[Senate Hearing 112-339]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 112-339



                               before the

                              COMMITTEE ON
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION




                       THURSDAY, OCTOBER 20, 2011


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                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         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                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Charles Yi, Chief Counsel

              Erin Barry Fuhrer, Professional Staff Member

                 William Fields, Legislative Assistant

                 Andrew Olmem, Republican Chief Counsel

            Chad Davis, Republican Professional Staff Member

                       Dawn Ratliff, Chief Clerk

                     Riker Vermilye, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor


                            C O N T E N T S


                       THURSDAY, OCTOBER 20, 2011


Opening statement of Chairman Johnson............................     1

Opening statements, comments, or prepared statements of:
    Senator Shelby...............................................     2


Janis Bowdler, Director, Wealth-Building Policy Project, Office 
  of Research, Advocacy, and Legislation, National Council of La 
  Raza...........................................................     3
    Prepared statement...........................................    25
    Response to written question of:
        Senator Shelby...........................................    67
John Fenton, President and CEO, Affinity Federal Credit Union, on 
  behalf of the National Association of Federal Credit Unions....     5
    Prepared statement...........................................    31
Anthony B. Sanders, Ph.D., Distinguished Professor of Finance, 
  George Mason School of Management..............................     7
    Prepared statement...........................................    39
    Response to written question of:
        Senator Shelby...........................................    68
Paul S. Willen, Ph.D., Senior Economist and Policy Advisor, 
  Federal Reserve Bank of Boston.................................     8
    Prepared statement...........................................    45
    Response to written questions of:
        Senator Shelby...........................................    69
Susan E. Woodward, Ph.D., President, Sand Hill Econometrics......    10
    Prepared statement...........................................    47
    Response to written question of:
        Senator Shelby...........................................    69



                       THURSDAY, OCTOBER 20, 2011

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 10:02 a.m. in room SD-538, Dirksen 
Senate Office Building, Hon. Tim Johnson, Chairman of the 
Committee, presiding.


    Chairman Johnson. I call this hearing to order.
    I would like to thank our witnesses for being with us 
today. This will be the 11th housing finance reform hearing 
held by the Committee. Before we began our series of hearings, 
I released my agenda for the Committee which included several 
priorities for housing finance reform. Maintaining the widely 
available 30-year, fixed-rate, prepayable mortgage was one of 
those priorities.
    I firmly believe that we need to reform our housing finance 
system, but I am concerned about the unintended consequences 
for our housing market and economy that could result. A new 
system that eliminates the most popular and stable mortgage 
product in the country would be a step backwards rather than an 
improvement to our housing market.
    Let me be clear. I am not advocating that the 30-year 
fixed-rate mortgage be the only product available. Shorter-term 
fixed-rate loans, like the 15-year or 20-year mortgage, can be 
appropriate for certain borrowers or families refinancing their 
mortgages. Well-underwritten, conventional, adjustable-rate 
mortgages can also be appropriate for borrowers who can afford 
them. However, any new housing finance system must ensure that 
the 30-year fixed-rate mortgage continue to be widely available 
to qualified borrowers across the country.
    The prepayable, long-term fixed-rate mortgage allows 
households to budget their finances better and establishes a 
stable housing cost which is not always available by renting. 
Homeownership is not the right choice for everyone, but for 
those who choose to own a home, the 30-year fixed-rate mortgage 
is the most predictable option for financing a home.
    Witness testimony during our last hearing stated that under 
some proposed systems, the 30-year fixed-rate mortgage would 
likely require substantial downpayments, higher incomes, and 
higher interest rates, restricting the number of borrowers to a 
substantially small number compared to today. This is the last 
thing our housing recovery needs.
    Our witnesses have extensive experience and knowledge about 
the impact the 30-year fixed-rate mortgage has had on 
homeowners, the mortgage market, and the economy. I look 
forward to hearing their testimony regarding its merits and 
risks as well as the options for Congress if we are to continue 
what I believe is a necessary product.
    With that, I will turn to Senator Shelby.


    Senator Shelby. Thank you, Mr. Chairman.
    Today's hearing, as you said, will examine the pros and 
cons of the Federal Government continuing basically to 
subsidize the 30-year fixed-rate mortgage. During the Great 
Depression, the Federal Government established direct and 
indirect subsidies for 30-year fixed-rate mortgages. For many 
Americans, the 30-year fixed-rate mortgage has made 
homeownership possible, yet the failure of Fannie and Freddie 
and the $169 bailout of those institutions demonstrate that the 
Federal Government's support for the 30-year mortgage comes 
with a cost.
    Accordingly, if this Committee ever decides to undertake 
housing finance reform, it will need to determine whether the 
benefits of the Government's support for the 30-year fixed-rate 
mortgage outweigh the costs. In addition, if it decides to 
continue to subsidize the 30-year fixed-rate mortgage, the 
Committee will need to find a way to protect taxpayers from 
having to pay for bailouts in the future.
    Today's hearing should provide some insight into how the 
Federal Government's support for the 30-year fixed-rate 
mortgage impacts consumers and taxpayers. For example, is the 
30-year fixed-rate mortgage always the best option for 
consumers? Is the prepayment option included in these 30-year 
fixed-rate mortgages truly free? And what has the subsidy of 
this product already cost the American taxpayer? And can this 
product be offered without that subsidy?
    Consumer choice I think is very important. Consumers should 
be able to purchase a 30-year fixed-rate mortgage at the 
appropriate market rate if they determine that that product is 
best for them. I think we must not create incentives that 
should push people toward a 30-year fixed-rate mortgage even 
when it would be harmful to them.
    I also hope to learn from today's hearing how subsidizing 
the 30-year fixed-rate mortgage impacts our financial system. 
For instance, is the claim that the financial crisis could have 
been averted if only more people possessed the 30-year fixed-
rate mortgage a fact or fiction? What unintended consequences 
have been created by subsidizing the 30-year fixed-rate 
    These are all important questions, and there are many more 
that I think need to be answered as we go along. For many 
people it is assumed that the narrative surrounding the 30-year 
fixed-rate mortgage has already been written and that there is 
no need to investigate the facts. As we proceed with housing 
finance reform, I think we must seek a full understanding of 
the facts. In other words, legislating by anecdote is not 
    We need to take a hard look at this product and determine 
if the preferential pricing resulting from these subsidies 
truly creates a public good. Only by doing a thorough, fact-
based analysis can we develop sensible, profound housing 
    Thank you, Mr. Chairman.
    Chairman Johnson. Thank you, Senator Shelby.
    Are there any other Members who wish to make a brief 
opening statement?
    [No response.]
    Chairman Johnson. Thank you all.
    I want to remind my colleagues that the record will be open 
for the next 7 days for opening statements and any other 
materials you would like to submit.
    Now I would like to welcome the witnesses for our panel 
today. Our first witness is Ms. Janis Bowdler. She is the 
Director of the Wealth-Building Policy Project with the 
National Council of La Raza.
    Mr. John Fenton is President and CEO of Affinity Federal 
Credit Union and is appearing on behalf of the National 
Association of Federal Credit Unions.
    Dr. Anthony Sanders is a Professor of Finance at George 
Mason University School of Management.
    Dr. Paul Willen is Senior Economist and Policy Advisor with 
the Federal Reserve Bank of Boston.
    And, finally, we have Dr. Susan Woodward, who is the 
President of Sand Hill Econometrics and the former Chief 
Economist at the SEC and prior to that HUD.
    We welcome you all here today and thank you for your time. 
Ms. Bowdler, you may proceed with your testimony.


    Ms. Bowdler. Thank you and good morning, and thank you for 
having me. My name is Janis Bowdler. I am the Director of the 
Wealth-Building Policy Project at the National Council of La 
Raza. My project promotes fair markets where Latino families 
can obtain assets and build wealth they can share with their 
children. I hope that today's hearing will shed light on a 
critical issue: the importance of the 30-year fixed-rate 
mortgage. Without this flexible financing tool, homeownership 
would become a luxury reserved for the affluent. We urge 
Congress not to abandon their commitment to providing a path to 
homeownership, which has long been the cornerstone of middle-
class wealth.
    This morning I will provide a brief overview of the 
importance of the 30-year fixed-rate mortgage. I will also 
share our ideas on how to maintain a responsible path to 
homeownership for future generations. Let me start with the 
benefits of the 30-year fixed.
    The long term makes the asset more affordable. The fixed 
rate provides certainty. Modest downpayments open the door for 
those with sufficient incomes but who lack the family wealth. 
The amortization feature means the borrower can predict the 
final payment and build wealth as principal is repaid. Finally, 
most prime 30-year fixed-rate notes are prepayable, which means 
that the borrower can refinance or sell without penalty.
    In sum, there are two key reasons why supporting the 30-
year fixed-rate mortgage is good public policy. It makes 
homeownership affordable to working- and middle-class families 
who did not inherit wealth, and it provides stability to 
families who have to budget carefully to keep their biggest 
asset and investment--their home. Together, these features have 
helped create a stronger middle class. This is especially true 
for Hispanic and black homeowners for whom home equity makes up 
the majority of their wealth.
    Unfortunately, the benefits of homeownership have not been 
equally available. An abundance of research has documented the 
unfair steering of borrowers of color to toxic mortgages, even 
when they qualified for prime loans. The subprime loans are not 
only expensive, they are also more likely to end up in default. 
So it is not surprising that Latinos have been hit hard by the 
foreclosure crisis. In fact, new data shows that wealth held in 
white households exceeds that of Latinos by a staggering 18:1, 
and 20:1 for African Americans. This gap is attributed to 
differences in home equity and the loss of homes through 
    Critics of the 30-year fixed note will argue that families 
would be better off in adjustable mortgages. However, most 
families do not view their home as a get-rich-quick scheme. 
They do not play the markets and they do not hedge interest 
rate risk. Rather, they are investing in a nest egg and a 
community with the anticipation of long-term returns. The 
predictability and security of a 30-year fixed-rate mortgage 
helps them meet those goals.
    Of course, no one is suggesting that a family enter 
homeownership unprepared, and we definitely need a robust 
rental market for families for whom homeownership is not 
available or desirable. That said, now is not the time to 
abandon our commitment to putting ownership in reach of 
qualified families when it is their time. Several decades of 
innovative, affordable lending has taught us how to reduce the 
risk of lending to new buyers and low-wealth households.
    For example, in a recent comparison of like borrowers where 
the only difference was the kind of loan they received, an 
affordable 30-year versus a subprime loan, the 30-year fixed 
dramatically outperformed the subprime loan. This reflects our 
own experience with first-time homebuyers. Over the last 13 
years, NCLR Homeownership Network counselors have helped more 
than 25,000 moderate-income families purchase a home with a 
prime mortgage. This evidence shows that when families receive 
the right loan with the right support, they can be successful 
homeowners and build wealth, even with modest incomes and low 
    Unfortunately, tight credit standards, pricing adjustments 
by the GSEs, and overlays on FHA are limiting prime loans in 
the market today and preventing qualified families from taking 
advantage of low rates and home prices. However, it is the 
threat to the future of affordable lending that has us most 
concerned. Earlier this year, Federal bank regulators promoted 
the idea of a wealth standard that would cement high 
downpayment requirements and regulations, and critics of Fannie 
and Freddie are going further by pushing for a complete 
dismantling of our current secondary market system, even though 
lenders, especially small community lenders, say they would not 
be able to offer a fully amortizing 30-year loan in a 
completely private system.
    Rather than dismiss a proven finance tool and affordability 
features, we should work together to preserve those aspects of 
our housing finance system that work well. I have attached to 
my written statement a set of principles to guide our thinking 
on GSE reform. It is signed by NCLR and 16 other civil rights 
organizations. In addition to the principles laid out in that 
letter, I offer three specific recommendations today:
    Maintain secondary market liquidity for affordable 30-year 
fixed-rate loans that are made equally available to all 
qualified families;
    Support pre-purchase housing counseling and other credit 
enhancements that we know work for working families;
    And reduce barriers to purchasing a home by eliminating 
loan level pricing adjustments and expanding the use of proven 
affordable lending models.
    Thank you, and I would be happy to answer any questions.
    Chairman Johnson. Thank you.
    Mr. Fenton, you may proceed.

                         CREDIT UNIONS

    Mr. Fenton. Good morning, Chairman Johnson, Ranking Member 
Shelby, and Members of the Committee. My name is John Fenton, 
and I am testifying today on behalf of NAFCU. We appreciate the 
opportunity to share our views on housing finance reform and 
the value of the 30-year fixed-rate mortgage to credit unions 
and our members.
    Credit unions were not the cause of the recent economic 
crisis, and an examination of their lending data indicates that 
credit union mortgage lending has outperformed bank mortgage 
lending during the downturn. Credit unions focused on placing 
their members in solid products that they could afford.
    Furthermore, there is no evidence that the recession and 
collapse of the housing market was due to the presence of 30-
year fixed-rate mortgages. Congress gave credit unions the 
authority to offer 30-year mortgages back in 1977, and it has 
since been our dominant instrument in mortgage originations.
    The fixed-rate mortgage is regarded as a consumer-friendly 
instrument because it is straightforward, easy to understand, 
and provides a predictable monthly payment schedule. With a 
fixed-rate mortgage, the lending institution assumes the risk 
associated with interest rate risk increases. Having too many 
long-term fixed-rate mortgages in the portfolio subjects the 
financial institution to greater interest rate risk and can be 
cause for examiner concern. At Affinity we mitigate risk in our 
long-term fixed-rate mortgage portfolio by hedging with 
interest rate swaps, caps, and matched borrowings. Selling on 
the secondary market to Fannie and Freddie is also an important 
risk mitigation tool. The securitization activities of Fannie 
and Freddie help lower the relative cost of 30-year fixed-rate 
mortgages and are an important factor in its viability.
    Without a Government role in the secondary market, the 30-
year fixed-rate mortgage may still exist, but likely with 
higher cost to the consumer and scarce availability. Long-term 
fixed-rate mortgages will become riskier propositions for 
credit unions. For safety and soundness reasons, consumers may 
face additional costs to mitigate risk. The lack of a 
Government role as a stabilizing force in the secondary market 
would have a significant impact on the ability of credit unions 
to offer affordable, consumer-friendly mortgages such as the 
30-year fixed-rate mortgage. We believe that it would further 
limit the availability of long-term fixed-rate mortgage 
products and substantially increase the costs of mortgages to 
    Fannie and Freddie, as well as the Federal home loan banks, 
are valuable partners for credit unions who seek to hedge 
against the interest rate risks by selling their fixed-rate 
mortgages to them on the secondary market. Because Fannie and 
Freddie will buy loans on the secondary market, the credit 
union is not only able to mitigate the risks associated with 
these interest rates, but the liquidity created allows them to 
reinvest those funds into their membership or institution by 
making new loans. Without these relationships, credit unions 
would be unable to provide the services and financial products 
that their memberships demand and expect.
    NAFCU would like to stress the importance of retaining a 
system that provides credit unions with access to the secondary 
market necessary to serve the mortgage needs of our 93 million 
members. As you consider legislative proposals for housing 
finance reform, we believe there is a core set of principles 
that must be considered to ensure that credit unions are 
treated fairly.
    One, a healthy and viable secondary market must be 
    Two, there should be at least two GSE-type entities to 
ensure competition and to perform the essential functions 
currently performed by Fannie and Freddie.
    The U.S. Government should issue explicit guarantees on the 
payment of principal and interest on mortgage-backed 
    Four, during any transition to a new system, credit unions 
must have uninterrupted access to the GSEs and, in turn, to the 
secondary market.
    Five, credit unions could support a model for the GSEs that 
is consistent with a cooperative or a mutual entities model.
    Six, a board of advisors should be formed to advise the 
FHFA regarding GSEs.
    Seven, while a central role for the U.S. Government in the 
secondary market is vital, the GSEs should be self-funded. GSE 
fee structures should place increased emphasis on quality of 
loans. Risk-based pricing for loan purchases should reflect 
that quality difference.
    Eight, Fannie and Freddie should continue to function, 
until such time as necessary to repay the Government debts.
    And, ten, reform of the Nation's housing finance system 
must take into account the consequence of any legislation on 
the health and reliability of the Federal home loan banks.
    In conclusion, the 30-year fixed-rate mortgage remains the 
most popular mortgage product to credit union members today. As 
such, it is necessary for the health of the housing market and 
the continued recovery of our economy that it remains a readily 
available product. The ability of credit unions to make these 
loans and to mitigate the interest rate risk by selling them to 
GSEs on the secondary market is important. With efforts to 
reform the Nation's housing finance system, it is important to 
consider the impact reforms may have on credit unions and make 
sure that they maintain access to a viable secondary market.
    We thank you for your time and the opportunity to testify 
before you here today, and I would welcome any questions you 
    Chairman Johnson. Thank you.
    Dr. Sanders, you may proceed.


