credit quality of these
investments has deteriorated. Approximately 40 percent are now
rated below investment grade and an additional 29 percent are
rated investment grade but either have been downgraded or are
on negative watch. The private-label MBS portfolios are in run-
off mode, In the first half of 2009, the FHLBanks incurred
credit-related impairment charges on these investments of $953
million. Additional losses on these investments are possible
and depend on house prices, unemployment, and other housing
market conditions. For the past 18 months, the Division of
FHLBank Regulation and its predecessor entity have devoted
intense supervisory efforts to private-label MBS.
Q.2. Assuming that the GSEs may be taking on additional risk as
part of the Administration's effort to help keep people in
their homes, what is being done to make sure that the increased
risk to the taxpayer is manageable?
A.2. FHFA does not believe the GSEs have taken on additional
credit risk as a result of their participation in the Making
Home Affordable (MHA) program. The MHA program is designed to
reduce preventable foreclosures. Consistent with this
objective, underwriting standards are in place. Income and
employment are verified. Modified mortgages are better aligned
with the borrowers' capacity to service the debt. This in turn
lessens the likelihood of foreclosures and reduces the risks to
Fannie Mae, Freddie Mac, and ultimately the U.S. Treasury and
taxpayers. If the MHA programs are applied consistently and
uniformly, they will contribute to stabilizing the mortgage
market and home prices, so that the value of the collateral
underlying the GSEs' portfolios can stabilize and increase.
This can have only a positive impact on their risk profile and
capital position.
That said, FHFA recognizes that implementing and managing
the program results in increased operational complexities for
the GSEs. FHFA is closely monitoring the GSEs' roles under the
``Treasury Agency'' agreements to ensure that the program is
implemented and managed in a safe and sound manner.
Q.3. FHFA was given greater authority to oversee new programs--
including the imposition of new fees--initiated by the housing
GSEs. What are you doing to implement that new authority, and
how is that process working?
A.3. One of the important new powers that FHFA received in the
Housing and Economic Recovery Act of 2008 was the authority to
review and approve ``new products.'' FHFA has established an
interim rule implementing that authority, which empowers the
agency to review both new activities and, as an important
subset, new ``products,'' which in most cases must be subject
to public notice and comment before they can be approved and
commenced.
FHFA has received public comments on the interim rule, and
is working to incorporate those comments in a final rule. FHFA
is working to implement an operational process for reviewing
new activities and new products that will meet the statutory
directive and the needs of the public, while meshing with the
Enterprises' own internal processes for developing and
reviewing new business initiatives and efficiently deploying
the agency's supervisory resources. FHFA has reviewed a number
of Enterprise initiatives to date, none of which have been
determined to be new products, an outcome consistent with the
fact that both Enterprises are currently in conservatorships
and are managed to conserve and preserve their assets while
carrying out their mission. Several more initiatives are under
review today, both for safety and soundness considerations and
to be sure that the agency and the Enterprises address the
Congressional desire that new products be exposed to public
review through the notice and comment process.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
FROM WILLIAM B. SHEAR
Q.1. Affordable Housing Mission--Mr. Shear, in its review of
the GSEs' housing goals performance in 2004-2005, HUD concluded
that both Fannie Mae and Freddie Mac produced a higher share of
their financings in low mod borrowers than the primary mortgage
market. Yet your report concludes that there is no evidence
that the housing goals expanded credit for such loans. Can you
please explain how to reconcile these two assertions?
A.1. While HUD first established the housing goals in 1993,
their effectiveness in supporting home ownership opportunities
for targeted groups and areas is not clear. For example, for
many years, the goals were set conservatively and do not appear
to have materially enhanced the enterprises' performance in
funding such mortgages compared to the primary mortgage market.
In 1998, we found that the goals HUD has set for the period
1996 through 1999 were conservative goals, which placed a high
priority on maintaining the enterprises' financial soundness.