    Mr. Sanders. Mr. Chairman and distinguished Members of the 
Committee, my name is Dr. Anthony B. Sanders, and I am the 
Distinguished Professor of Finance at George Mason University 
and a senior scholar at the Mercatus Center. It is an honor to 
testify before this Committee today.
    The fixed-rate mortgage occupies a central role in the U.S. 
housing finance system. The dominant instrument since the Great 
Depression, the FRM currently accounts for more than 90 percent 
of mortgage originations. One reason why it enjoys enduring 
popularity is that the FRM is a consumer-friendly instrument. 
Not only does the FRM offer payment stability, the instrument 
provides a one-sided bet in the borrower's favor. If rates 
rise, the borrower benefits from a below-market interest rate. 
If rates fall, the borrower can benefit from exercising the 
prepayment option in the FRM to lower their mortgage interest 
    But these consumer benefits have costs. It is costly to 
provide a fixed nominal interest rate for as long as 30 years. 
And the prepayment option creates significant costs. If rates 
rise, the lender has a below-market rate asset on its books. If 
rates fall, the lender again loses as the mortgage is replaced 
by another one at a lower interest rate. To compensate for this 
risk, lenders incorporate a premium in mortgage rates that all 
borrowers pay regardless of whether they benefit from a 
refinance or not. Exercise of the prepayment option in the 
contract also has significant transactions costs for the 
borrower and imposes additional operating costs for the 
mortgage industry.
    The adjustable-rate mortgage, or ARM, and shorter-maturity 
mortgages also have consumer-friendly benefits that are often 
overlooked. Banks, S&Ls, and other lenders will originate and 
hold 30-year fixed-rate mortgages even without the Government 
guarantee, just like they have done in previous years. This may 
be a short-term effect if some claim they cannot do this simply 
because Freddie Mac, Fannie Mae, and the FHA have cornered the 
mortgage market.
    Second, we are the only country in the world with such a 
high 30-year fixed-rate concentration and Government housing 
mortgage subsidies. Most countries have higher percentages of 
shorter-maturity mortgages and ARMs than the United States and 
did not suffer the magnitude of the housing bubble burst that 
the United States experienced.
    Third, the U.S. homeownership rate is comparable to that of 
other countries that have higher ARM and short-maturity 
mortgages, so there is nothing magical about the 30-year fixed-
rate mortgage and homeownership.
    Fourth, ARM rates such as 5/1 ARMs are typically less 
expensive to consumers than fixed-rate mortgages, generally 
from 100 to 150 basis points.
    Fifth, all 30-year fixed-rate mortgage borrowers pay for 
the prepayment option even if they do not use it. Why not give 
consumers a choice of a less expensive non-prepayable mortgage 
that carries a lower rate of interest or a mortgage with 
refinancing penalties, again, resulting in a lower mortgage 
interest rate for consumers?
    Sixth, the 30-year fixed-rate mortgage, which has a 95-
percent market share, is risky for consumers since the 
principal pays down so slowly, small house price declines 
coupled with low downpayments put the borrowers into a 
stressful negative equity position, often very quickly. Should 
we be promoting 10- and 15-year mortgages instead, or 7? The 
30-year fixed-rate mortgage leads to consumption of larger 
housing compared with 15-year mortgages since the payments are 
reduced via slower principal amortization. Is that our public 
policy objective, to put households in the biggest houses they 
can afford?
    Eight, ARMs actually are consumer friendly in that by 
sharing the interest rate risk with lenders and investors, 
borrowers will be more careful about taking on more debt; that 
is, buying too much house even if the underwriting allows them 
    Ninth, if we examine FHFA's 2001-02 enterprise loan 
acquisitions, we find that ARMs actually had lower default 
rates than fixed-rate mortgages.
    And, tenth, please bear this in mind. Homeowners, according 
to the Federal Reserve, lost $7.25 trillion from the peak of 
the housing bubble. Can we afford to do this again? Should we 
be putting everybody into low downpayment, 30-year, slow 
amortization mortgages which are catastrophic to those 
households if the market tanks again?
    I understand why some consumers like the comfort of the 
fixed mortgage payments where they can prepay and lower their 
mortgage payment at will, but comfort comes at a cost in terms 
of higher mortgage rates and costs to taxpayers.
    On the other hand, I do not equate Government policy 
encouraging households to buy larger houses and take on greater 
risk that they can afford as consumer friendly.
    Thank you for the opportunity to testify.
    Chairman Johnson. Thank you.
    Dr. Willen, you may proceed.


    Mr. Willen. Thank you. Chairman Johnson, Ranking Member 
Shelby, and distinguished Members of the Committee, I thank you 
for your invitation to testify today. My name is Paul Willen, 
and I am a senior economist and policy advisor at the Federal 
Reserve Bank of Boston. I come to you today, however, as a 
researcher and not as a representative of either the Boston Fed 
or the Board of Governors.
    What I am going to take on today in my spoken remarks is a 
kind of conventional wisdom about the fixed-rate mortgage, and 
it starts with the invention of the fixed-rate mortgage, which 
is widely attributed to the FHA. The conventional wisdom is 
that in the 1930s most--prior to the 1930s, prior to the 
Depression, most American families or almost all of them had 
short-term variable-rate mortgages. These mortgages exposed 
them to volatile payments and caused massive disruptions during 
the Depression. And so the FHA, the conventional wisdom says, 
in order to solve this problem invented a new type of mortgage, 
which was the long-term fixed-rate mortgage. And the point of 
it was that the payment the borrower made never changed until 
the loan was paid off. Month in, month out, the borrower was 
never vulnerable to payment shock. And I think the conventional 
wisdom sort of views the fixed-rate mortgage as a sort of 
safety mortgage, sort of like the safety elevator came along. 
Before the safety elevator, if the cable in an elevator 
snapped, the passengers plunged hundreds of feet to certain 
death, and the safety mortgage took something that was very 
risky, like the previous elevators, and replaced it with 
something that was sort of inherently safe.
    The conventional wisdom goes on to say that in the 2000s 
lenders forgot the lessons of the 1930s and started issuing 
complex, exotic, adjustable-rate mortgages. Borrowers were hit 
with these payment shocks, and the critical number of these 
payment shocks is what caused the crisis. So I am going to take 
on this conventional wisdom and argue that these basic premises 
do not fit the facts.
    The first thing is the long-term fixed-rate mortgage was 
not invented in the 1930s by FHA. It was invented 100 years 
earlier by building and loan societies, and building and loan 
societies were not some niche player in the housing market. 
They were the single largest source of funding for the typical 
American family when they got a mortgage. They were widely 
used, and in 1929, the year immediately preceding the 
Depression, when they were supposedly invented, 40 percent by 
dollar value and a much higher number in number of the 
mortgages originated were originated by building and loan 
societies, and 95 percent of those originations were long-term, 
fixed-rate, fully amortizing mortgages. You can see it is in 
Table 2 in my prepared testimony. Despite offering only long-
term fixed-rate mortgages, building and loan societies were 
devastated by foreclosures during the Depression.
    In the recent crisis, you say, well, maybe it was not an 
issue in the Depression, what about the most recent crisis, 
wasn't that cause by payment shocks and adjustable rate 
mortgages? So in Table 1 of my prepared testimony, I show some 
data that we put together, but everyone who has looked at the 
individual level data, who has looked at it, the mortgage level 
data or property level data, has come to the same conclusion. 
Our sample is a sample of 2.6 million foreclosures, so these 
are all borrowers who lost their home, and what we show is that 
88 percent of them suffered no payment shock prior to 
defaulting on their mortgage. The mortgage payment they made 
when they defaulted on the loan was exactly the same as the 
payment they made when they got the loan, the initial payment 
on their mortgage. In fact, of that sample, 59 percent of them 
actually had fixed-rate mortgages. That is something like 1.6 
million mortgages. That alone should disabuse us of any notion 
that a fixed-rate mortgage is an inherently safe product.
    OK. So let me just conclude by saying that when owning a 
home financed by a mortgage, a family faces many risks. There 
is job loss. There is illness. There is business failure. There 
is divorce. And what we have learned recently, the most 
important one of all, there is falling house prices. What our 
research has shown over and over again is that, compared to 
those risks, fluctuating mortgage payments present a small 
problem. So let me just say that the benefits in terms of 
foreclosure prevention of ensuring availability of a mortgage 
with a payment that can never go up in my opinion is very 
    Let me say I hope you find that these findings add insight 
to your work as policymakers, and thank you again for the 
opportunity to appear today. I would be happy to address any 
    Chairman Johnson. Thank you.
    Dr. Woodward, you may proceed.