\1\ According to HUD's 2004 final rule, which set the
enterprises' housing goals for the period 2005 through 2008,
while Freddie Mac's performance in funding affordable mortgages
had improved in prior years, it consistently lagged the
performance of the primary market. \2\ Specifically, HUD found
that Freddie Mac lagged the primary market in funding
affordable home purchase loans for special affordable and low-
moderate income borrowers and underserved neighborhoods
targeted by the housing goals. From 2001 through 2003, HUD
found that Fannie Mae led the primary market in funding special
affordable and low- and moderate-income loans, but lagged the
market in funding underserved area loans. HUD also found that
Fannie Mae and Freddie Mac lagged by a rather wide margin the
primary market in funding mortgages for first-time homebuyers,
and that their share of the market for minority first-time
homebuyers was very small. HUD increased the goals starting in
2005 to encourage the enterprises to facilitate greater
financing and home ownership opportunities for the groups
targeted by the goals.
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\1\ GAO, ``Federal Housing Enterprises: HUD's Mission Oversight
Needs To Be Strengthened'', GAO/GGD-98-173 (Washington, DC: July 28,
1998).
\2\ 69 Fed. Reg. 63580, 63692 (Nov. 2, 2004).
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Recent research also indicates that, although the
enterprises have enhanced their product offerings to meet the
housing goals, the effects of the housing goals on
affordability and opportunities for target groups have been
limited. For example, a 2006 study found that as the
enterprises' activities increased in certain areas pursuant to
the mortgage purchase program, they may have been offset by a
decline in FHA's existing activities in those areas. \3\
Earlier research sponsored by HUD in 2001 found that the
enterprises generally did not play a leading role in affordable
multifamily mortgage finance because their underwriting
standards were considered conservative and fairly inflexible,
compared with those of other multifamily mortgage providers.
\4\ In contrast, as discussed in our September 2009 report,
representatives from mortgage finance, housing construction,
and consumer groups we contacted said that the benefits from
enterprise purchases of multifamily mortgages were significant.
The representatives said that the enterprises' involvement in
or guarantees of the financing of affordable multifamily
projects were crucial to their successful completion. In
addition, they said that during the current financial crisis
the enterprises were the only source of funding for multifamily
projects because many other traditional providers, such as
banks and insurance companies, largely have withdrawn from the
market.
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\3\ Xudong An and Raphael Bostic, ``GSE Activity, FHA Feedback,
and Implications for the Efficiency of the Affordable Housing Goals'',
Journal of Real Estate Finance and Economics 36 (2008).
\4\ ABT Associates ``Studies of Multifamily Underwriting and the
GSEs' Role in the Multifamily Market: Final Report'', prepared for HUD
(August 2001).
Q.2. Implied Guarantee--Mr. Shear, your report argues that the
GSEs' implied guarantee encouraged them to take greater risks
than a fully private entity would. In reviewing the last few
years' experience, did you compare the GSEs' portfolio
performance to that of other institutions, such as Lehman
Brothers, Bear Stearns, Merrill Lynch, and others holding large
amounts of mortgages and mortgage backed securities,
particularly private label securities? If so, how does the
performance of these fully private portfolios compare with
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those of the GSEs?
A.2. The enterprises' structures (for profit corporations that
derived benefits from their Government sponsorship,
particularly the implied Federal guarantee on their financial
obligations) undermined market discipline and provide them with
incentives to engage in potentially profitable business
practices that were risky and not necessarily supportive of
their public missions. In particular, the large retained
mortgage portfolios that the enterprises acquired over the
years, while potentially more profitable than their mortgage
securitization and guarantee business, exposed them to
considerable interest rate risk without a clear link as to how
such large portfolios benefited housing finance and other
mission objectives. In conjunction with the ineffective
regulatory structure that existed for the housing GSEs for many
years, the enterprises' activities involved significant risks
to taxpayers and financial stability. While the enterprises'
recent financial deterioration involved credit losses rather
than losses resulting from interest rate fluctuations, their
mortgage portfolios have proven to be a significant source of
operational and financial risk. As stated in our September 2009
report, the substantial financial restatements that both Fannie
Mae and Freddie Mac were required to make earlier in this
decade are generally attributable to the misapplication of
accounting rules for reporting on derivatives, which the
enterprises used to manage the interest rate risks associated
with their large mortgage portfolios. The report also noted
that, more recently, the enterprises purchased large volumes of
questionable subprime mortgage assets, which were held in their
portfolios. According to former FHFA Director Lockhart, by June
2009, 60 percent of the AAA-rated private label MBS that the
enterprises had purchased had been downgraded to below
investment grade and the losses on such asset had contributed
to the need to place the enterprises in conservatorships.
While our September 2009 report did not compare the GSEs'
recent business activities, particularly their investments in
private label MBS and guarantees on Alt-A mortgages, with those
of other private financial institutions, we acknowledge that
their appears to have been a breakdown in basic risk management
practices used to manage credit risk in a range of corporate
structures in addition to those of the GSEs, including
commercial banks and investment banks. It may take a
considerable period to determine why basic risk management
principles were ignored at so many companies and other market
participants, such as creditors and ratings agencies, as well
as why financial regulators failed to exercise sufficient
oversight and better ensure sound business practices. It does
appear, though, that the previously identified weaknesses in
the enterprises' corporate structures and regulatory oversight
structure facilitated their participation, along with many
other financial participants, in mortgage asset investments
that were unsafe and unsound and ultimately threatened
financial stability.
Q.3. Serving the Underserved--A number of witnesses, including
Director DeMarco, have said that they would prefer to see some
more transparent subsidy, like downpayment assistance, instead
of affordable housing goals in the future. However, one purpose
of the goals is to try to draw people into the mainstream
financial system. For example, FDIC Chairman Bair is trying to
bring the unbanked into the banking system because of the
overall benefits of doing so. Aren't there many additional
benefits to pulling people into the mainstream system, over and
above simply helping them get an affordable home?
A.3. Yes, there are clearly a range of additional benefits
associated with bringing individuals into the mainstream
financial system. In previous work, for example, we noted that
Federal officials and consumer advocates maintain that
predatory lenders often target certain populations, including
the elderly and some low-income and minority communities. \5\
Some advocates say that in many cases, predatory lenders target
communities that are underserved by mainstream institutions,
such as banks and thrifts, leaving borrowers with limited
credit options. A number of tools, including numeric mortgage
purchase goals, have the potential to bring individuals,
especially those that may be underserved by the market, into
the mainstream financial system.
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\5\ GAO, ``Consumer Protection: Federal and State Agencies Face
Challenges in Combating Predatory Lending'', GAO-04-280 (Washington,
DC: Jan. 30, 2004).
Q.4. Availability of Fixed-Rate, 30-Year Mortgage--One of the
crown jewels of our mortgage finance system is the availability
of a 30-year, fixed rate mortgage that a borrower can prepay
without penalty when interest rates decline. How do we ensure
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that this product remains available for American families?
A.4. While the fixed-rate, 30-year mortgage is likely to endure
under any of the options to revise the enterprises' long-term
corporate structures, we did state in our September 2009 report
that privatizing or terminating the enterprises could have a
limiting affect on their availability compared to prior
experience. If the enterprises were privatized or terminated,
the report noted, any ensuing private-secondary market
alternatives (such as a consortium of private-sector lenders)
might be less willing to purchase such mortgages then the
enterprises had been. As a result, lenders may be less willing
to originate fixed-rate 30-year mortgages due to the interest
rate risks associated with holding them in their portfolios.