    Ms. Woodward. Senators and Committee staff, I am honored to 
be invited to share my views with you. Thank you so much for 
inviting me.
    I am Susan Woodward. I am here representing myself. I am an 
independent economist now, but I lived for 10 years in 
Washington and served 4 years as Chief Economist at HUD and 
another 4 years as Chief Economist at the Securities and 
Exchange Commission.
    The critics of the 30-year fixed-rate loan claim that it is 
unfair for homeowners to benefit from the risk avoided by 
fixed-rate loans while taxpayers bear the risk from it. I think 
what this claim forgets is that taxpayers are homeowners, too. 
If we consider the lifetime exposure of homeowner/taxpayers, 
there is nothing unfair about this tradeoff. In fact, I think 
it is a really important piece of social policy. But let me 
offer first a few facts.
    While the homeownership rate now stands between 65 and 70 
percent, the fraction of households that eventually become 
homeowners at some point in their lives is more like 85 
    Second, household incomes rise over time and peak at about 
age 55.
    Third, homeowning households on average have higher incomes 
and pay more taxes than others. Thus, the people who benefit 
from the availability of a 30-year fixed-rate loan are also the 
same people who pay taxes if and when problems arise. The 
benefits come when families are young and have more need for 
security, and the same people potentially bear a cost when they 
are older and have more income. This is a fair tradeoff. Ask 
the taxpayer/home-owners. Tell them what the deal is. My guess 
is all of them will say, yes, we want the 30-year fixed to be 
    And we should not forget the risk of adjustable-rate loans. 
This has been downplayed so far, but in the current 
environment, I think there is some considerable risk. The ARM 
design is basically flawed because it does not link payment 
changes to household income changes. To take an example based 
on numbers that are relevant to today, suppose the rate of 
inflation picked up from, say, 2 percent to 4 percent, moving 
the homeowners rate from 4 percent to 6 percent, the likely 
change in the homeowner's income is the current inflation rate 
of about 4 percent. But the borrower's payment on a young-ish 
mortgage will rise about 25 percent. Only affluent households 
with a lot of room to maneuver can tolerate this level of cash-
flow uncertainty. And it was mostly affluent households that 
prior to this financial crisis had the adjustable-rate loans.
    ARMs threaten the economy, too. The recession of 1980-82 
would have been far worse with far higher levels of mortgage 
defaults and an even bigger collapse in economic activity if 
all borrowers had had ARM loans then. That is my first point. 
Yes, the 30-year fixed-rate loan has some risk of potential 
cost to taxpayers, but since taxpayers are virtually all 
homeowners also, there is nothing unfair about this tradeoff.
    OK. The second issue, do we need Government support for the 
30-year fixed? I believe that the answer is yes, that it helps. 
The two most important innovations in financial markets in the 
20th century were undertaken by the Federal Government. The 
first was FHA's support for long-term, amortizing, fixed-rate, 
and prepayable loans. Now, Paul and I have discussed this 
before the hearing, exactly what FHA's role was. It made the 
amortization baked in and more precisely scheduled, not tied to 
ownership of shares in building and loan societies. And it also 
pooled the default risk nationwide through the FHA insurance 
fund. And so borrowers really were better off, and banks were 
better off, too, because they were much more comfortable making 
these loans than with the situation that we had before. So it 
was a huge innovation, and it improved the stability of housing 
finance and the quality of life for households, too.
    The second big innovation was Ginnie Mae. Ginnie was and is 
an astounding success. Ginnie Mae's role is to package already 
insured FHA loans into traded securities. When Ginnie was 
introduced, FHA borrowing rates fell 70 basis points. With a 
long-term real mortgage rate of about 4 percent, that is a big 
    What is more, I believe that there is no cost to taxpayers 
from Ginnie Mae. This was all entirely already insured FHA 
Loans, and what this was was an improved packaging of them.
    And so at the end of the day, we are not going to have 
institutions like Ginnie or Fannie and Freddie without some 
Government push, especially now when the large banks have such 
better access to the capital markets than the smaller lenders 
do. If we are going to give the smaller lenders that access 
also, and I believe there are many reasons that we should, then 
we should have a continued role of the Federal Government in 
the market.
    Thank you.
    Chairman Johnson. Thank you.
    Dr. Woodward, what elements of today's housing finance 
market must be preserved to ensure the availability of the 30-
year fixed-rate mortgage for borrowers in rural areas like 
those in my State of South Dakota?
    Ms. Woodward. I think that the really essential function if 
Ginnie Mae, Fannie, and Freddie is to be able to turn illiquid 
whole loans into liquid securities through an entity like them.
    Chairman Johnson. Dr. Willen, in the past 4 years, we have 
seen a major dip in the origination of adjustable-rate 
mortgages as the credit markets dried up and an increase in 
percentage of 30-year fixed-rate products. If the 30-year 
fixed-rate mortgage were eliminated, how would the availability 
of credit to average Americans change in times of economic 
    Mr. Willen. Well, I think there are two separate questions 
here. Again, I think we need to make sure, I think in all these 
conversations, that we separate out what it is--the 30-year 
fixed-rate mortgage, really what we are here discussing I think 
is the fixed-rate part of it. I think there is an issue. What 
happened in the last 4 years, when the mortgage market 
collapsed in 2008, is that every part of the mortgage market 
collapsed, including the Government-insured part of it, 
including Fannie and Freddie. And so if Fannie and Freddie had 
been doing--or if the mortgage market--if the Government was 
going to intervene to back up the market, they could have just 
as well intervened to back up the adjustable-rate market. The 
point was that the portion of the market that we intervened to 
help was the fixed-rate part of the market, and that is why the 
fixed-rate part of the market was the part that survived. So, 
for example, when the Federal Reserve engaged in large-scale 
asset purchases, we almost exclusively bought mortgage-backed 
securities backed by fixed-rate products.
    Chairman Johnson. Ms. Bowdler, I have a question for you 
about eliminating the Government guarantee. How would the 
absence of a Government guarantee affect the availability of 
the 30-year fixed-rate, prepayable mortgage? How would this 
ultimately affect the average American borrower?
    Ms. Bowdler. Our understanding, from having talked to a lot 
of lenders, is that without that guarantee they would not only 
offer--they would not offer 30-year fixed-rate mortgages, and 
they would not be able to offer long-term financing at rates 
that the average person can afford. And so, yes, some sort of 
financing may continue to exist without the next generation of 
Fannie and Freddie, but it would not be for the average middle-
class family. It would only be for families that have large 
amounts of inherited wealth that they can put toward 
downpayment or that they can use to ride out interest rate 
    Chairman Johnson. Dr. Woodward, in your research what 
skills do borrowers need to have to evaluate the risks of 
adjustable-rate mortgages or understand how their interest 
rates would adjust?
    Ms. Woodward. They need at least an MBA. I think it cannot 
be even 1 percent of households that really understand the 
interest rates that are behind ARMs, the London Interbank 
Borrowing Rate, even the 1-year Treasury rate, I had a friend's 
panicked daughter come to me in 2007 because she could not 
refinance her ARM. And so I looked at her loan documents, and 
her ARM was tied to the 12-month moving average of 1-year 
Treasurys. I know exactly where to look up this number. It is a 
fairly benign ARM index. But she was completely panicked. She 
had no idea to what rate her loan might reset. Once I told her 
what it was going to look like, then she calmed down, and she 
just let the ARM reset. It was fine. But I think that almost no 
households really understand the interest rates to which their 
ARMs are linked.
    Finance is hard. People have to stay in school a long time 
to learn finance
    Chairman Johnson. Mr. Fenton, what are the characteristics 
of the borrowers that come to your institution and request 30-
year fixed-rate mortgages? Why is that product so popular?
    Mr. Fenton. The characteristics are very diverse. We have 
all different segments of the community come in to borrow, and 
the product itself is important at different times. You have to 
offer members choice. They have all different levels of credit 
backgrounds and understanding of the products that are out 
there. But the key to it is to understand that in a time of low 
interest rates you need to be able to support a product like a 
30-year fixed-rate mortgage, and in times of rising interest 
rates you might look at a different type of product. And in our 
case, we evaluate each member as they come in based on their 
needs and what is the best product for them.
    Chairman Johnson. Senator Shelby.
    Senator Shelby. Thank you, Mr. Chairman.
    Dr. Sanders, a central argument made by some advocates for 
the continuation of the Federal guarantee of mortgages is that 
without the guarantee the 30-year fixed-rate mortgage would not 
be available to consumers. For the moment, if we could just set 
aside the question of whether the 30-year mortgage is always 
the best product for consumers and go to this: Based on your 
research, if a consumer desires this product, would it be 
available even if there is not a Federal guarantee? Just 
anecdotally, I can go back to myself many years back, and I 
bought a house. It was a conventional 30-year mortgage from an 
insurance company. There was no Federal guarantee involved. The 
Federal Government was not involved. We had to come up with a 
pretty healthy downpayment, but that is what we wanted to do. 
    Mr. Sanders. Well, again, like yourself, my experience has 
been I have had home loans, both ARMs and fixed-rate mortgages 
from S&Ls and banks, and they were never touched by Fannie and 
Freddie. So the answer is that once we get out of this rut we 
are in, they will start making loans again. The problem we have 
now is since Fannie, Freddie, and FHA have such a dominant 
presence in the securitization market, and as Mr. Willen has 
pointed out, one of the key things of our various bailouts is 
that we bailed out the 30-year fixed and not the ARM, so we de 
facto have made it the contract of choice in the United States. 
So we kind of undercut the private sector so that they do not 
want to hold the interest rate risk.
    And, by the way, just to follow up on something, everyone 
here is mentioning the fact that there is interest rate risk 
associated with a 30-year fixed, but they are more than willing 
to dump them on the taxpayers and Fannie and Freddie because 
they do not want to be touched by the--and I understand it, but 
we should be forcing consumers to bear a part of that risk as 
opposed to having somebody in Keokuk, Iowa, suddenly get hit 
with a higher tax bill because somebody had a fixed-rate 
mortgage that went underwater again. But it will come back.
    Senator Shelby. The prepayment option, in your testimony 
you discuss how borrowers who have a 30-year fixed-rate 
mortgage with a so-called free prepayment option are, in fact, 
paying for that option whether or not they realize it or not. 
Explain what you mean.
    Mr. Sanders. Well, in other countries they actually have 
non-prepayable mortgages. You sign up, and unless you move or 
sell the house or some other form of termination, you are stuck 
with the interest rate you get. And if we compare in other 
countries the non-prepayable mortgages with a prepayable one, 
there is a substantial difference in interest rates. It can be 
anywhere from 30 to 70 basis points. So, in other words, we 
could help consumers out by actually offering them a non-
prepayable mortgage, and it would actually cut their expenses. 
ARMs are cheaper, 15-fixed are cheaper. I do not know why we 
are bent on the most expensive of the contracts to give 
consumers. To help them?
    Senator Shelby. I do agree with the economist here that a 
lot of consumers do not understand the adjustable-rate 
mortgage. What can we do to make them understand? Can we be 
more explicit in their terms when they are buying a house or 
making a loan and say, ``look, you are paying X today, but this 
could go up, it might go down,'' you know, rather than just 
``sign here, sign here''? A lot of them do not understand, and 
they are not that sophisticated. A lot of them are very 
    Mr. Sanders. Two issues. We discussed this at one of the 
Wharton mortgage conferences where we said it was very simple 
to have a simple cover sheet, like we do in securities, where 
we have a risk page, saying that--in fact, we sort of do have 
this, but saying here is your current rate, and it will be 
fixed for this amount of time, and at the end of that time it 
goes up to whatever LIBOR plus some spread, have that laid out 
explicitly, and I know Susan is going to kick me after this 
thing is over, but I just want to point out one thing. If a 
consumer sees something and it has terminology like LIBOR in 
the contract and they have no idea what it is, why did you sign 
it? I would suggest a little research by consumers to help 
themselves to look into these things.
    And, again, I think--and Susan actually clarified this 
quite nicely. It is much more benign than we are making it 
sound. LIBOR-indexed ARMs are not a problem. But, again, we 
could make it more clear perhaps. But that is not because of 
the problem in the country.
    Senator Shelby. Dr. Willen, I want to direct this to you, 
if I could. I want to say this. Dr. Woodward states, quoting 
her, ``The 30-year fixed-rate loan is unquestionably easier for 
households to understand than any adjustable-rate mortgage.'' 
She further states that the average household will not 
understand what risk it is undertaking with an ARM, adjustable-
rate mortgage.
    Dr. Woodward's behavior on economics approach, as I 
understand it, to this issue suggests that consumers are not 
capable of making educated choices. I think they could make 
those choices.
    Based on your research, Dr. Willen, have you seen any 
evidence that suggests that consumers are not sophisticated 
enough to handle an adjustable-rate mortgage and this has led 
to an increase in foreclosures? And let me ask a follow-up to 
this. Are there in stances in your research in which the 30-
year fixed-rate mortgage could actually be more harmful to a 
borrower than an adjustable-rate mortgage?
    Mr. Willen. All right. So let me answer.
    Senator Shelby. First, first.
    Mr. Willen. First, first. There are many things we deal 
with in life that we do not--where we have as much 
understanding as we need. So most people do not understand what 
a transmission is or how it works, but that does not stop them 
from driving cars.
    The risk embedded in an adjustable-rate mortgage--this is 
what I keep coming back to--compared to employment risk, 
compared to the risk they face in their jobs, the income risk 
that they face in their jobs, is tiny and no one understands 
employment risk. You know, to understand the distribution of 
your labor income next year, no one understands that, and yet 
everybody lives with--you know, those people who do not work 
for the Government live with income risk all the time, and 
    Senator Shelby. And that is most people, isn't it?
    Mr. Willen. And that is most people, and they deal with it. 
And it is much bigger. So, you know, if the mortgage payment is 
a third of your income and it goes up by 10 percent, that is 3 
percent of your income. People deal with 25-percent income loss 
in a year, and they do not end up in foreclosure, and they do 
not end up bankrupt. So I think people can handle risk, so that 
is the answer to your first question. Remind me of the second? 
Oh, the benefits.
    Senator Shelby. That is right.
    Mr. Willen. So, actually, I think in this crisis we have 
seen exactly how much damage the fixed-rate mortgage can do. So 
everybody focuses on the fact that rates on adjustable-rate 
mortgages can go up, and we completely dismiss the fact that 
they can go down. And they do not go down randomly. They go 
down when interest rates go down. And when do interest rates go 
down? Usually they go down in recessions, and they have gone 
down by 500--LIBOR has gone down by 500 basis points. We looked 
in the data. So people who had fixed-rate mortgages from 2005 
and 2006 and 2007, most of them are paying 5.5 percent or more 
on those mortgages. These are the people with negative equity. 
The people who had adjustable-rate mortgages, their rates are 
under 4.5 and a third of them are paying less than 3.5 percent 
on their mortgages. They do that without any assistance 
whatsoever from anyone. They do not have to beg their lender. 
They do not have to get a modification. The only people with 
fixed-rate mortgages and negative equity who are paying low 
interest rates are people who have fought bitterly with their 
servicer to get a modification.
    So the adjustable-rate mortgage has this automatic built-in 
stabilizer property which the fixed-rate mortgage does not.
    Just one more thing. Prepayment is not free. You have to 
get an entirely new mortgage, and that costs----
    Senator Shelby. It is built in to the price, isn't it?
    Mr. Willen. No, no. When you get the--in other words, the 
option is not free, that is right. But even when you get the--
right now why are we having this problem? Why are we having 
hearings about the fact that people cannot refinance their 
mortgages? It is because between the closing costs, getting new 
title insurance, you know, covering the transaction costs to 
the lender and all of that, it costs 2 points. So there is no 
free prepayment, forgetting the option price. That is why so 
few people are refinancing right now.
    Senator Shelby. But in all fairness, adjustable-rate 
mortgages, you have got to tell the consumer it can go down, 
which it has been doing because of the price of money.
    Mr. Willen. Absolutely.
    Senator Shelby. But it could go up, too.
    Mr. Willen. Absolutely.
    Senator Shelby. And oftentimes I think a lot of people have 
not realized that. But they should.
    Mr. Willen. They should. Let me say, just going back to 
this, at least in Massachusetts, there is a rider on an 
adjustable-rate mortgage which every borrower signs, which goes 
through--it does exactly what you describe. It says this is 
your rate, this is what it is tied to, this is where you can 
find it out, and this is what will happen if the rate goes up 
and this is what will happen if the rate goes down.
    Senator Shelby. Thank you, Mr. Chairman.
    Chairman Johnson. Senator Reed.
    Senator Reed. Dr. Willen, in your testimony you point out, 
I believe, that adjustable-rate mortgages are defaulting more 
than fixed-rate mortgages--or, in your words, fixed-rate 
mortgages default less often than adjustable-rate mortgages. I 
will put it precisely. So if there is this automatic correction 
benefiting from falling rates, why are people with adjustable 
mortgage rates defaulting more?
    Mr. Willen. OK, so let me be careful about that. There is a 
difference. It is a relatively small difference. It is not 
anywhere of the order of magnitude of the increase in 
foreclosures that we have seen. In other words, going from 1 or 
2 percent of borrowers or 1 percent of borrowers to 5 percent 
of borrowers, that is not because of adjustable-rate mortgages. 
That is because of falling house prices. So they do default 
more. I think what I said in my written testimony is the people 
who take out adjustable-rate mortgages are different from the 
people who take out fixed-rate mortgages. The assumption here 
is that if they took out fixed-rate mortgages, they would also 
be more likely to default. So for people who intend to keep 
properties for a short period of time--there are a lot of 
unobserved factors in the data. The fact that the borrower did 
not intend to keep the property for a long time, that is why 
they went with an adjustable-rate mortgage, and people like 
that are more likely to be people who are speculating on 
property. That is what we think that difference is picking up, 
not anything about the product itself. There is no evidence 
that the product--and as I said--there are two things. In point 
of fact, adjustable-rate mortgage defaults have been much lower 
relatively than we expected, partly because of the falling 
interest rates. So the notorious option ARMs, which were the 
sort of poster child for the complicated mortgage product, 
because interest rates have fallen a lot, those loans have 
ended up performing much better than we expected back in 2007. 
So I think the--so let me just say the other thing, which is--I 
keep coming back to here that the reason people default on 
their mortgage is negative equity and something else--job loss, 
illness, some life event that hits them. That is why they 
default on the mortgage. That does not depend on a fixed or 
adjustable-rate mortgage. There is nothing you can do about 
that. But since we have spent a lot of time in the last 2 
months talking about how we can stimulate consumption by 
getting people into lower interest rate products, the 
adjustable-rate mortgage product does that automatically.
    You know, it is difficult to measure in the data, but 
presumably the people with adjustable-rate mortgages have more 
free cash-flow with which to consume. At least that is the goal 
that we have.
    Senator Reed. Dr. Woodward, what is your view of this 
differential between adjustable-rate defaults and----
    Ms. Woodward. I think that Paul is right, that the 
households that sign up for ARMs are different from the 
households that sign up for fixeds.
    Now, in terms of, you know, when interest rates change, how 
they change, how it affects households, remember that we had an 
episode of rising interest rates from 1970 to 1980, and there 
were ARM loans outstanding then, but they were all very 
affluent households that had those ARM loans. They were not 
ordinary households.
    So then from 1980 until now interest rates have come down, 
down, mostly down, and so we have not really seen the full 
force of what happens when ARMs reset upwards.
    Now, today we look at sort of the term structure of 
interest rates. It is pretty flat. It does not predict that 
interest rates are going up much, but could they? Yes, they 
could. It is certainly much more likely that they could go up a 
lot than that they could go down a lot, because we are so close 
to zero we cannot go down very much. And it is the case that if 
the ARMs reset up 2 points, the payment is going to rise 25 
percent, and the household income increase is not going to be 
that big.
    So you want households that are good at managing their 
finances, not bad at managing their finances, taking that risk. 
And what we can see in the ARM data is that the default rates 
are higher, and they are higher, other things equal. You know, 
the same credit score, same debt-to-income ratio, same loan-to-
value ratio, the households that sign up for ARMs are taking 
some risk somewhere else, too, that we cannot observe.
    Senator Reed. We had an experience in the 1980s where we 
had a significant increase in the interest rates.
    Ms. Woodward. We did. I am old enough to remember, too.
    Senator Reed. My father told me about it.
    Senator Reed. In Canada, they had, I think, much less of a 
commitment to 30-year fixed-rates, and they saw a lot of 
turbulence in their housing market.
    Ms. Woodward. They did.
    Senator Reed. And that was an example where--in fact, that 
might be the example which has influenced a lot of people to 
get into 30-year fixeds, that if you were, like I was and like 
you were, I suspect, about 25 to 26 in the 1980s, having a 
fixed-rate looked really good then.
    Ms. Woodward. It looked really good.
    Senator Reed. We might be sort of captives of our history.
    Ms. Woodward. Two things about the Canadian market. Yes, 
they did have a lot of defaults in the early 1980s as ARMs 
reset, and that is even in a market where the rate to which 
they reset is kind of managed by the Government. You know, it 
is not a completely objective rate like LIBOR or 1-year 
Treasurys. There is some pushing against it at the Federal 
level. But they still had big defaults.
    Senator Reed. Thank you all.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman.
    As we look at the GSEs and the low guarantee rate that has 
been charged and the fact that, you know, credit was available 
all the way through, it seems that it had two effects. Number 
one, when you have an artificially low interest rate, it 
actually drives up the prices of housing because people are 
looking at what their mortgage payments are. I go back to Dr. 
Woodward. I think that is, generally speaking, what people are 
looking at when they go buy a home, is what is their payment 
going to be, regardless of all those other issues.
    And so what we have had is a situation where our Government 
guarantees, which artificially kept prices lower than they 
should have been, have actually done the opposite thing for 
consumers that we like to see happen, and that is, it has 
actually driven up home prices. It has. There is no question. 
And I am not asking a question. It is just a fact. It has.
    And then you have a situation where you do not have any 
price signals; in other words, because we continue just to have 
these--as we had this bubble, you know, we had nothing in the 
market that was slowing that down, and without this Government 
guarantee, I think the private sector, which we do have a 30-
year mortgage market in the private sector today without 
Government guarantees, and it is not as robust as it was 
because we had this housing crisis. But it seems to me that 
much of what has happened could have been avoided without the 
GSEs playing the major role they did. And I wonder if you might 
respond to that, Dr. Sanders or Dr. Willen.
    Mr. Sanders. I will take the first crack at it. I would 
say, yes, the GSEs, courtesy of the guarantee, whether it was 
implied or explicit later, did help--they underpriced their 
insurance; therefore, they could charge lower rates to 
consumers. It sounds good, but when you couple that with lower 
downpayment mortgages and sort of easing of credit standards 
over time, we got what Austrian economists would call a nice 
``credit bubble.'' We got housing prices climbing up, and once 
in the house I put that, and I said, ``This is making housing 
affordable?'' Which you will notice Fannie and Freddie no 
longer have that as a slogan, which they did a couple decades 
    We created a bubble, and it burst. And as I said, $7.25 
trillion of home equity has been lost, which has been 
devastating, particularly for lower- and middle-income 
households. So I think those guarantees are dangerous 
instruments, and they have got to be pared back or taken away.
    Senator Corker. I know that there has been a whole industry 
sort of built around those, and it is sort of interesting to be 
here in Washington in various sectors, not just this one. There 
is a whole infrastructure that is built around making money off 
what sort of the Government has put in place. And I know that 
we all thoughtfully want to move away from that. I think 
everybody wants to see us move away regardless of where you sit 
today from where we are today. I think that is universal. We 
want to do it in an appropriate way.
    But let us just move back to where the GSEs are at this 
moment. I never have understood why we do not have a built-in 
prepayment penalty. I mean, why has it been in sort of the 
psychology of what we have done here a one-way street? You 
know, I own commercial buildings, or have in the past. When you 
pay the loan off, you have got to pay a penalty. I am sorry. 
You know, if it is not--if rates are lower than when you have 
financed, you have got to pay a penalty. Why have we not had 
that? It seems like that would solve a big part of the problem 
we have today?
    Mr. Sanders. Yes, I was going to put that into my 
testimony, that on the commercial side we have ARMs galore, and 
they have either lockouts, prepayment penalties, yield 
maintenance, or something, saying that if you are going to 
refinance, you are going to pay a hefty price.
    One of the reasons why we do not in the residential market 
is we have built kind of a huge empire of mortgage-backed 
securities that are agency--Fannie, Freddie, and Ginnie Mae. 
And to facilitate trading, you want to have liquid prepayments, 
meaning that the option to prepay is what everyone likes to 
speculate on, how it is going to do, and they really avoid 
having prepayment penalties or non-prepayable mortgages because 
there is not a lot of action in them, so to speak, on the 
market. But that should not be driving public policy, the fact 
that mortgage-backed security traders like the prepayment 
    Senator Corker. Any other comments regarding the prepayment 
    Ms. Woodward. Yes.
    Senator Corker. Yes, go ahead, Dr. Woodward.
    Ms. Woodward. You know, it is my understanding that the 
absence of prepayment penalties is mostly a matter of State 
law. Essentially all 50 States have limits on the prepayment 
penalties that can be created. And as far as the mortgage-
backed securities market goes, what the mortgage-backed market 
wants is not necessarily the absence of prepayment penalties. 
What they want is securities where the prepayment penalties are 
all the same so that they can trade as liquid instruments.
    Senator Corker. So the penalty is zero.
    Ms. Woodward. Well, it does not matter whether it is zero 
or it is $100 or $1,000. What they want is for all mortgages to 
have the same prepayment penalties so that they can trade 
    Senator Corker. Well, my time is up. I would just--go 
    Mr. Sanders. I agree with Susan on that statement, but I 
would say if you looked at the number of prepayable mortgages 
with huge prepayment penalties or yield maintenance or 
something, you are going to find the number close to zero at 
Fannie, Freddie, and the FHA. They are just non-existent.
    Senator Corker. May I ask another question?
    Chairman Johnson. Yes.
    Senator Corker. What do you think would happen if Fannie 
and Freddie all of a sudden said, you know, we will continue 
doing what we are doing, and we all know they are jacking up 
their G-fees and all of that. But what if they also said, but 
we are going to have yield maintenance on these things, and, 
you know, candidly, if you want to refinance in 7 years, which 
is what most people--that is what the average is. If you want 
to refinance in 7 years but have the opportunity for a 30-year 
low fixed-rate mortgage, you are going to pay yield maintenance 
on that. What would happen in the marketplace.
    Mr. Sanders. Well, what would happen is that mortgage rates 
would actually decline because since you are sharing some of 
the risk with consumers--and, again, the risk, I guess with 
Paul, is relatively negligible. But since you are sharing some 
of that risk, that leads to the rate declining because, once 
again, the prepayment option raises mortgage rates, which is 
one of my arguments in HAMP. Why weren't we refinancing 
households into ARMs, 5/1 ARMs? Why did we pick 30-year fixed? 
That is a problem across the whole system. If we are interested 
in homeowners, we should have lowered the rates if we believed 
that theory. We should have done 5/1 ARMs or 3/1 ARMs for 
consumers that were getting loan mods, but we did not.
    Senator Corker. Thank you.
    Mr. Fenton. Senator, if I may?
    Senator Corker. Yes, sir.
    Mr. Fenton. I would like to disagree with that to some 
extent. I believe it is an affordability issue, and if you add 
on prepayment penalties to the consumer, you are shifting that 
cost out to the consumer and in the long-term effect, it is 
going to have a negative effect on the real estate markets as 
we go forward.
    I think you have to have a choice. There are members in 