However, the potential exists that the establishment of a
Government mortgage bond insurer for catastrophic risk, as has
been proposed in conjunction with proposals to privatize or
terminate the enterprises, could provide a mechanism for
primary mortgage originators to sell mortgages into secondary
markets and thereby help maintain the availability of fixed-
rate, 30-year mortgages.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
FROM SUSAN M. WACHTER
Q.1. Serving the Underserved--A number of witnesses, including
Director DeMarco, have said that they would prefer to see some
more transparent subsidy, like down payment assistance, instead
of affordable housing goals in the future. However, one purpose
of the goals is to try to draw people into the mainstream
financial system. For example, FDIC Chairman Bair is trying to
bring the unbanked into the banking system because of the
overall benefits of doing so. Aren't there many additional
benefits to pulling people into the mainstream system, over and
above simply helping they get an affordable home?
A.1. While down payment assistance is indeed a potential policy
tool, the cost of mainstreaming such a program is likely to
limit its availability. The housing finance system can
successfully encourage home ownership through cross-
subsidization. That is, marginal borrowers whose risk is
acceptable nonetheless pay a risk-adjusted rate that reflects
the average risk for the entire mortgage book of business,
without putting the financial system at risk. As to the
benefits of bringing the ``unbanked'' into the system, they are
real and important.
Q.2. Availability of Fixed-Rate, 30-Year Mortgage--One of the
crown jewels of our mortgage finance system is the availability
of a 30-year fixed-rate mortgage that a borrower can prepay
without penalty when interest rates decline. How do we ensure
that this product remains available for American families?
A.2. Fixed-rate mortgages are too risky for depositary
institutions to hold on their books because of interest-rate
risk. Thus, the availability of a 30-year fixed-rate mortgage,
which a borrower can prepay without penalty when interest rates
decline, cannot be ensured without a secondary market in which
mortgages are securitized. Throughout the world, there is only
one other country (Denmark) where fixed-rate prepayable
mortgages are offered, and the Danish mortgage system is based
on regulated securitization.
The Savings and Loan (S&L) crisis and similar crises in
other countries have made this point clear: fixed-rate
mortgages cannot be offered and held on portfolio by banks
without causing systemic risk. The result globally was that
banks shifted away from fixed-rate to adjustable-rate
mortgages. Because long-term, fixed-rate products are essential
to protect against the systemic risk of defaults caused by
volatile interest rates, a secondary market is an indispensable
part of a stable future housing finance system.
Nonetheless, we have seen the results, in the present
crisis, of the creation of secondary markets for mortgage-
backed securities without strict Government regulatory
oversight. In markets without such oversight, firms will
compete to offer aggressive lending instruments funded by
mortgage-backed securitization. As banks and securitization
firms compete for market share, the inevitable result is the
lowering of lending standards to increase securitization
profits over time. The result is increased demand for housing
and higher prices, making it appear as though real estate
markets are healthy and that lending is safe. The spread
throughout the market of aggressive lending boosts artificial
demand for real estate assets, fueling an unsustainable boom.
When the boom eventually busts, the resulting property value
declines lead to sharp declines in credit availability, which
negatively reverberates throughout the entire economy.
Regulatory control and oversight are needed to prevent
reckless lending from overcoming markets. Such regulatory
control is not possible without information on the loans that
are being securitized, their underwriting standards, and the
terms on which they are offered. In order to process such data
and to monitor markets and identify reckless lending, some
standardization is necessary. Without standardization, the
heterogeneity and complexity of MBS make real-time analysis of
what is in fact being offered in markets in the aggregate, and
how these terms are changing over time, nearly impossible.
Standardization both of mortgages and mortgage-backed
securities can assist in enabling risk and underwriting to be
monitored over the cycle, preventing the procyclical erosion of
lending standards. Standardization promotes liquidity, ensures
suitability, and enhances system stability, but standardization
will not come about without strict regulatory oversight. Thus
there must be a mechanism for limiting residential mortgage-
backed securitization to entities that are strictly monitored.