every life segment and every life style, and so depending on 
where you are in those, there are options for you. Prepayment 
may be one of those. Adjustable rates may be one of those. We 
cannot just have one product, but there are different timings 
of it all and you have got to have an effect. The consumer 
should not bear all of the cost on this, nor should any one 
segment. Risks should be spread balanced over all of the 
    Senator Corker. Well, it seems to me that the person who 
has taken a loan out should bear the cost of that loan. I mean, 
I do not understand what you are saying about consumers not--
that is a really weird statement to me. I mean, if I am 
borrowing money and I decide that--and there is a cost to 
society of me taking certain actions, it seems that I should 
bear that cost. That is a strange statement, it seems, that you 
just made.
    Mr. Fenton. Well, it is how you view cost. Cost is an 
investment sometimes, and it depends on which angle you are 
looking at it from. From a public policy perspective, I think 
the cost is an investment that returns in a more vibrant 
economy eventually. And so there is return for us making that 
investment. It should not be borne by the consumer because the 
consumer, A, does not understand it fully enough, and sometimes 
it is going to affect their ability to go into it, and so 
rather than go into it, they will rent a home as opposed to 
buying it. And again, I think that has a negative impact on the 
economy. So you need to look at it from all different angles, 
from the policy statements as well as what the effect is on the 
    Senator Corker. Thank you.
    Chairman Johnson. Dr. Sanders, the fixed-rate mortgage has 
been criticized as problematic for homeowners when interest 
rates and home values fall because homeowners cannot take 
advantage of lower interest rates without refinancing. Do all 
ARMs allow for a drop in interest rates?
    Mr. Sanders. Yes. Virtually all ARMs allow you to 
refinance, but you--yes, they do. But, again, most people 
refinance at the reset dates.
    Senator Johnson, can I finish my answer?
    Chairman Johnson. Yes.
    Mr. Sanders. One of Susan and my common friends, maybe 
Paul, too, is a famous person locally in the mortgage market 
and he only uses ARMs. Why? Because he did a study showing that 
ARM rates continually, with a couple of episodes, have always 
been lower than fixed rates, so he just says, I will either 
roll them over if the rates stay low. If they are not, I will 
just--and the reset has been always very trivial in comparison. 
So other than one shock, we have not seen a problem with them.
    Chairman Johnson. Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    I appreciate the witnesses being here. I certainly 
appreciate Mr. Fenton from New Jersey, who is well known as an 
expert in the financial industry and in our home State, as well 
as Ms. Bowdler, who has worked for La Raza and has been 
    I am concerned that there is a universe of borrowers who, 
in fact, can be responsible borrowers, but at the end of the 
day, without the guarantee of a 30-year fixed mortgage ends up 
eliminating the opportunity for them to be a responsible 
borrower and basically gets them out of the market.
    I have noticed that even though there are those who argue 
that the private sector alone will do this, that we have not 
really seen much securitization at all of jumbo mortgages in 
this marketplace, so the private sector has not come in as of 
now to provide the opportunity to do that.
    So if we do not have an evidentiary set of circumstances 
under the most probably propitious opportunity for the private 
sector to come in and they have failed to come in to accomplish 
them, then how is it that we expect individuals who can be 
responsible borrowers under a long-term fixed rate to be part 
of the marketplace? Do any of you have a comment on that?
    Mr. Fenton. Senator, I do agree with you that the 
securitization and jumbos is a great example of where 
privatization has not entered the marketplace. You cannot rely 
solely on privatization to come in and bring capital in without 
some offset to the risks that they are going to take. Risk is 
offset by price, and in this case, I think the price would 
negatively affect a different segment, which is the consumer 
segment. And so we need to be able to balance that, and that is 
where the Government has a role to come in to try to encourage 
the private sector to bring their capital to the table.
    Senator Menendez. Yes, Ms. Bowdler.
    Ms. Bowdler. I would also point out that while we have this 
issue on the jumbo side, we have the same problem on the lower 
end of the market. I mean, right now, what Fannie and Freddie 
are financing is essentially middle market, affluent, sort of 
the best of the best. I mean, they are taking cream of the crop 
right now, and borrowers who are qualified but maybe live in a 
neighborhood that they have deemed not desirable or lack the 
family wealth to make sizable downpayments are getting left out 
of the market. And those are borrowers that we know, the 
research shows, right product with the right support, those can 
be qualified families who perform very well and we do not see 
the private market stepping in to help those families, either, 
and Fannie and Freddie is not serving them.
    Senator Menendez. Dr. Sanders, welcome back.
    Mr. Sanders. Thank you very much, Senator Menendez.
    Senator Menendez. You are a regular at our hearings, so----
    Mr. Sanders. That is right. I am a Jersey boy, so----
    Senator Menendez.----our Subcommittee hearings, so we 
appreciate it.
    Mr. Sanders. Let me just take a little bit different spin 
on it, although I do not disagree with what anyone is saying. 
What I am saying is that the guarantee in the 30-year fixed, 
the low downpayment mortgages, when you combine that all into a 
ball, what we have done is we have really encouraged households 
to take on more risk than they ordinarily would have. We give 
them the illusion that everything is going to be fine with a 
30-year fixed, and then, lo and behold--I have said this about 
five times already today--from the peak of the housing bubble 
to now, $7.25 trillion--that is a mind-boggling number if you 
want to figure out one of the reasons why our economy is not 
jump starting very well--we lost that much wealth in the 
housing market, and that is terrible.
    So again, I am saying, if we can figure out a way to pare 
back some of this, we are not encouraging people to take this 
risk that turned out to be a bad pony. Housing was great for a 
while during the run-up, but it had a catastrophic collapse and 
a lot of middle-income and lower-income households really got 
creamed in it. And so I am just saying----
    Senator Menendez. Dr. Sanders, let me interrupt you there 
for a moment. But the reality--a bubble, regardless of when 
that bubble is, is problematic whether you are in a fixed 
mortgage or whether you are in an adjustable rate mortgage. As 
a matter of fact, it seems to me that part of our challenge 
that created this bubble was that we had all of these 
instruments, including no doc loans and teaser rates and a 
whole host of other set of circumstances, that brought people 
into a market that probably should not have been, certainly not 
under those circumstances. And that is part of creating the 
    So I do not know that a bubble itself is the reason not to 
look at a 30-year fixed-rate mortgage. On the contrary, it 
seems to me that there is long-term stability there for the 
individual to know what their responsibility is and not 
necessarily with engaging in the fluctuations of the 
marketplace, including on the mortgage side, which some of the 
adjustables and no downpayment and interest rates ended up 
being. So I appreciate your comment about the bubble, and I 
understand that. I just do not necessarily subscribe it to a 
30-year mortgage.
    And the final point I would like to make is I am 
increasingly concerned, because my dear friend and colleague, 
Senator Isakson, who has a long-term experience--he is actually 
someone who has been a Realtor for, I think, 30-some-odd years 
and knows this pretty well--he made a comment on the floor 
yesterday on an amendment we have which is it is not just the 
size of the loan, but it is the lending criteria. And he 
commented that the lending criteria has been almost so pristine 
now and so difficult that the risk is dramatically downsized, 
and I get concerned, in addition to the 30-year issue and 
having some Government role, that I think the least we can do 
in a very difficult, to say the least, housing market is to do 
no further harm, at least in the short term.
    It is this whole issue of what is the down, because, you 
know, saying that a qualified residential mortgage is now 20 
percent, well, that is going to eliminate a whole universe of 
people who can, again, be responsible borrowers. I mean, I look 
at it, a middle--a median single-family home cost approximately 
$170,000 in 2009. Median household income is approximately 
$50,000. Just think about how long it will take for a family 
earning twice the median to save $17,000, much less--that is 
about 10 percent--much less 20 percent as a mandatory.
    So it seems to me lending criteria is important to 
determine who will be a responsible borrower and not permit the 
bubble to take place, but that lending criteria is not in and 
of itself that you have got to have 20 percent down. In other 
words, you could have 20 percent down and still not have the 
other criteria to be a responsible borrower. Is that a fair 
    Mr. Fenton. Senator, if I can, I would go further with 
that. Lending criteria is one of the keys that actually was a 
major influence in the crisis that we are just coming out of. 
There were a lot of lax credit standards, so we ignored some of 
the rules that we had actually established for ourselves, and 
that is what had more of an effect than interest rates, whether 
it is adjustable rates or 30-year fixed-rates, on this whole 
    So what stops us from lax credit standards? The GSEs had 
set those--established those standards and allowed them to 
become more lax. There were certainly different components in 
the unregulated market. They were selling products that were 
not good for the consumers. Credit unions have always stood by 
and looked at the consumer and said, let us figure out what is 
best for you. If it is a 30-year or a 40-year fixed, it may not 
be the best thing for them. So we try to look beyond that. I am 
suggesting that that was not done in all parts of the economy.
    Senator Menendez. All right. My time is over, but maybe, 
Ms. Bowdler, you can make a final comment if the Chair permits 
    Ms. Bowdler. Sure. So in my written statement, I went 
through some things that we know that can make borrowers very 
successful and I think that is the better place to focus this 
conversation, not about taking options away, but what makes 
borrowers at any income range really succeed in their 
mortgages. What makes them responsible. Certainly, that is 
underwriting criteria, but there are other things we can do, as 
well, like housing counseling, which we are a big proponent of. 
We have invested a lot of money in helping families figure out 
how to eat their veggies. Let us get your budget right. Let us 
get your credit right and step into this when it is your right 
    I am concerned that there has been a dichotomy here that 
somehow everybody who got ARMs were really savvy consumers and 
people who are getting 30-year fixed are somehow the chumps 
that do not really understand interest rate markets. In fact, I 
think people are making these choices because, at least in 
part, it works for them.
    Now, I completely agree that there should be choices and 
there is certainly not a single product for everybody, but a 
good housing counselor or other advisor like a credit union can 
help families evaluate those options and make the choices that 
really fit for their family and their long-term financial 
    Senator Menendez. Thank you, Mr. Chairman.
    Chairman Johnson. I would like to thank all of our 
witnesses for being here with us today. This hearing has been 
very useful to the Committee as we continue to explore the 
future of the housing finance system and the financial products 
for that system.
    This hearing is adjourned.
    [Whereupon, at 11:16 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
                Director, Wealth-Building Policy Project
             Office of Research, Advocacy, and Legislation
                      National Council of La Raza
                            October 20, 2011
    Good morning. My name is Janis Bowdler. I am the Director of the 
Wealth-Building Policy Project at the National Council of La Raza 
(NCLR). NCLR is the largest national Hispanic civil rights and advocacy 
organization in the United States, dedicated to improving opportunities 
for Hispanic Americans. I oversee our research, policy analysis, and 
advocacy on issues that are critical to building financial security in 
Latino communities, such as homeownership, consumer credit, auto 
lending, and financial planning. In this capacity I have produced a 
number of publications on related issues, including The Foreclosure 
Generation: Long-Term Impact of the Housing Crisis on Latino Families 
and Children; American Dream to American Reality: Creating a Fair 
Housing System that Works for Latinos; and Jeopardizing Hispanic 
Homeownership: Predatory Practices in the Homebuying Market.
    The NCLR Wealth-Building Policy Project promotes fair and 
accessible financial markets where Latino families have the opportunity 
to obtain assets and build wealth in a manner that will last a lifetime 
and can be shared with the next generation. NCLR conducts research and 
analysis on public policy affecting the financial security of Latino 
families, such as threats to sustainable Hispanic homeownership, access 
to affordable financial services, and access to affordable credit. The 
NCLR Homeownership Network (NHN) provides financial, homebuyer and 
foreclosure prevention counseling to more than 65,000 families 
annually. Our subsidiary, the Raza Development Fund (RDF), is the 
Nation's largest Hispanic community development financial institution 
(CDFI). Since 1999, RDF has leveraged more than $680 million in 
financing for local development projects throughout the country. This 
work has increased NCLR's institutional knowledge of how Latinos 
interact with the mortgage market, their credit and capital needs, and 
the impact of Government regulation on financial services markets.
    I hope that today's hearing will shed light on a critical issue--
the viability and advantages of the 30-year fixed-rate mortgage. For 
nearly eight decades, 30-year fixed-rate mortgages have put 
homeownership within reach of America's middle class and first-time 
homebuyers. Long-term financing allows credit to be extended at a price 
that is affordable to middle-income families, and the fixed rate 
provides certainty around housing costs. Without this flexible 
financing tool, homeownership will become a luxury reserved for the 
affluent, and the majority of families will be left without the 
appreciable asset that has long been the cornerstone of middle class 
    In my testimony today I will discuss the role of the 30-year fixed-
rate mortgage and explain its advantages for homeowners. I will also 
share our perspective on how to maintain a viable path to homeownership 
for future generations of homebuyers.
Advantages of a 30-Year Fixed-Rate Mortgage
    The 30-year fixed-rate mortgage has become so ubiquitous that some 
have taken its benefits for granted. However, such financing has not 
always been available. Prior to the creation of the Federal Housing 
Administration (FHA) in 1934, most loans were limited to 50 percent of 
the home value, which means that a family would have to pay the other 
50 percent in cash to purchase a new home. Such loans were often short-
term notes where a family would have to refinance every few years to 
cover the final balloon payment. Even this payment schedule could not 
be counted on. In the lead-up to the Great Depression, cash-strapped 
banks could call the note for immediate repayment, forcing many into 
foreclosure.\1\ President Franklin D. Roosevelt and Congress responded 
by creating FHA mortgage insurance to reduce barriers to purchasing a 
home and provide banks and consumers with certainty and predictability 
in the transaction. This, along with the introduction in 1938 of the 
Federal National Mortgage Association, popularly known as Fannie Mae, 
standardized the 30-year fixed loan and made it available nationwide.
    \1\ Jacob Gaffney, This housing crisis is the not the Great 
Depression, HousingWire, June 16, 2011, http://www.housingwire.com/
2011/06/16/this-housing-crisis-is-not-the-great-depression (accessed 
October 16, 2011).
    The 30-year fixed-rate mortgage remains an essential financing tool 
for homebuyers in the modern mortgage market. By spreading the cost of 
the home purchase over a 30-year term, the asset becomes more 
affordable. The fixed interest rate provides certainty, allowing a 
family to budget their housing costs and make long-term financial 
plans. Modest downpayment requirements have opened the doors of 
homeownership to families with incomes sufficient to cover monthly 
mortgage payments and maintenance costs but who lack the family wealth 
for a high downpayment. The amortization feature of the 30-year fixed-
rate loan means the borrower knows when the final payment will be due 
and their family wealth grows as principle is repaid. Finally, most 
prime 30-year fixed-rate notes are prepayable, which means the 
homeowner can refinance their loan or sell without penalty.
    The standard structure of the 30-year mortgage has opened 
homeownership to millions of families over the last seven decades. As a 
result of this financing tool, two out of three Americans own their own 
home today, the vast majority of whom relied on some type of mortgage 
to finance their purchase. Building wealth through home equity can fuel 
retirements, business ownership, and the advanced education of one's 
children. Those fortunate enough to own their home or land are able to 
pass their wealth to their children, a practice that has helped expand 
America's middle class.\2\ Even without dramatic increases in home 
values, the home acts as a forced savings account that captures some of 
the income put toward house payments, which is unavailable for 
individuals who do not own their homes. Over the last 50 years until 
the most recent recession, wealth among American households grew 
steadily, peaking at $65 trillion in 2007.\3\ While home equity does 
not account for the entirety of that wealth, a home is still the 
highest valued asset for most Americans. This is especially true for 
Hispanic and Black homeowners, for whom home equity makes up 65 percent 
and 59 percent of household wealth, respectively. For Hispanic 
households, no other asset type besides a home, e.g., interest-earning 
assets at financial institutions constituted more than 10 percent of 
total net worth in 2005.\4\
    \2\ Melvin Oliver and Thomas Shapiro, Black Wealth, White Wealth: A 
New Perspective on Racial Inequality (New York: Routledge, Taylor & 
Francis Group, 2006).
    \3\ Chris Isidore, America's lost trillions, CNN Money, June 9, 
2011, http://money.cnn.com/2011/06/09/news/economy/household_wealth/
index.htm (accessed October 17, 2011).
    \4\ Paul Taylor, Richard Fry, and Rakesh Kochhar, Wealth Gaps Rise 
to Record Highs Between Whites, Blacks, Hispanics (Washington, DC: Pew 
Research Center, 2011).
    Unfortunately, the benefits of homeownership have not been equally 
available to all. Historical discrimination in the distribution of 
land, unfair restrictions on FHA mortgage insurance and redlining, and 
exploitation by predatory subprime lenders has left communities of 
color with lower homeownership and wealth rates.\5\ Latino and Black 
homeowners were more likely to receive exotic mortgage products, even 
when they had solid credit that warranted a sustainable 30-year fixed 
loan.\6\ When the toxic mortgages began to reset and brokers and 
lenders could no longer maintain their refinance schemes, a recession 
ushered in record-high foreclosure rates. Since the dawn of the crisis 
in 2007, more than six million homeowners have lost their home to 
foreclosure.\7\ The foreclosure crisis has been particularly acute 
among Latino homeowners. For example, nearly half of foreclosures in 
California have been on Latino families.\8\ In fact, recent research 
revealed that wealth in White households exceeds that of Hispanic 
households by a staggering 18-to-1 ratio and by 20-to-1 for Black 
households a gap that is attributable largely to differences in home 
equity and the loss of homes through foreclosure.\9\
    \5\ Meizhu Lui et al., The Color of Wealth: The Story behind the 
U.S. Racial Wealth Divide (New York: The New Press, 2006).
    \6\ Robert B. Avery, Kenneth P. Brevoort, and Glen Canner, The 2007 
HMDA Data, Federal Reserve Bulletin 94 (December 23, 2008); and Debbie 
Gruenstein Bocian, Keith S. Ernst, and Wei Li, Unfair Lending: The 
Effect of Race and Ethnicity on the Price of Subprime Mortgages 
(Durham, NC: Center for Responsible Lending, 2006). For a review of 
predatory practices aimed at Hispanic families see Janis Bowdler, 
Jeopardizing Hispanic Homeownership: Predatory Practices in the 
Homebuying Market (Washington, DC: National Council of La Raza, 2005).
    \7\ Center for Responsible Lending, Snapshot of a Foreclosure 
Crisis, 2010, http://www.responsiblelending.org/mortgage-lending/
research-analysis/snapshot-of-a-foreclosure-crisis.html (accessed 
October 17, 2011).
    \8\ Debbie Gruenstein Bocian et al., Dreams Deferred: Impacts and 
Characteristics of the California Foreclosure Crisis (Oakland, CA: 
Center for Responsible Lending, 2010).
    \9\ Wealth Gaps Rise to Record Highs.
    Our present foreclosure crisis demonstrates the importance of 
preserving the standard 30-year fixed-rate mortgage. Critics of the 30-
year fixed note argue that families pay a premium in their interest 
rates for the benefit of extending the term. However, most families do 
not view their home as a strict financial transaction or a get-rich-
quick scheme. Rather, they are investing in a nest egg and a community 
with the anticipation of long-term returns. Most homeowners are not in 
the position to play the markets or hedge interest rate risk. The 
predictability and security of a 30-year fixed-rate mortgage is worth a 
modest premium in the interest rate.
Paving the Way for Sustainable Homeownership
    Research shows that families who lack the cash for high 
downpayments can be successful in a well-underwritten prime 
mortgage.\10\ The Center for Community Capital compared low-income 
homebuyers who received flexible but responsible conventional prime 
mortgages with similarly situated borrowers who received subprime 
mortgages. Those with subprime loans have suffered foreclosure at a 
rate three to five times that of borrowers who received flexible yet 
responsibly underwritten 30-year fixed loans. In fact, not only were 
the borrowers with the responsible loans less likely to foreclose, they 
also gained an average of $20,000 in home equity as of 2009. NCLR's 
experience with Latino first-time homebuyers tells a similar story. 
Over the last 13 years, NHN counselors have helped more than 25,000 
moderate-income families purchase a home with prime mortgages. 
Counselors overwhelmingly report that few, if any, of their clients who 
received counseling before they bought their home returned for 
foreclosure prevention counseling. This evidence shows that when 
families receive the right loan with the right support, they can be 
successful and sustainable homeowners and build wealth even with modest 
incomes and low downpayments.
    \10\ Lei Ding et al., Risky Borrowers or Risky Mortgages: 
Disaggregating Effects Using Propensity Score Models, working paper 
(Chapel Hill, NC: UNC Center for Community Capital, 2010), http://
www.ccc.unc.edu/documents/Risky.Disaggreg.5.17.10.pdf (accessed October 
17, 2011).
    Several decades of innovative affordable lending have taught us how 
to mitigate the risk of extending credit to first-time homebuyers, low-
wealth borrowers, and underserved communities. For example, mortgage 
insurance a longstanding requirement by lenders and investors on home 
loans where the loan-to-value (LTV) ratios exceed 80 percent allows 
banks and credit unions to lend safely and responsibly to qualified 
families with higher LTVs. Analysis conducted on behalf of Mortgage 
Insurance Companies of America (MICA) of 43 million loans made between 
2001 and 2008 with LTVs up to 97 percent found that those with mortgage 
insurance outperformed noninsured loans, and performed well considering 
the economic downturn.\11\ Housing counseling is another excellent risk 
way to mitigate risk. Research shows that objective advice from an 
independent, trained housing counselor prior to purchase effectively 
reduces the likelihood of default.\12\ Similarly, recent research has 
shown that counseling during a delinquency improves cure rates and 
lowers rates of redefault.\13\ Finally, a homeowner's own savings can 
provide a cushion in times of unexpected financial distress. Modest-
income borrowers would better positioned to manage unexpected expenses 
if they have some cash liquidity, rather than storing all of their cash 
savings in their home via a large downpayment.
    \11\ MICA regulatory comment letter on credit risk retention, 
August 1, 2011, http://www.privatemi.com/news/pressreleases/
attachments/MICA_QRM_Letter.pdf (accessed October 17, 2011). 
Specifically, see attached analysis: Kenneth Bjurstrom, Johnathan 
Glowacki, and Tanya Havlicek, Mortgage Insurance Loan Performance 
Analysis as of March 31, 2011, July 28.
    \12\ Abdighani Hirad and Peter M. Zorn, A Little Knowledge Is a 
Good Thing: Empirical Evidence of the Effectiveness of Pre-Purchase 
Homeownership Counseling (Joint Center for Housing Studies, Low-Income 
Homeownership Working Paper Series, Boston, 2001).
    \13\ Neil Mayer et al., National Foreclosure Mitigation Counseling 
Program Evaluation: Preliminary Analysis of Program Effects September 
2010 Update (Washington, DC: The Urban Institute, 2010).
    Moreover, the affordable housing market continues to innovate with 
the 30-year fixed loan as a foundation. New tenure forms, such as 
community land trusts, lease-purchase, and shared equity mortgages, can 
help families take important steps toward ownership with far less risk 
overall to the lender, consumer, and the market. Affordability tools 
such as soft second loans and mortgage revenue bonds often used by 
housing finance agencies can reduce the upfront cost of realizing 
homeownership.\14\ To achieve scale that is sufficient to move such 
options into the mainstream housing market, these innovative approaches 
require the same ingredients that made the affordable 30-year fixed 
mortgage a market standard: secondary market liquidity, credit 
enhancements, and a stable, competitive marketplace. Of course, 
deciding to buy a home is a major family decision and must come at a 
time when a family is financially prepared. Therefore, policymakers 
must also support a robust rental market that provides affordable 
options for future buyers and families for whom homeownership is not 
desirable or possible.
    \14\ For a review of five successful examples, see David Abromowitz 
and Janneke Ratcliff, Homeownership Done Right: What Experience and 
Research Teach Us (Washington, DC: Center for American Progress 2010), 
homeownership_done_right.pdf (accessed October 17, 2011).
    Despite all of the evidence demonstrating the importance and 
viability of affordable 30-year fixed-rate mortgages, this market 
staple is restricted in the current credit environment. The January 
2008 Federal Reserve Senior Loan Officer Opinion Survey revealed that a 
significant number of prime lenders had tightened their credit 
standards, and subsequent surveys show that little change has occurred 
over the last 3 years. The Community Reinvestment Association of North 
Carolina found that loan-level pricing adjustments (LLPAs) imposed by 
Fannie Mae and Freddie Mac add significant costs to loans and reduce 
access to credit, particularly for Latino and Black homebuyers.\15\ 
Furthermore, challenges have surfaced among FHA loans, which have been 
the primary financing tool available to borrowers of color since the 
collapse of the mortgage market. The National Community Reinvestment 
Coalition revealed that national lenders were layering additional 
credit criteria on FHA mortgages, thereby restricting their 
availability.\16\ Consequently, despite the average 30-year mortgage 
rate having dropped to below 4 percent, fewer borrowers are able to 
take advantage of the low rates and lower home prices.
    \15\ Adam Rust, The New Hurdle to Homeownership: How Loan Level 
Pricing Changes the Cost and Access to Credit (Durham, NC: Community 
Reinvestment Association of North Carolina, 2011), http://cra-nc.org/
Ownership.pdf (accessed October 16, 2011).
    \16\ National Community Reinvestment Coalition, Working-Class 
Families Arbitrarily Blocked from Accessing Credit (Washington, DC: 
National Community Reinvestment Coalition, 2010), http://www.ncrc.org/
(accessed October 17, 2011).
    The threats to affordable, long-term housing financing are not 
limited to today's credit crunch. Unfortunately, the future 
availability of affordable 30-year fixed loans for working families is 
in question. Earlier this year Federal bank regulators promoted the 
idea of a wealth standard in their proposed risk retention rule, which 
would unnecessarily cement high downpayment requirements in 
regulations. The idea of requiring a high downpayment for loans secured 
by Fannie Mae and Freddie Mac and those insured by FHA was also 
introduced by the Department of Housing and Urban Development and the 
Department of the Treasury in a white paper sent to Congress.\17\ Such 
strict regulatory requirements will decrease the availability of 
responsible and affordable credit to qualified families. Critics of 
Fannie Mae and Freddie Mac are going further by pushing for a complete 
dismantling of our current secondary market system through 
privatization, even though lenders especially small community lenders 
say that they would not be able to offer fully amortizing 30-year notes 
in a completely private system.\18\
    \17\ U.S. Department of the Treasury and U.S. Department of Housing 
and Urban Development, Reforming America's Housing Finance Market. 
Washington, DC, 2011, http://portal.hud.gov/hudportal/documents/
huddoc?id=housingfinmarketreform.pdf (accessed October 18, 2011).
    \18\ See: Lew Sichelman, ``The End of the 30-Year Fixed-Rate 
Mortgage?'' Urban Land, June 22, 2011, http://urbanland.uli.org/
Articles/2011/June/Sichelman30yr (accessed October 17, 2011). In this 
article, Sichelman quotes members of the mortgage industry asserting 
that the 30-year fixed-rate mortgage would become either extremely 
expensive or disappear altogether without the secondary market 
liquidity provided by Fannie Mae and Freddie Mac. Sichelman also quotes 
critics who question the benefits of fixed-rate financing and argue for 
a fully privatized housing finance system.
    Rather than dismiss a proven finance tool such as the 30-year 
fixed-rate mortgage and affordability features such as low 
downpayments, policymakers should be exploring those factors that set 
families up for success. The conservatorship of Fannie Mae and Freddie 
Mac is neither desirable nor sustainable from a public policy or market 
perspective. However, we caution against throwing away portions of our 
housing finance system that work well. In a letter to President Obama, 
NCLR and 16 other civil rights organizations outlined a set of 
principles to guide housing finance reform in a manner that ensures 
equitable and sustained access to credit for all qualified homebuyers. 
I have attached a copy of this letter for the record.
    Without the advantages of long-term fixed-rate financing, many 
qualified, middle-income families will be shut out of homeownership 
opportunities, particularly Hispanic and Black borrowers and other low-
wealth households. Policymakers should take steps to strengthen the 
role of the classic, 30-year fixed-rate mortgage and other market 
innovations that build off its success. In addition to the principles 
outlined in the attached letter, NCLR offers three specific 
recommendations to the Committee:

    Maintain secondary market liquidity for affordable 30-year 
        fixed-rate loans that are made equally available to all 
        qualified families. The 30-year fixed mortgage is the 
        foundation of affordable homeownership. A robust secondary 
        market that provides liquidity throughout the Nation is 
        critical to keeping this popular home financing tool broadly 
        available to working families. The Federal Government must use 
        its resources to facilitate a stable, liquid housing finance 
        system that will extend credit and capital on an equitable 
        basis to all borrowers and in all communities, with the goal of 
        achieving parity between communities of color and Whites. 
        Families should not be relegated to substandard mortgage 
        products because a bank refuses to lend in their neighborhood 
        or employs discriminatory practices. Such policy implementation 
        should be further bolstered by support for a robust, 
        integrated, and affordable rental market.

    Support prepurchase housing counseling and other credit 
        enhancements. Prepurchase counseling has been shown to serve as 
        a credit enhancement by reducing the likelihood of default. Yet 
        funding for this proven method of reducing risk was eliminated 
        by Congress and the administration for fiscal year 2011. 
        Recently, the Senate Appropriations Committee passed the 
        Transportation and Department of Housing and Urban Development 
        appropriations bill with $60 million allotted for housing 
        counseling. While this represents a serious cut from the 
        industry high of $87.5 million in fiscal year 2010, it is a 
        critical step in restoring the program. NCLR also calls on the 
        private mortgage industry to step up its support for housing 
        counseling. Lenders, investors, and mortgage insurers benefit 
        from a well-educated consumer. The industry has long viewed 
        housing counseling as a philanthropic endeavor, but we 
        encourage financial institutions to create business 
        partnerships with nonprofit counseling providers. Finally, 
        credit enhancements such as housing counseling, mortgage 
        insurance and shared equity models require the support of 
        Fannie Mae and Freddie Mac to achieve scale. The entities 
        should leverage proven and promising approaches in their 
        current lending, and policymakers must ensure that this element 
        is maintained as we reform our housing finance system.

    Reduce barriers to financing experienced by today's 
        borrowers. Rigid credit markets are making it difficult for 
        working families to obtain mortgages. This slows the recovery 
        of the housing market and leaves neighborhoods at the mercy of 
        absentee investors with little interest in the up-keep of the 
        property or its impact on the surrounding community. These 
        burdens could be reduced with the elimination of LLPAs and the 
        use of proven underwriting criteria such as modest downpayments 
        for counseled borrowers.

    Thank you. I would be happy to answer any questions.
Civil Rights Statement of Principles for Secondary Market Reform
    Equal access to mainstream financial services and affordable rental 
and owner-occupied housing is a critical step toward providing all 
families with access to wealth-building opportunities, good jobs, 
schools, transportation, health care, and other factors that determine 
positive life outcomes. Providing this access has been, and must 
remain, an important Government policy goal.
    One of the lessons of the current financial crisis is that our 
Nation's housing finance system has not worked well for people of color 
and other underserved groups. Perverse incentives in the secondary 
market often drove unregulated brokers to target borrowers in 
communities of color with unsustainable loans. This fed a 
securitization regime so poorly understood and regulated that it 
ultimately destabilized the global economy. As the secondary market 
helped to drive this phenomenon, it also failed to make necessary 
investments in rental housing that met the needs of communities and 
opened opportunities for people.
    Unregulated and often predatory subprime lending not only failed to 
maintain or promote sustainable homeownership opportunities but also 
established a dual credit market where factors other than a borrowers 
creditworthiness determined the type and terms of the mortgages that 
were sold. All too often, families were denied the best credit for 
which they qualified, and their communities were flooded with 
unsustainable mortgage credit. As these unsustainable loans failed, the 
housing finance system failed to provide these families with the home-
saving options that they were due. Instead of being able to use 
homeownership as the path to wealth-building and financial stability 
that our public policy promises, families have had their wealth 
stripped away and are facing financial setbacks that will take a 
generation or more to overcome.
    It is because of this unfortunate history of exclusion of 
underserved communities from sustainable credit and housing options 
that civil rights organizations are invested in the housing finance 
reform debate and should be counted on as important civic partners. 
This debate is unfolding in the context of four decades of widening 
income and wealth inequality that have kept many borrowers from 
accessing the financial tools and options that provide an economic 
ladder to the middle class. Federal housing policy must reverse this 
and incorporate bold policy solutions to address inequality and 
segregation in the United States. It is in this spirit that we offer 
the following principles for secondary mortgage market reform. The 
principles were drafted by a group of more than 20 organizations that 
serve millions of members of underbanked communities throughout the 
United States, including African-American, American Indian, Asian-
American, Pacific Islander, Latino, and low-income populations, as well 
as people with disabilities and the elderly. The points below are 
critical in shaping the future secondary mortgage market.

  1.  Federal housing finance policy must align with and support 
        longstanding Federal housing goals to protect against 
        discrimination. The secondary mortgage market must promote 
        residential integration, the elimination of housing 
        discrimination, and the provision of safe, decent, and 
        affordable housing for all.

  2.  The Federal Government has a responsibility to ensure that the 
        secondary market serves all borrowers in a fair and equitable 
        manner and to foster the equalization of homeownership rates. 
        Despite clear demand from qualified families, the mortgage 
        market does not reach all segments of borrowers and geographic 
        areas. It is incumbent upon the Federal Government to use its 
        resources to facilitate a stable, liquid housing finance system 
        that will extend credit and capital on an equitable basis to 
        all borrowers and in all communities, with the goal of 
        achieving the same rates of homeownership among communities of 
        color as among whites. While not all household heads must 
        become homeowners, a commitment should be made to achieve 
        similar homeownership levels across all communities. In 
        addition, the system must be made accessible by a wide range of 
        lending institutions for both owner-occupied and rental 

  3.  A reformed housing finance system must eliminate the dual credit 
        market. Such a market has relegated people of color and other 
        underserved groups and communities to riskier, higher cost 
        forms of credit that strip wealth and undermine financial 
        security. To accomplish this goal, reform of the secondary 
        market must be coordinated with reform in the primary market 
        for housing and other types of credit.

  4.  Regulatory oversight of the housing finance system must be 
        rigorous and comprehensive and must include effective fair 
        lending enforcement. Further, oversight and enforcement must 
        extend to all secondary market entities, whether or not they 
        avail themselves of any Federal guarantee or other support.

  5.  Secondary market transactions must be transparent and accountable 
        to the public. Detailed, granular data about the operations of 
        all secondary market entities must be made available to the 
        public on a timely and consistent basis. This includes data 
        about the race, gender, national origin, and other relevant 
        characteristics of borrowers; how a loan was serviced, 
        purchased, and securitized; and the terms and conditions of the 

  6.  The system must have an affirmative obligation to offer capital 
        and credit in communities devastated by the foreclosure crisis 
        and offer access to families who were targeted for 
        inappropriate and unsustainable mortgages. It must engage with 
        community-based financial institutions and community-based 
        organizations to design sustainable solutions that are 
        appropriate for specific locales.

  7.  The housing finance system must provide capital for sustainable 
        rental and ownership development in all communities. 
        Neighborhoods require affordable and sustainable rental and 
        homeownership opportunities to thrive. Capital, especially that 
        which comes with a Government subsidy or guarantee, should be 
        directed to underserved areas and investments in opportunity-
        rich neighborhoods. This balance will provide the maximum range 
        of housing choices for all, as there is not currently an 
        adequate supply of affordable housing for underserved families.

  8.  The housing finance system must support product flexibility and 
        sustainable innovation and offer access to institutions of all 
        sizes and in all geographic areas. To do so requires that the 
        secondary market avoid over concentration and that secondary 
        market institutions have the ability to retain loans in their 
        portfolio. Local institutions are often the first responders to 
        local needs, adapting underwriting models to fit their 
        clientele and funding innovation through their own deposit-
        based portfolios. Without a secondary market outlet, the volume 
        of these loans will always be constrained. Further, because 
        innovation is not always immediately scalable or easily 
        standardized, it runs the risk of being overlooked by large 
        financial institutions or secondary market purchasers.

The following organizations contributed to and support the principles 

Center for Responsible Lending
David L. Bazelon Center for Mental Health Law
Kirwan Institute
NAACP Legal Defense & Educational Fund, Inc.
National Community Reinvestment Coalition
National Council of La Raza
National Council of Negro Women
National Fair Housing Alliance
National Urban League
North Carolina Institute of Minority Economic Development
National Coalition for Asian Pacific American Community Development
PICO National Network
Poverty and Race Research Action Council
The Leadership Conference on Civil and Human Rights
The Opportunity Agenda
            President and CEO, Affinity Federal Credit Union
     on behalf of the National Association of Federal Credit Unions
                            October 20, 2011
    Good morning, Chairman Johnson, Ranking Member Shelby and Members 
of the Committee. My name is John Fenton, and I am testifying today on 
behalf of the National Association of Federal Credit Unions (NAFCU). I 
appreciate the opportunity to share my views with the Committee on 
housing finance reform and the value of the 30-year fixed-rate mortgage 
to credit unions and our members. Thank you for holding this important 
    I am president and chief executive officer of Affinity Federal 
Credit Union, headquartered in Basking Ridge, New Jersey. I also serve 
as chairman and chief executive officer of Affinity Financial Services, 
LLC, a wholly owned subsidiary of Affinity Federal Credit Union. 
Affinity Financial Services provides diversified financial services, 
including insurance, investment products, and mortgage origination and 
    Prior to joining Affinity in 1995, I was president and CEO of 
Synergy Federal Credit Union from 1987 to 1995. I have also held the 
positions of vice president of administration and finance at East 
Bergen Teachers Federal Credit Union (1982-1987) and vice president of 
finance at the Clifton Savings and Loan Association (1975-1982).
    Affinity Federal Credit Union was chartered on December 13, 1935, 
the year after the Federal Credit Union Act was passed and signed into 
law by President Roosevelt. It was formed as the W. E. Headquarters 
Federal Credit Union to provide cooperative credit and to serve 
employee-member needs of Western Electric Company.
    In 1974, the membership base of the credit union was extended to 
include AT&T employees and the credit union changed its name to GHQ 
Federal Credit Union (General Headquarters).
    In 1984, with assets of $93.7 million, headquarters were moved 
across the river from New York City to New Providence, New Jersey, and 
GHQ became the second largest credit union in the State of New Jersey. 
At the close of 1986, the credit union changed its name from GHQ to 
AT&T Employees Federal Credit Union (AT&T EFCU) to more accurately 
reflect the current membership.
    In 1995, I was named the new President and CEO, and was charged to 
be a catalyst for change. Although serving a single sponsor for most of 
these 60 years, the announcement that AT&T would be split into three 
separate companies encouraged the credit union to adopt a new name and 
Affinity Federal Credit Union was chosen.
    Today, Affinity is the largest credit union in the State of New 
Jersey with 21 branches, more than 137,000 members from more than 2,000 
businesses and organizations, and total assets in excess of $2 billion.
    As you may know, NAFCU is the only national organization 
exclusively representing the interests of the Nation's federally 
chartered credit unions. NAFCU-member credit unions collectively 
account for approximately 62 percent of the assets of all federally 
chartered credit unions. NAFCU and the entire credit union community 
appreciate the opportunity to participate in this discussion regarding 
housing finance reform and the continuation of the 30-year fixed-rate 
Background on Credit Unions
    Historically, credit unions have served a unique function in the 
delivery of necessary financial services to Americans. Established by 
an act of Congress in 1934, the Federal credit union system was 
created, and has been recognized, as a way to promote thrift and to 
make financial services available to all Americans, many of whom would 
otherwise have limited access to financial services. Congress 
established credit unions as an alternative to banks and to meet a 
precise public need-a niche credit unions fill today for nearly 93 
million Americans. Every credit union is a cooperative institution 
organized ``for the purpose of promoting thrift among its members and 
creating a source of credit for provident or productive purposes.'' (12 
 USC 1752(1)). While over 75 years have passed since the Federal 
Credit Union Act (FCUA) was signed into law, two fundamental principles 
regarding the operation of credit unions remain every bit as important 
today as in 1934:

    credit unions remain totally committed to providing their 
        members with efficient, low-cost, personal financial service; 

    credit unions continue to emphasize traditional cooperative 
        values such as democracy and volunteerism. Credit unions are 
        not banks.

    The Nation's approximately 7,200 federally insured credit unions 
serve a different purpose and have a fundamentally different structure 
than banks. Credit unions exist solely for the purpose of providing 
financial services to their members, while banks aim to make a profit 
for a limited number of shareholders. As owners of cooperative 
financial institutions united by a common bond, all credit union 
members have an equal say in the operation of their credit union--``one 
member, one vote''--regardless of the dollar amount they have on 
account. These singular rights extend all the way from making basic 
operating decisions to electing the board of directors-something 
unheard of among for-profit, stock-owned banks. Unlike their 
counterparts at banks and thrifts, Federal credit union directors 
generally serve without remuneration--a fact epitomizing the true 
``volunteer spirit'' permeating the credit union community.
    Credit unions continue to play a very important role in the lives 
of millions of Americans from all walks of life. As consolidation of 
the commercial banking sector has progressed, with the resulting 
depersonalization in the delivery of financial services by banks, the 
emphasis in consumers' minds has begun to shift not only to services 
provided, but also--more importantly--to quality and cost of those 
services. Credit unions are second-to-none in providing their members 
with quality personal financial services at the lowest possible cost.
Credit Union vs. Bank Mortgage Lending
    Credit unions were not the cause of the recent economic crisis, and 
an examination of their lending data indicates that credit union 
mortgage lending has outperformed bank mortgage lending during the 
recent downturn. This is due in part to the fact that credit unions 
were not the cause of the proliferation of subprime loans, instead 
focusing on placing their members in solid products that they could 
afford. The graphs below highlight how credit union real estate loan 
growth has outpaced banks during the downturn, and how credit unions 
have fared better with respect to real estate delinquencies and real 
estate charge-offs. The fourth graph demonstrates how credit unions are 
holding more long-term real estate loans as a percentage of total real 
estate loans than banks.