Without such risk monitoring, securitization, while necessary
for the steady provision of a 30-year fixed-rate mortgage, will
not be sufficient. It will subject homeowners and the overall
economy to credit-induced crises, which will cause housing
prices to plummet, putting the availability of all credit for
mortgages, including the 30-year fixed-rate mortgage,
cyclically at risk.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD
FROM ANDREW JAKABOVICS
Q.1. Serving the Underserved--A number of witnesses, including
Director DeMarco, have said that they would prefer to see some
more transparent subsidy, like downpayment assistance, instead
of affordable housing goals in the future. However, one purpose
of the goals is to try to draw people into the mainstream
financial system. For example, FDIC Chairman Bair is trying to
bring the unbanked into the banking system because of the
overall benefits of doing so. Aren't there many additional
benefits to pulling people into the mainstream system, over and
above simply helping them get an affordable home?
A.1. Connecting the underserved with the mainstream banking
system has benefits that flow to underserved families and
communities as well as to the institutions that extend credit.
Access to credit on fair and affordable terms allows low-income
and other ``unbanked'' individuals and families to keep more of
their hard-earned money. While credit card issuers have rightly
been chastised for recent moves to hike interest rates on their
cards prior to more stringent regulations coming into effect,
even the relatively high rates charged on those cards are far
less usurious than fees charged by payday lenders. From an
institutional perspective, bringing the unbanked into the
mainstream banking system allows the institutions to grow their
depository base. Moreover, lending to low- and moderate-income
households is often a profitable, not charitable, endeavor, in
part because these borrowers have typically been less likely to
refinance their mortgages as interest rates fall.
Q.2. Availability of Fixed-Rate, 30-Year Mortgage--One of the
crown jewels of our mortgage finance system is the availability
of a 30-year, fixed-rate mortgage that a borrower can prepay
without penalty when interest rates decline. How do we ensure
that this product remains available for American families?
A.2. Absent a policy intervention to ensure the availability of
these long-term mortgages, they probably will not exist, a
point implicitly acknowledged by Wells Fargo CEO John Stumpf in
a recent call for the GSEs to be given permission to purchase
jumbo mortgages as a way to ``help revive the moribund market
for big mortgages.'' Indeed, the existence of such mortgages
can be directly traced to public policy. The Home Owners' Loan
Corporation was created in 1933 at the height of the depression
to refinance distressed borrowers into stable, long-term--then
15-year--mortgages at up to 80 percent loan-to-value. FHA
followed the HOLC offering these innovative long-term products.
The adoption of the self-amortizing, fixed-rate mortgage by the
private sector was a reflection of a need to compete on the
best terms with public entities--in contrast to the race to the
bottom among lenders we have witnessed over the past several
years.
As we contemplate both the regulatory environment and the
institutions likely to emerge to provide capital and liquidity
to the mortgage markets, it will be necessary to ensure the
presence of an entity that has the ability to bridge the gap
between homeowners' desire for long-term affordable mortgages
and secondary market participants' need for easily marketable
securities that allow them to appropriately hedge against
interest rate risk. This role is currently being played by FHA/
Ginnie Mae and the GSEs, but we should not discount the private
sector's willingness to come back into the market in the
future. (There are a number of proposals that have been put
forth describing a restructured secondary mortgage market that
ignore the potential reemergence of a private label securities
market, thus leaving potential securitizers entirely
unregulated.)
Earlier this year, the Mortgage Finance Working Group
(MFWG) convened by the Center for American Progress released a
set of principles to guide redevelopment and regulation of a
renewed mortgage finance system. (The principles are available
here: http://www.americanprogress.org/issues/2009/03/pdf/
mortgage_finance_principles.pdf.) I believe that a system based
upon these principles offers the best way to ensure the ongoing
availability of 30-year, fixed-rate mortgages while still
leaving space for innovative (but safe) mortgage products to be
introduced into the marketplace. Members of the MFWG have been
developing a more complete blueprint of a restructured mortgage
finance system that we hope to introduce before the new year
that will more fully address the mechanisms through which we
can ensure a continuous presence of the loans that have proven
so critical in building the middle class.