The 30-Year Fixed-Rate Mortgage
    The 30-year fixed-rate mortgage (FRM) we know today had its origins 
in the reforms of President Franklin Delano Roosevelt's New Deal. 
Congress created the Federal Housing Administration (FHA) in 1934 as 
part of the National Housing Act of 1934 (Housing Act) during President 
Roosevelt's first term. The goal of the Housing Act was to enable home 
ownership for a broad sector of the American public. President 
Roosevelt's measure was in response to the Great Depression, which 
included a collapse of the banking system and subsequent mass 
    When the FHA was created, the housing industry was in dire straits. 
Millions of Americans lost their homes. Two million construction 
workers had lost their jobs. Terms were difficult to meet for 
homebuyers seeking mortgages. Mortgage loan terms were often limited to 
50 percent of the property's market value, with a repayment schedule 
spread over three to 5 years, and ending with a balloon payment. 
America had become a Nation primarily of renters. Only 40 percent of 
occupied homes were owned.
    At this time Fannie Mae and the Federal Deposit Insurance 
Corporation (FDIC) were also formed. The creation of these entities 
allowed the Government to restructure loan opportunities and create the 
30-year fixed-rate mortgage (FRM). These entities have allowed tens of 
millions of home mortgages and tens of thousands of multifamily 
projects to come to fruition.
    Prior to the introduction of the 30-year FRM, U.S. homeowners were 
at the mercy of adjustable interest rates. After making payments on a 
loan at a fluctuating rate for a certain period, the borrower would be 
liable for the repayment of the remainder of the loan (balloon 
payment). Before the innovation of the 30-year FRM, borrowers could 
also be subject to the ``call in'' of the loan, meaning the lender 
could demand an immediate payment of the full remainder. The 30-year 
FRM was an innovative measure for the banking industry, with lasting 
significance that enabled mass home ownership through its 
predictability. Congress gave credit unions the authority to offer 30-
year mortgages in 1977.
    Over the long-term, a 30-year FRM can be more expensive than an 
adjustable-rate mortgage (ARM). The ARM, however, is subject to 
fluctuations of a number of indicators in the market, and therefore 
carries greater risk to the borrower. Homebuyers who value more 
certainty in mortgage payments, and who can resist the lure of more 
risky but possibly cheaper financing, the 30-year fixed-rate mortgage 
offers the greatest long-term option, as it protects borrowers against 
interest rate spikes.
    The FRM is the dominant instrument of mortgage originations. The 
FRM is regarded as a consumer-friendly instrument because it is 
straight forward, easy to understand, and provides for a predictable 
monthly payment schedule. The table on the next page outlines first 
mortgage activity (both new and outstanding) at federally insured 
credit unions for the first half of 2011. As you can see longer term 
fixed-rate mortgages (defined as greater than 15 years) make up the 
largest percent of the total loans granted and outstanding in terms of 
dollar amounts. Shorter term fixed-rate mortgages (15 years and under) 
are the next highest, buoyed by the current low interest rate 
environment. In 2009, during a higher interest rate environment, fixed-
rate mortgages made up over 80 percent of the total loans made, with 
longer term fixed-rate mortgages accounting for over 55 percent of the 
total loans made by insured credit unions. 


     With a fixed-rate mortgage, the lending institution assumes the 
risk associated with any interest rate increase. Having too many long-
term fixed-rate mortgages in portfolio subjects the financial 
institution to greater interest rate risk, and can be cause for concern 
for examiners. At Affinity FCU we mitigate risk in our long-term FRM 
portfolio by hedging with interest rate swaps, caps, and matched 
borrowing. Selling on the secondary market to Fannie Mae and Freddie 
Mac is also an important risk mitigation tool. The securitization 
activities of Fannie Mae and Freddie Mac help lower the relative cost 
of the 30-year FRM and are an important factor in its viability.
    Credit unions cannot raise funds from the capital markets, only 
from their members. The development of secondary markets for loans and 
mortgage backed securities (MBSs) through Government-sponsored 
enterprises (GSEs) was key to allowing credit unions to offer loans of 
longer terms. Credit unions were able to offer longer-term funding to 
match the terms of the mortgages and transfer some of that risk through 
loan sales to secondary markets. Without the Housing Act and the 
support of the GSEs, it is not clear that today's mortgage loans would 
have a 30-year term. Without a Government role in the secondary market, 
the 30-year FRM may still exist, but likely with higher cost to the 
consumer and scarce availability. The system of long-term fixed-rate 
mortgages financed through stable securitization has helped provide 
remarkable stability in the U.S. economy, as well as strong and 
sustainable homeownership.
    There is no evidence that the recent economic downturn and collapse 
of the housing market was due to the presence of long-term fixed-rate 
mortgages, especially at credit unions. The success of credit unions 
during the economic downturn is evidence of this. Credit unions did not 
aid in the proliferation of subprime ARMs. Credit union loans are seen 
as quality loans, and their performance has backed that up. This is 
evidence that the 30-year FRM is not problematic by itself, and can be 
an important product for consumers and financial institutions. At 
Affinity FCU, we found that when our members got into trouble it was 
not from a particular first mortgage product; rather, it was likely 
from one of the following two factors: 1) loss of a job or 
unemployment; and 2) a decline in home value after a large amount of 
equity was pulled out in a line of credit.
The Future of the 30-year FRM
    Full privatization of the secondary market is not a good option 
because the focus will shift away from the best interest of the 
consumer and overall housing market, to a business' bottom line. The 
existence of private label securitization of real estate loans was a 
significant factor in the recent housing market crisis. Going forward, 
a totally privatized secondary market will not allocate enough capital 
because of the inherent risks, both credit and interest rate, without 
some sort of Government guarantee. Without a Government role, 30-year 
(and other longer term) fixed-rate mortgages will become riskier 
propositions for credit unions. For safety and soundness reasons, 
additional risk will have to be passed on to the consumer. While some 
additional risk being borne by the consumer may not be a bad thing in 
and of itself, lack of a Government role as a stabilizing force in the 
secondary market would have a significant impact on the ability of 
credit unions to offer affordable, consumer-friendly mortgage products 
such as the 30-year FRM. We believe that it would further limit the 
availability of long-term, fixed-rate mortgage products, and 
substantially increase the costs of mortgages to the consumer.
    It should be noted that the Government support for the secondary 
market does not only come from support and guarantees for the GSEs, but 
also in an indirect way when Government entities purchase mortgage 
backed securities (MBSs). This Government role in the market helps 
serve as a check on interest rates for the consumer. The loss of this 
Government role would likely drive up rates.
    If the Government totally withdrew from the housing market, it 
could lead to an absence of, or at least a limited availability of, 
longer term FRMs. This would cause risk to be shifted back to the 
consumer and the cost associated with that risk would likely drive many 
low and moderate income consumers out of the homeownership market. 
Furthermore, not having an outlet to sell 30-year FRMs currently held 
in portfolio, if needed, could create additional risk for financial 
institutions such as credit unions.
    The Housing Act, its creation of the FHA, and the resulting 
introduction of the 30-year fixed-rate mortgage, brought long-term 
stability to the American housing market and helped to stimulate 
economic recovery in the United States in the wake of the Great 
Depression. Accordingly, NAFCU believes that limiting the availability 
of the 30-year fixed-rate mortgage in these tough economic times will 
further drive down the already struggling housing market.
The 30-Year FRM and other products at Affinity Federal Credit Union
    At Affinity FCU, we offer fixed-rate mortgage products in 10, 15, 
20, and 30-year terms. Our 30-year FRM has traditionally been the most 
popular loan product with our members as it drives affordability and 
accounts for over 64 percent of our fixed-rate mortgage portfolio and 
nearly 48 percent of our overall loan portfolio. Our 15 and 20 year 
fixed-rate mortgages combined make up nearly another 22 percent of our 
total loan portfolio. This demonstrates a clear interest from our 
members in having a longer term fixed-rate mortgage product.
    I should note that in the current record low interest rate 
environment, we are seeing increased interest in the shorter term 
fixed-rate products, as monthly payments are more affordable. This has 
also been seen in our adjustable-rate products, as people who have 
shorter timeframes may opt for the historic low rates of ARMs in this 
current rate environment. We believe it is important that any reforms 
do not try to limit financial institutions to offering only ``plain 
vanilla'' products. As member-owned institutions, credit unions have a 
strong track record of offering products our members want, working to 
place them in the right product for their needs. It is important that 
housing finance reform does not close the door on the ability of credit 
unions to match the member with the best mortgage product for them.
    We also believe preference for mortgage products is somewhat 
generational. Post World War II and the baby boom generation tended to 
prefer the stability of long-term fixed-rate products, as many bought 
houses that they were going to live in for a number of years. Today, in 
a more mobile society, we see members who are approaching retirement or 
know they may be moving in a set time opting for a shorter term product 
to build faster equity when they buy or refinance. At the same time, we 
see many first-time or younger home buyers still opting for the 
stability of longer term fixed-rate products. It is important to note 
that few 30-year mortgages ever go to their full term, as homeowners 
will likely move, refinance or pay off the loan early long before loan 
maturity. Still, we have found that our members prefer the certainty of 
these longer-term fixed-rate products in their financial planning.
Managing Interest Rate Risk
    Recent trends in asset portfolios, coupled with the current 
interest rate environment presents a unique challenge to credit union 
management. Over the last few years, interest rates have fallen to 
record lows, credit unions have experienced vigorous share growth, and 
credit union participation in the mortgage lending arena has increased 
to historic highs. Given these trends, it is more important now than 
ever to have a solid risk management program. The National Credit Union 
Administration (NCUA) has been active in watching interest rate risk at 
credit unions from long-term fixed-rate mortgages, issuing a letter to 
credit unions on the matter as far back as September 2003 and issuing 
an interagency (along with banking regulators) interest rate risk 
advisory in 2010. Additionally, they are currently in the process of 
finalizing a new interest rate risk rule.
    The low interest rate environment is an additional deterrent for 
attracting private capital. In any housing reform, Government support 
is going to be a necessity for the foreseeable future. Curtailing that 
support will lead to additional credit stress on individuals and 
further threaten the safety and soundness of the financial system. 
Rates will rise exacerbating an already stressed economy if lenders do 
not have readily available avenues to manage risk.
    Credit unions hedge against interest rate risk in a number of ways, 
including interest rate swaps, caps, borrowing and selling products for 
securitization on the secondary market. Lenders, such as credit unions, 
must be able to manage risk. Funding low-rate long-term fixed-rate 
paper with short-term deposits is a recipe for disaster. Lenders must 
have continued and unfettered access to hedging mechanisms. 
Unfortunately, the three ways that lenders manage interest rate risk 
(loan sales, term FHLB borrowings and plain vanilla interest rate 
swaps) are in the crosshairs of public policy debates.
    Some of the options put forth as part of housing finance reform 
such as tighter underwriting standards, increasing guarantee fees, 
reducing conforming loan limits, increasing downpayments and limiting 
FHLB borrowings all could impact lender access to risk management 
tools. These ideas must be carefully orchestrated so that lenders can 
manage risk, rates are kept at a level that supports the recovery and 
consumers have access to credit on reasonable terms.
    Fannie Mae and Freddie Mac, as well as the Federal Home Loan Banks, 
are valuable partners for credit unions who seek to hedge against these 
interest rate risks by selling their fixed-rate mortgages to them on 
the secondary market. Because Fannie and Freddie will buy loans on the 
secondary market, the credit union is not only able to mitigate the 
risk associated with interest rates, but they are also able to reinvest 
those funds into their membership or institution by offering them new 
loans or additional forms of financial services. Without this 
relationship with Fannie and Freddie credit unions would be unable to 
provide the services and financial products that their memberships 
demand and expect.
    It should also be noted that the Government plays an important role 
in helping to set standards and bring conformity to the housing market. 
The tools that Fannie and Freddie provide help smaller institutions, 
such as credit unions, make the conforming loans that are sought on the 
secondary market. Changing standards to eliminate or make conformity 
difficult could make it hard for credit unions to sell loans on the 
secondary market, constraining their ability to manage risk in this 
Housing Finance Reform
    In the 3 years since the Federal Government took control of Fannie 
Mae and Freddie Mac from their stockholders through conservatorship, 
the future of the Government-sponsored enterprises and the secondary 
mortgage market has become a topic of debate. The development and 
reform of housing finance policy is highly significant to NAFCU and 
credit unions.

    In February, the Department of Treasury released a proposal that 
would ultimately wind down Fannie Mae and Freddie Mac by offering three 
different scenarios for moving forward with varying degrees of 
Government involvement. Several pieces of legislation, from 
comprehensive to piecemeal approaches, have also been introduced in the 
House and Senate.

    NAFCU would like to stress the importance of retaining a system 
that provides credit unions with the secondary market access necessary 
to serve the mortgage needs of their 93 million members. As you 
consider legislative proposals, NAFCU would like to reiterate a core 
set of principles we believe must be considered to ensure that credit 
unions are treated fairly during any housing finance reform process:

    A healthy and viable secondary mortgage market must be 
        maintained. A secondary mortgage market, where mortgage loans 
        are pooled and sold to investors, is essential in providing the 
        liquidity necessary for credit unions to create new mortgages 
        for their members.

    To effectuate competition and ensure access for credit 
        unions, there should be at least two Government Sponsored 
        Enterprises (GSEs) that would perform the essential functions 
        currently performed by Fannie Mae and Freddie Mac.

    The U.S. Government should issue explicit guarantees on the 
        payment of principal and interest on MBSs. The explicit 
        guarantee will provide certainty to the market, especially for 
        investors who will need to be enticed to invest in the MBSs and 
        facilitate the flow of liquidity.

    During any transition to a new system (whether or not 
        current GSEs are to be part of it) credit unions have 
        uninterrupted access to the GSEs, and in turn, the secondary 

    Credit unions could support a model for the GSEs that is 
        consistent with a cooperative or a mutual entities model. Each 
        GSE would have an elected Board of Directors, be regulated by 
        the Federal Housing Finance Agency, and be required to meet 
        strong capital standards.

    A board of advisors made up of representatives from the 
        mortgage lending industry should be formed to advise the FHFA 
        regarding GSEs. Credit unions should be represented in such a 

    While a central role for the U.S. Government in the 
        secondary mortgage market is pivotal, the GSEs should be self-
        funded, without any dedicated Government appropriations. GSE's 
        fee structures should, in addition to size and volume, place 
        increased emphasis on quality of loans and risk-based pricing 
        for loan purchases should reflect that quality difference. 
        Credit union loans provide the high quality necessary to 
        improve the salability of many agency securities.

    Fannie Mae and Freddie Mac should continue to function, 
        whether in or out of conservatorship, and honor the guarantees 
        of the agencies at least until such time as necessary to repay 
        their current Government debts.

    NAFCU does not support full privatization of the GSEs 
        because of serious concerns that small community-based 
        financial institutions could be shut-out from the secondary 

    The Federal Home Loan Banks (FHLBs) serve an important 
        function in the mortgage market as they provide their credit 
        union members with a reliable source of funding and liquidity. 
        Reform of the Nation's housing finance system must take into 
        account the consequence of any legislation on the health and 
        reliability of the FHLBs.

    A vibrant and responsive secondary market for 30-year fixed-rate 
paper and access to term funding through the FHLB system are essential 
for community-based lenders so they can manage risk, offer a continuing 
supply of credit to consumers and small businesses and support the 
economic recovery.
    NAFCU strongly believes that any reforms must not disrupt the 
fragile housing finance system that is slowly beginning to recover. As 
you know, any such disruption could trigger a ``double-dip'' recession 
and such an occurrence will have a devastating impact on our country's 
economy as well as the global finance system. In addition, we believe 
it is critical that the essential functions of Fannie Mae and Freddie 
Mac are retained until taxpayer dollars that the Federal Government 
injected into the GSEs are recovered. The essential functions include, 
but are not limited to, purchasing and guaranteeing mortgages 
originated by credit unions.
    The 30-year fixed-rate mortgage product remains the most popular 
mortgage product available today. As such, it is necessary for the 
health of our housing market and continued recovery of our economy that 
it remains readily available. The ability of credit unions to make 
these loans and mitigate their interest rate risk by selling these 
loans to GSEs on the secondary market is as important to economic 
vitality as their availability in the marketplace. By allowing credit 
unions to hedge against interest rate risk by selling these mortgages, 
credit unions are better able to serve their members by continuing to 
offer products and services they want and need.
    We thank you for your time and the opportunity to testify before 
you here today on this important issue to credit unions and our 
Nation's housing market. I would welcome any questions that you may 
                   Distinguished Professor of Finance
              George Mason University School of Management
                            October 20, 2011
     Mr. Chairman, and distinguished Members of the Committee, my name 
is Dr. Anthony B. Sanders and I am the Distinguished Professor of 
Finance at George Mason. It is an honor to testify before this 
Committee today.
    The FRM occupies a central role in the U.S. housing-finance system. 
The dominant instrument since the Great Depression, the FRM currently 
accounts for more than 90 percent of mortgage originations. One reason 
why it enjoys enduring popularity is that the FRM is a consumer-
friendly instrument. Not only does the FRM offer payment stability--the 
instrument provides a one-sided bet in the borrower's favor. If rates 
rise, the borrower benefits from a below market interest rate. If rates 
fall, the borrower can benefit from exercising the prepayment option in 
the FRM to lower their mortgage interest rate.
    But these consumer benefits have costs. It is costly to provide a 
fixed nominal interest rate for as long as 30 years. And the prepayment 
option creates significant costs. If rates rise, the lender has a below 
market rate asset on its books. If rates fall, the lender again loses 
as the mortgage is replaced by another with a lower interest rate. To 
compensate for this risk, lenders incorporate a premium in mortgage 
rates that all borrowers pay regardless of whether they benefit from 
refinance. Exercise of the prepayment option in the contract also has 
significant transactions costs for the borrower and imposes additional 
operating costs on the mortgage industry.
    Another major reason for the FRM's dominance is Government support 
and regulatory favoritism. The FRM is subsidized through the 
securitization activities of Fannie Mae, Freddie Mac and Ginnie Mae. 
Their securities benefit from a Government guarantee that lowers the 
relative cost of the instrument, which is their core product. These 
guarantees have a significant cost as the Government backing of Fannie 
Mae and Freddie Mac has exposed taxpayers to large losses.
    Are the FRM's benefits worth its costs? Would the FRM disappear if 
Fannie and Freddie stopped financing it? Are there mortgage 
alternatives that balance the needs of consumers and investors without 
exposing the taxpayer to inordinate risk? These are important questions 
and the answer is that short-term FRM and ARMs have decided benefits to 
consumers and taxpayers over the vaunted 30-year FRM.
Benefits of FRMs
    A long history of Government support is not the only reason for the 
FRM's dominance.\1\ The instrument offers consumers several advantages. 
First and foremost, it provides nominal payment stability, which helps 
consumers budget and reduces the likelihood of default. The monthly 
payment on an FRM is the same throughout the life of the loan, whereas 
borrowers with ARMs can experience payment shock in a volatile 
interest-rate environment, making them more likely to default.\2\ The 
FRM is also a simple instrument for borrowers to understand, which has 
lead to proposals that lenders be required to offer the instrument to 
consumers applying for a mortgage.
    \1\ See Michael Lea and Anthony B. Sanders, 2011, ``Government 
Policy and the Fixed-Rate Mortgage,'' Annual Review of Financial 
    \2\ ARMs have had a much worse default experience during the 
recession. In part, this reflects the predominance of ARMs in the 
subprime market. It also reflects a selection bias whereby riskier and 
more speculative borrowers went into ARMs.
    The option to prepay an FRM without penalty is another consumer 
advantage.\3\ This feature effectively converts the FRM into a 
downwardly adjustable-rate mortgage. When market interest rates fall, 
the borrower can refinance into a new loan at a lower rate. When rates 
rise, the fixed-rate feature protects the borrower against rising 
mortgage payments. Thus, the FRM (as opposed to a short-term ARM, for 
example) shields borrowers from most interest-rate risk. But the risk 
does not disappear--the lower the risk for the borrower, the greater it 
is for the lender/investor.
    \3\ Prepayment is not costless, however. There are significant 
transaction costs associated with refinancing.
Costs of FRMs
    The instrument's supporters point out that it is easier for 
investors than consumers to manage interest-rate risk. It is true that 
lenders and investors have more tools at their disposal to manage 
interest-rate risk. But managing prepayment risk is costly and 
difficult and many institutions have suffered significant losses as a 
result (e.g., savings and loans in the 1980s; hedge funds and mortgage 
companies in the 1990s and 2000s).\4\ Furthermore, borrowers rarely 
stay in the same home or keep the same mortgage for 15 to 30 years,\5\ 
so one can reasonably ask why rates should be fixed for such long 
periods (increasing the loan's cost and risk). Also, the taxpayer 
ultimately bears a significant portion of the risk through support of 
Fannie Mae and Freddie Mac.
    \4\ The uncertainty about prepayment leads to considerable 
speculation on the future direction of mortgage rates that has little 
social benefit. Hedging also increases systemic risk through 
counterparty exposure. The huge hedge positions of Fannie and Freddie 
were one reason why the Government placed them in conservatorship in 
    \5\ Over the past 50 years the average life of a 30-year mortgage 
has never been higher than 12 years (during periods of high interest 
rates) and often no more than 5 years (during period of lower interest 
    One of the lingering questions about Government loan modification 
programs is why borrowers are refinanced into longer-term FRMs rather 
than less expensive ARMs, such as a 5/1 ARM.
Does the FRM Promote Financial and Housing Market Stability?
    It has been argued that the FRM promotes financial- and housing-
market stability. A system dominated by ARMs or short-term fixed-rate 
mortgages is more sensitive to interest-rate fluctuations than one 
dominated by the FRM and can contribute to boom-bust cycles in housing. 
Housing demand is more rapidly influenced by monetary policy with ARMs 
relative to FRMs. But FRMs hardly eliminate housing cycles. The United 
States has experienced pronounced housing cycles in most decades since 
World War II, including a massive housing boom and bust in the last 
decade. Min attributes the most recent cycle to the rapid growth in 
short-duration mortgages. In large part, the shortening average life of 
mortgages reflects the widespread exercise of the FRM prepayment 
    The FRM has a uniquely one-sided design that protects the borrower 
at the expense of the lender/investor. But such protection comes at a 
cost. Longer-term fixed-rate loans have higher rates than shorter-term 
fixed-rate loans in most interest-rate environments (Table 1). Having a 
range of fixed-rate terms allows the borrower to tradeoff monthly 
payment stability with overall mortgage affordability. For example, a 
mortgage whose interest rate is fixed for 30 years will usually have 
the highest interest rate, while a 3:1 ARM, whose interest rate is only 
fixed for the first 3 years, will usually have the lowest interest 
    Also, prepayable mortgages have higher rates than non-prepayable 
mortgages. In effect, all U.S. mortgage borrowers pay for the option to 
refinance, regardless of whether they exercise it. This system differs 
from the Canadian and European systems. In those systems, the borrower 
receives a short- to medium-term fixed-rate loan without a free 
prepayment option. If the borrower wants to prepay for financial 
reasons (as opposed to moving), they must pay a penalty equivalent to 
the investor's or lender's cost to reinvest the proceeds at the new, 
lower market rate. The option's cost is thus individualized--borne by 
the individual exercising the option. In the United States, the 
option's cost is socialized, with all borrowers paying a premium in 
their mortgage rates (on average, around 50 basis points, or 0.5 
percent). In effect, the prepayment option is a tax on all borrowers.
    Because all borrowers pay for the prepayment option, borrowers who 
do not exercise the option effectively subsidize those who do. Most 
often, unsophisticated borrowers who are intimidated by the refinance 
process or who are credit impaired pay the subsidy. The latter group is 
most likely to benefit at the margin (e.g., by lowering the risk of 
default) but least able to refinance.
The 30-Year FRM, Slow Principal Amortization and Negative Equity
    The potential for negative equity with a slowly amortizing mortgage 
product is daunting. When the principal is very slow to pay down and 
house price drop suddenly (as they did during the housing bubble 
burst), The FRM can create negative equity for borrowers in a rising 
interest-rate environment as well. When interest rates rise, a house's 
value may fall. And the economic value of the mortgage falls. However, 
the borrower is still responsible for repaying the loan at par value 
(the nominal outstanding balance). The combination of falling house 
price and constant mortgage value can lead to or exacerbate negative 
equity. Homeowner negative equity can also produce significant economic 
costs in that they are less likely to move in order to change their 
housing consumption or to take advantage of job opportunities. Negative 
equity has made loan modifications under private and public programs 
quite difficult and would have been far less of a problem if short-term 
mortgages (and faster principal amortization) had been the pre-dominant 
mortgage design.
    Rising interest rates cause other problems for FRM borrowers and 
investors. If rates rise because of expected inflation, FRMs create 
affordability problems for new borrowers.\6\ Unhedged investors 
experience an economic loss on their holdings of FRM-backed securities 
when interest rates rise (they also do not benefit from a rate decline, 
as noted earlier).\7\ Rising interest rates also create an extension 
risk (the risk that the average life of securities rises) for 
investors. As rates rise, prepayments slow and the effective maturity 
of the securities increases beyond that expected by investors.
    \6\ This scenario occurred during the 1970s in the United States.
    \7\ Hedging uncertain prepayment is both costly and risky. It leads 
to considerable speculation on the future direction of mortgage rates 
that has little social benefit. Hedging also increases systemic risk 
through counterparty exposure. The huge hedge positions of Fannie and 
Freddie were one reason why the Government placed them in 
conservatorship in 2008.
Interest-rate Volatility and the 30-Year FRM
    Volatile interest rates cause problems for both borrowers and 
lenders. Long-term fixed-rate instruments have greater sensitivity to 
interest-rate changes than shorter-term instruments do. Volatility in 
pricing also makes mortgage shopping more difficult for borrowers in 
that mortgage prices can vary significantly on a daily (or even 
intraday) basis.\8\
    \8\ Mortgage shopping in the United States is also complicated by 
the use of points to adjust pricing. Borrowers are confronted with an 
array of rate and point combinations that differ across lenders. Points 
were introduced in the 1970s when market rates rose above FHA rate 
ceilings--another effect of Government regulation.
    Interest-rate volatility also causes refinancing waves, which 
increase costs for mortgage originators and borrowers. As interest 
rates rise and fall, mortgage origination volume is subject to massive 
swings. Mortgage originators and servicers have significant costs 
associated with managing such volatility. For example, origination 
volume rose from less than $3 trillion in 2002 to nearly $4 trillion in 
2003 and fell to less than $3 trillion in 2004. Thus, the industry had 
to increase capacity by 33 percent in 1 year and reduce it by 25 
percent the following year. FRM refinancing was the main reason for 
this volatility. For mortgage borrowers, the cost of refinancing lies 
in the thousands of dollars they must pay in origination fees simply to 
lower their mortgage rates.\9\ The effect of the 30-year FRM on 
prepayments can be seen in Table 1 where the Mortgage Bankers 
Association Refinancing Index has become more volatile with 
progressively declining interest rates; shorter-term mortgages do not 
have the volatility of prepayments than longer-term mortgages.
    \9\ Refinancing transactions costs could be eliminated with use of 
a ``ratchet mortgage,'' in which the rate is automatically lowered 
without transaction costs.
     The FRM has also created significant costs for taxpayers. Until 
1981, federally insured depositories were prohibited from offering 
ARMs. Predictably, when inflation and interest rates rose in the 1970s 
and early 1980s, reliance on this instrument effectively killed off the 
S&L industry. In 1982, approximately 80 percent of the S&L industry was 
bankrupt and insolvent due to the mismatch between FRM assets and the 
short-term deposits that funded them. A similar mismatch rendered 
Fannie Mae insolvent. When numerous thrifts eventually failed, the 
taxpayer picked up a significant tab to restructure the industry.\10\
    \10\ Although the popular press tended to focus on excessively 
risky nonresidential mortgage investments as the cause of the S&Ls' 
failure, the fact was that they were bankrupted by the asset-liability 
mismatch and tried to grow out of their earnings and capital problems 
through investment in high-risk assets.
    Learning from the experience, banks and thrifts continued to 
originate 30-year FRMs, but only if the loans could be sold to Fannie 
Mae, Freddie Mac, or guaranteed by the Ginnie Mae. In other words, 
banks and thrifts did not retain the interest-rate risk that they 
created by originating the FRMs. Instead, investors absorbed the risk. 
As the ultimate risk bearers, private investors attempted to price and 
manage the risk (with varying degrees of success). The GSEs hold a 
significant portion of the FRM inventory,\11\ so when interest rates 
rise, they may suffer large losses that will be borne by taxpayers.
    \11\ The GSEs hold whole loans in their portfolios. They also 
repurchase securities they guarantee-in effect investing in the cash-
flow risk associated with funding callable mortgages with a blend of 
callable and non-callable debts of different maturities.
    The FRM's popularity and its Government backing produce another 
significant risk for the Government. In order to finance the FRM and 
allocate the interest-rate risk to investors, the Government--through 
FHA insurance and Fannie/Freddie guarantees--absorbs the mortgages' 
credit risk. Ironically, it was credit risk that led to the failures of 
Fannie and Freddie in the financial crisis. While part of their losses 
can be attributed to speculative investments in subprime and Alt-A 
backed securities (mostly non-fixed-rate mortgages), a significant 
portion of their losses have come from FRM defaults.\12\ The Federal 
Housing Finance Agency now projects GSE losses to be $220 to $360 
billion. A portion of these losses can be attributed to the policy goal 
of ensuring the FRM's availability through the Government's absorption 
of the credit risk.
    \12\ Federal Housing Finance Agency (FHFA) projections of GSE 
losses found that most of the losses are due to their purchased loans 
rather than securities. See FHFA, ``Projections Showing Range of 
Potential Draws for Fannie Mae and Freddie Mac,'' October 21, 2010 
(Attachment to the Press Release FHFA Releases Projections Showing 
Range of Potential Draws for Fannie Mae and Freddie Mac).
Alternative Designs in International Mortgage Markets
    The FRM is a unique instrument by international standards. Only one 
other country, Denmark, has a long-term, fixed-rate, prepayable 
(without penalty) mortgage.\13\ Several other countries have long-term 
fixed-rate products (e.g., France, Japan, and Germany), but the typical 
terms are shorter and prepayment is subject to penalty. Shorter 
amortization periods benefit both borrowers and lenders because 
borrowers accumulate equity faster.
    \13\ The Danes add a unique twist to the instrument in that the 
loan is backed by an individual mortgage bond. If rates rise, the 
borrower can buy the bond at a discount and cancel the loan with the 
lender. This feature facilitates automatic deleverage and reduces the 
likelihood of negative equity.
    A more common fixed-rate instrument is the rollover mortgage, which 
is the dominant instrument in Canada and several European 
countries.\14\ Its interest rate is typically fixed for up to 5 years 
and ``rolls'' into a new fixed rate at the end of the term. The new 
rate is negotiated with the lender and is set at market. These loans 
also have prepayment penalties during the fixed-rate term but allow 
total repayment without penalty at the end of the term.
    \14\ Canada subsidizes mortgages through CMHC. The degree of 
support is far less that U.S. support for housing (around 50 percent 
insured and 30 percent securitized) and the Canada bond program was 
designed to eliminate the prepayment volatility because investors don't 
like it (through cash-flow swaps with private investors).
    Adjustable-rate loans are the dominant instrument in a number of 
countries, including Australia, Spain, and the United Kingdom. Table 2 
shows the types of mortgages available in different countries and how 
common each product is.
    Many countries have had housing booms and busts during the last 
decade (e.g., Australia, Denmark, Ireland, Spain). Yet only Ireland has 
had as severe of a downturn as the United States (Table 3). Some have 
attributed the U.S. housing cycle to a shortening of the duration of 
mortgages over the past two decades, which caused house prices to 
become more sensitive to interest rates. Low interest rates, ample 
credit and borrower demand clearly contributed to the boom--however, 
throughout the boom period a majority of loans were in fact fixed 
rates. Most of the reduction in average mortgage maturity was due to 
borrowers exercising the prepayment option in their FRM contracts. And 
much of the shortening was for cash-out refinances to facilitate 
consumption at the expense of wealth accumulation. The inability of 
households to refinance FRMs to reduce negative equity has exacerbated 
the current crisis as noted above.
    The prepayment option on the 30-year FRM is far from free. While 
only some borrowers will actually utilize the prepayment option, 
everyone has to pay for it (even if consumers don't want it). Fannie 
Mae and Freddie Mac will only purchase prepayable mortgages, even 
though non-prepayable mortgages may be in many borrowers' best 
Are The Benefits of the FRM Worth the Costs?
    The fundamental question remains: Are the benefits of the FRM worth 
the costs? All borrowers pay a substantial tax--50 basis points or 
more--for this instrument. Furthermore, taxpayers have absorbed 
substantial losses in order to support this instrument, first through 
the S&Ls and now through Fannie Mae and Freddie Mac. Should the 
Government subject taxpayers to the risk of another catastrophic 
meltdown to preserve the FRM? Are there alternatives that maintain some 
of the FRM's benefits while greatly reducing the costs?
    If the Government abolished Fannie Mae and Freddie Mac, the FRM 
would not cease to exist. Private-label securitization in the United 
States and covered bonds in Denmark have funded this instrument in the 
past and are fully capable of funding it in the future. Investors are 
sophisticated enough to price both credit risk and interest-rate risk. 
Conventional wisdom suggests that U.S. investors won't accept both 
credit risk and interest rate risk for large volumes of mortgages and 
the reason is clear: private investors can get the Government to absorb 
the credit risk at a lower cost than would be charged by the private 
market. The loss experiences of Fannie and Freddie suggest that they 
were funding mortgages at below-market (risk-adjusted) rates. Without 
Fannie and Freddie, the FRM would still be offered by lenders, but not 
at a subsidized rate. The FRM would have a smaller market share, but it 
would not disappear, as some have asserted. Nor would the only 
alternative be a short-term ARM as international experience suggests.
    What would emerge as the ``standard'' U.S. mortgage instrument 
without Government support of the FRM? A rollover mortgage similar to 
that offered in Canada and several European countries is the likely 
candidate.\15\ This instrument offers borrowers short- to medium-term 
payment stability, and borrowers can manage interest-rate risk by 
adjusting the fixed-rate term upon renewal. Modern international 
experience does not bear out the assertion by some that borrowers would 
be unable to refinance. Borrowers could hedge the interest-rate risk by 
locking in a forward rate in advance of renewal. German lenders offer 
forward rates up to 5 years--certainly U.S. lenders could do the same, 
given the deep derivative market. Alternatively, borrowers can adjust 
the degree of risk by varying the length of the fixed-rate period.
    \15\ Canada supports its mortgage market through default insurance 
and cash-flow guarantees comparable to FHA insurance and Ginnie Mae 
guarantees in the United States. The market share of Government-backed 
mortgages is considerably less, however, with approximately 50 percent 
of mortgages backed by Government insurance and 25 percent of mortgages 
backed by guarantees. European countries (with the exception of the 
Netherlands) do not support their mortgage markets through insurance or 
    A complete and robust housing-finance system should offer borrowers 
a menu of mortgage options, ranging from short-term ARMs for borrowers 
who can handle payment change to long-term FRMs for borrowers who value 
payment stability. To assert that the FRM is the preferred alternative 
for most borrowers is naive. Many borrowers have shorter-term time 
horizons and can handle some interest-rate risk. The reason borrowers 
select a longer-term fixed rate is the fact that Government guarantees 
subsidizes the rate. International experience does not support the 
assertion that the switch to shorter-duration instruments would lead to 
massive defaults if and when interest rates increase.
    The prohibition of prepayment penalties on fixed-rate mortgages is 
also misguided. Borrowers should be given a choice--long-term versus 
short-term fixed rates, with and without prepayment penalties. The 
market will price the differences, giving price breaks to those 
borrowers willing and able to handle interest-rate risk. Following 
Canadian and European tradition, the imposition of a prepayment penalty 
should be limited. It should not apply to borrowers moving house and it 
should be limited in term.\16\
    \16\ For example, the maximum term over which the penalty applies 
is 5 years in Canada and the Netherlands and 10 years in Germany.
    The private sector would continue to originate and hold/sell 30-
year FRMs without Government guarantees if there was continued consumer 
demand, but it is hoped that shorter-term mortgages and ARMs become 
more popular in the future. The most important result of a shift away 
from the FRM would be a reduction in taxpayer liability for mortgage 
risk. There is nothing so special about housing finance that Government 
should absorb the credit risk of the vast majority of the mortgage 
market or underwrite the interest-rate risk of that market. Two 
episodes of massive taxpayer losses should convince us of that fact.


                  Senior Economist and Policy Advisor
                     Federal Reserve Bank of Boston
                            October 20, 2011
    Chairman Johnson, Ranking Member Shelby, and distinguished Members 
of the Committee, I thank you for your invitation to testify today. My 
name is Paul Willen, and I am a Senior Economist and Policy Advisor at 
the Federal Reserve Bank of Boston. I come to you today, however, as a 
researcher and not as a representative of the Boston Fed, the other 
Reserve Banks, or the Board of Governors. My main objective today is to 
lay out some basic facts about long-term fixed-rate mortgages. The main 
benefit of fixed-rate mortgages, according to proponents, is that they 
eliminate the possibility of ``payment shocks'' and thus would have 
prevented many of the foreclosures we have seen in the last 5 years. I 
will explain that, contrary to popular belief, payment shocks played 
little role in the crisis and, in fact, most borrowers who lost their 
homes in the last 5 years had long-term fixed-rate mortgages. I will 
also discuss how long-term fixed-rate mortgages have been widely used 
throughout American history, including the years immediately preceding 
the Great Depression, and were as ineffective at preventing 
foreclosures in the 1930s as they are now.
``Payment Shocks'' Did Not Cause the Crisis
    One popular theory places mortgage payment shocks at the heart of 
the crisis. According to this theory, the explosion of foreclosures 
that started in 2007 occurred because borrowers took out complex 
mortgages with fluctuating payments. Borrowers who took the loans 
either did not realize the payments could increase, did not expect the 
payments to increase, or thought they could sell or refinance before 
the payments increased. The theory suggests that, when payments went 
up, borrowers found themselves facing unaffordable increases in monthly 
mortgage costs, the aforementioned payment shocks, for which 
foreclosure was the unfortunate outcome. According to the theory, long-
term fixed-rate mortgages would have largely mitigated the crisis 
because long-term fixed-rate mortgages guarantee a fixed payment for 
the life of the loan.
    But the data refute that theory. The data say that payment shocks 
played, at most, a minor role in the crisis. As you can see in Table 1, 
we studied 2.6 million foreclosures and, for 88 percent of them, the 
payment when the borrower defaulted was the same or lower than the 
initial payment.\1\ In other words, in only 12 percent of 
foreclosures--less than one out of eight--did the borrower suffer any 
payment shock at all prior to defaulting. Why didn't payments go up? It 
turns out that almost 60 percent of the borrowers who lost their homes 
had fixed-rate mortgages. This fact alone should dispel the 
misconception that a fixed-rate mortgage is inherently safe. But even 
borrowers who had adjustable-rate mortgages saw payments stay the same 
or go down. Why? Because contrary to popular belief, adjustable-rate 
mortgages do not only adjust up; if interest rates fall, payments 
either fall or stay the same. Starting in 2007, as in most recessions, 
interest rates fell. Indeed, in 2010, borrowers who lost their homes 
were almost as likely to have seen a payment reduction as a payment 
    \1\ ``Defaulted'' here refers to the first default in the 
delinquency spell that led to the foreclosure.
    If payment shocks don't cause foreclosures, what does? Our research 
has shown that life events such as job loss, illness, and divorce have 
been at the heart of this crisis all along, even before unemployment 
surged in the fall of 2008. It may seem counter-intuitive that life 
events can explain the surge in defaults in 2007, because there was no 
underlying surge in unemployment or illness that year. To better 
understand, one needs to know how falling house prices and life events 
interact to cause default. Foreclosures rarely, if ever, occur when 
borrowers have positive equity, for the simple reason that a borrower 
is almost always better off selling the house than defaulting. Thus, 
detrimental life events have no effect on foreclosures when prices are 
rising. Consider that in 2001, after 6 years of rising house prices, 
Massachusetts suffered a fairly severe recession which led to a large 
increase in delinquencies, but the number of foreclosures fell to a 
record low. You can see this evidence in Figure 1. On the other hand, 
when house prices fall, some borrowers can no longer profitably sell. 
It is then that disruptive life events--which are always present, even 
in normal times--take a toll. Thus we do not need to have a surge in 
life events to get a surge in foreclosures. Rather, a fall in house 
prices, as we have seen, will trigger a foreclosure surge. The problem 
is only amplified by rising job loss and other disruptive life events.
    It does turn out that fixed-rate mortgages default less often than 
adjustable-rate mortgages, but that fact reflects the selection of 
borrowers into fixed-rate products, not any characteristics of the 
mortgages themselves. In 2008, my colleagues and I showed that even 
accounting for observable characteristics of the loans--such as credit 
score, loan-to-value ratio, payment-to-income ratio, change in house 
prices, and change in payment--borrowers were more likely to default on 
adjustable-rate mortgages than on otherwise similar fixed-rate 
mortgages.\2\ The difference in default rates existed even for pools of 
loans where adjustable interest rates fell, further confirming that it 
was unobservable characteristics of borrowers, not of mortgages, that 
caused the difference. One possible explanation is that borrowers who 
intended to sell did not value the long-term certainty of fixed rates, 
gravitated to adjustable-rate loans, and those borrowers were the ones 
most likely to default when prices fell.
    \2\ ``Just the Facts: An Initial Analysis of the Subprime Crisis.'' 
With Chris Foote, Kris Gerardi and Lorenz Goette. 2008. Journal of 
Housing Economics, 17(4):291-305.
Long-term Fixed-rate Mortgages Were Widely Used Before the Great 
    The misconception that long-term fixed-rate mortgages are 
inherently safe has a long history. It is widely believed that the 
absence of long-term fixed-rate mortgages prior to the Great Depression 
was a major contributor to the ensuing foreclosure crisis. Again, the 
facts do not bear this out. As you can see in Table 2, building and 
loan societies accounted for 40 percent of U.S. residential lending 
during the Depression. Almost all loans from building and loan 
societies were long-term fixed-rate mortgages that provided for full 
amortization. As with the most recent crisis, it was the combination of 
falling house prices and massive economic dislocation that caused the 
foreclosures, something a fixed-rate mortgage is powerless to stop.
    The facts also disprove a closely related narrative about the 
Depression, which is that policymakers invented long-term fixed-rate 
mortgages, or were the first to use them widely. In fact, building and 
loan societies, the first of which began lending in 1831, always 
originated long-term fixed-rate mortgages and were, for much of the 
pre-depression era, the largest single source of funding for 
residential mortgages.
    I hope these findings add insight to your work as policymakers. 
Thank you again for the opportunity to appear today; I would be happy 
to address any questions.


                   President, Sand Hill Econometrics
                            October 20, 2011
    The focus of this hearing is the potential risk and unfairness of 
30-year fixed-rate loans. While these loans are appealing to borrowers 
for their simplicity and certainty, they have the potential for 
problems elsewhere in the economy, ultimately falling on taxpayers. 
Let's go directly to the risk issues first.
    The critics of the 30-year fixed-rate loan argue that this is 
unfair for households to get the benefits of reduced risk of fixed-rate 
loans while the taxpayers bear the risk. This criticism forgets that 
homeowners are taxpayers too. If we consider the situation over the 
lifetime of homeowner/taxpayers, there is nothing unfair about it. 
Indeed, it is a very desirable piece of social risk-sharing.

    First, we need a few facts:

  1.  While the homeownership rate is between 65 and 70 percent right 
        now, a much higher fraction of households, close to 85 percent, 
        become homeowners at some point in their lifetime.

  2.  Individual incomes tend to rise over time, and peak at about age 

  3.  Home-owning households on average have higher incomes than non-
        homeowning households, and as a result pay more taxes.

    This means that the overlap between homeowners and taxpayers is 
even higher than the 85 percent lifetime ownership rate. The people who 
benefit from our mortgage finance systems are thus the same people who 
pay taxes when problems arise. People benefit from the availability of 
a fixed-rate mortgage when they are young and have greater need for the 
security it provides, and the same people potentially bear a cost when 
they are older and have more income. The same folks who benefit from 
the availability of a 30-year fixed-rate loan are the ones who 
potentially could bear some costs from it. This is a fair tradeoff and 
one that most taxpayer/homeowners and potential homeowners ought to 
find an appealing part of national housing policy.
    So that's my first point: Yes, the 30-year fixed-rate loan 
potentially has some cost to taxpayers, but since taxpayers are 
virtually all homeowners too, there is nothing unfair about this 
    As an aside, somewhat more equity in lending institutions could 
also provide an additional buffer between mortgage finance and 
    Adjustable-rate loans have different problems, problems that are 
both individual households and to the wider economy. These problems 
appear to be more difficult to address than the potential problems of 
the FRM.
    The problem with ARMs is that the standard design is flawed. ARMs 
fail to link payment changes to household income changes. The designers 
of ARMs saw this problem and put in caps on the rate adjustment, 
typically 2 points for a given year and 5 for the life of the loan. 
This moves the ARM is the direction of being fixed rate. Nonetheless, 
the threat to household budgets is still substantial. For example, 
suppose the rate of inflation picked up from say, 2 percent to 4 
percent, moving the homeowners' rate from 4 percent to 6 percent. The 
likely change in the borrower's income is the current rate of 
inflation--6 percent. But the borrower's payment will rise 25 percent! 
Only affluent households with a lot of room to maneuver can tolerate 
this level of cash-flow uncertainty. People are not choosing badly when 
they opt for a fixed-rate loan.
    In addition, the ARMs can pose risks to the economy too. The 
recession of 1980-1982 would have been much worse, with much higher 
levels of mortgage defaults and an even bigger collapse in economic 
activity, if all borrowers had had ARM loans. How bad the macroeconomic 
damage can be from U.S.-style ARM loans in a recession with all ARMs is 
something we don't know, an experiment we have never performed.
    For both fixed-rate and adjustable-rate loans, risk arises mainly 
from fluctuations in the rate of inflation, so let's talk about 
inflation uncertainty.
    If the rate of inflation remains low, as it has since 1987 when the 
Federal Reserve made a new commitment to a low and stable inflation 
rate, changes in interest rates pose little threat to either borrowers 
or lenders, and thus little to taxpayers either. On the other hand, 
with inflation this stable, the 30-year fixed-rate loan presents no 
risk either. With low and stable inflation, the 30-year fixed-rate loan 
is better because it is simpler and easier for borrowers to understand. 
Borrowers do not have to struggle to understand the indexes that 
underly ARM mortgages, and they do not have to understand the potential 
fluctuations in these, nor do they need to worry about exotic features 
of their loan that may have escaped their attention.
    The FRM creates problems when the rate of inflation is higher than 
was expected. Lenders in the United States have, they have funded long-
term fixed-rate mortgages with either deposits or with other borrowing 
that is shorter-term than the mortgages. If the rate of inflation picks 
up, the cost of the short-term funding for them rises. The value of the 
assets fall, but the value of the liabilities does not, and the 
institution is potentially insolvent. Taxpayers can potentially be 
asked to bail out the insolvent institutions, and they were once. 
Though as another aside, the lenders who failed mainly failed because 
of the risks they took when they were ``de-regulated'' in the early 
1980s. Those who stuck with their old portfolios recovered without 
    When this happens, the homeowners have a gain, while lenders and 
the taxpayers potentially have a loss. These net out to zero. And as I 
pointed out before, the homeowners and the taxpayers are the same 
folks. The benefits are larger earlier in their lives, and the 
potential costs come at a later point when they are paying more taxes. 
This is a good trade, there is nothing unfair about it.
    Now on to the second issue: Do we need Government support for the 
30-year fixed-rate mortgage?
    I believe the answer is Yes.
    The two most important innovations in mortgage finance in the 20th 
century were undertaken by the Federal Government. The first was the 
creation of a long-term, amortizing, fixed-rate and prepayable mortgage 
loan. Loans of this type were made available by FHA just after FHA's 
creation. Mortgage loans available before this were shorter in term, 
usually 5 to 10 years, and were not amortizing. They were what we would 
today call ``balloon'' loans. FHA also provided, and still provides, 
insurance on these loans, which serves the function of making lenders 
more willing to lend against residential property.
    The second innovation was the creation of a secondary market via 
Ginnie Mae. Ginnie was and is an astounding success. Ginnie Mae's role 
is to package already-insured FHA loans into securities that are liquid 
and tradable. Ginnie's creation in 1968 lowered FHA borrowing rates by 
70 basis points. Given that the long-run real interest rate on 
mortgages is about 4 percent, this is a substantial savings to 
homeowners. There is no cost to taxpayers from this re-packaging of FHA 
loans. The loans were already fully insured, and this insurance is paid 
for by FHA borrowers. The additional risk from packaging the loans into 
securities is trivially small. So we get a big benefit from a 
Government program that has no cost to taxpayers.
    Why is the benefit so large? Because all parts of the financial 
market, including lenders themselves, prefer to hold a liquid asset 
than an illiquid one. It is that simple. By packing the loans into 
securities, illiquid whole loans are transformed into liquid securities 
that lenders are happy to hold at lower yields.
    Ginnie was such a success that the thrifts immediately created 
Freddie Mac, to perform the same function for the conventional mortgage 
market. Fannie expanded into creating securities somewhat later, but it 
became the most important part of Fannie's function also.
    Could the private market not create such an entity? Yes, it could, 
and once it did. When the thrifts created Freddie Mac, they copied the 
Ginnie design for themselves. I would not expect this to happen again 
now. When Freddie was created, even the largest thrift had only a tiny 
share, less than 1 percent, of the market. Both the larger and the 
smaller lenders had much to gain from better capital market access and 
more liquid assets. But now, with a few large lenders dominating 
mortgage lending, we should expect that the large players would not 
voluntarily create an institution to the benefit of their smaller 
competitors. These barriers to cooperation are much larger now than 
they were in 1968.
    The private market has done some securitization of mortgages 
outside of our three large institutions, but it has not created the 
market-wide benefits that securitization through Ginnie, Freddie and 
Fannie has. The reason is that these one-off securitizations are 
designed to make today's issue sellable, not with the view of creating 
an effective, liquid market for all lenders. If we are to have 
institutions that perform a function similar to what Ginnie Mae, 
Freddie Mac and Fannie Mae do, in re-packaging mortgages into liquid 
securities, we need some push from the Government to make sure they 
    I would hope to see one major reform to Fannie and Freddie or their 
successors: create a restraint so they could not again provide funding 
to new and unproven ideas like subprime lending. Ginnie Mae stood by 
and shrunk mightily as subprime expanded, while Freddie and Fannie 
rushed in. Ginnie's strategy was by far the better.
To make sure I cover everything of interest, I will address the 
        Committee's specific questions for this hearing.
  1.  What would the national housing market would look like in the 
        absence of the FRM, taking into account the accessibility and 
        affordability of credit for the average middle class American 
        family as well as the importance of stable finances?

    Without some Federal support, specifically the support of the 
secondary market for FRMs, there will be a lot more adjustable-rate 
loans. We can expect a variety of ARMs, tied to different indexes, with 
different re-set periods, different caps, and different margins, much 
like the ARM market that was active prior to the financial crisis, but 
larger, with more varieties.
    The 30-year fixed-rate loan is unquestionably easier for households 
to understand than any adjustable-rate mortgage. This simplicity is not 
in dispute. Even with the 30-year fixed-rate loan, we have substantial 
evidence that there is still borrower confusion. The terms that 
borrowers get demonstrate this confusion. The borrower confusion levels 
can only be higher on ARMs.
    Survey work of mortgage borrowers indicates that essentially none 
of them understand the indexes to which adjustable-rate loans are tied. 
Finance is difficult and arcane, and people stay in school a long time 
to learn it. The London Interbank Borrowing Rate (Libor)? The 1-year 
Treasury rate? A twelve-month moving average of the 1-year Treasury 
rate? We cannot expect any ordinary household to understand where any 
of these interest rates come from or to have any idea of what is the 
likely variation in such interest rates over the next 30 years. Only 
the most sophisticated households would understand them. Even Ph.D. 
economists have a difficult time predicting the level and volatility of 
interest rates. The average household will not understand what risk it 
is undertaking with an ARM. It will be more work for regulators to 
oversee an all-ARM market to try to curb abuse by lenders.
    And of course we will not be free of potential macroeconomic 
problems coming from the mortgage market. If the inflation rate rises, 
and ARMs reset higher, there will be households unable to make their 
payments and who will default. The full force of this remains to be 
seen and will depend on the nature of the ARM loans that are 

  2.  The Committee would appreciate your thoughts on the benefits of 
        long-term fixed-rate financing for homeowners in positive and 
        negative economic times.

    When times are good and inflation is low, there is still a benefit 
to the FRM because it is simpler for borrowers to understand. Mortgage 
finance is difficult enough on even fixed-rate loans, and it is more 
difficult on ARM loans. With an all-ARM market, lenders and finance 
professionals have more tools and varieties to take advantage of 
borrowers who are not financially sophisticated.
    In tougher times, the benefits of the FRM are less subtle. If the 
rate of inflation rises, the standard ARM loan puts borrowers in a 
difficult situation because their payments rise much faster than their 
incomes do. The simple result is more mortgage defaults.

  3.  Please also identify pieces of our current system that are 
        necessary if the 30-year fixed-rate prepayable mortgage is 
        going to continue to be widely available.

    To begin, we should keep FHA mortgage insurance and the Ginnie Mae 
program for securitizing FHA (and VA) mortgages. They provide a source 
of stability and a continuous demonstration of what is possible in 
effective and constructive mortgage finance. In addition, we need 
Government backing for a at least one entity to provide securitization 
to the conventional market, and entity like Freddie Mac between 1970 
and 1989. The portfolio role of Fannie Mae and the post-1989 Freddie 
Mac are not clearly essential. We have solid evidence that effective 
securitization lowers rates for borrowers about 70 basis points. The 
benefit of the portfolios in addition is not established.
    The secondary market entity could charge for a Federal backstop, 
and could include private mortgage insurance, much as it has for 40 
years. The important feature is not for the Federal Government to 
assume all of the risk, but to provide an institution that effectively 
provides liquidity in the secondary market.

  4.  Finally we would like you to discuss any concerns that you may 
        have regarding interest rate risk for both borrowers and 
        lending institutions, how that risk can best be mitigated and 
        by whom.

    Lending institutions are well-informed specialists in assessing 
interest rate risk. Thus, the real key to avoiding insolvent lenders is 
high levels of capital. There seems to be general agreement now that 
bank capital standards ought to be higher than they were before the 
financial crisis, to make insolvency less likely from mortgage defaults 
and interest rate fluctuations as well.
    As for risks posed to the taxpayers, the first line of defense is 
well-underwritten home loans that borrowers can afford. The second line 
of defense is the equity in lending institutions. The third line is for 
the Government to bear some risk, as it does through deposit insurance. 
Taxpayers are nearly all home owners too, so the folks who potentially 
pay for any risks of FRMs also get the benefit of them. This trade of 
benefit for risk is fair and constructive for society.
    This issues I discuss here I have also discussed at greater length 
in a paper that I wrote for the Joint Center for Housing Studies at 
Harvard last year. I attach that paper as well.
  The Future of the Capital Markets: Connecting Primary Consumer and 
               Mortgage Credit Markets to Global Capital
                          Susan E. Woodward *
     * Thanks to Barry Zigas and to the reviewers at the Joint Center 
for suggestions and improvements. All remaining errors are my own.
Prepared for the Joint on Housing Studies Center Symposium, February 18 
                    & 19, 2010 draft of August, 2010
Policy Issues: The Roles Fannie Mae and Freddie Mac Emerging from the 
        Financial Crisis of 2008
    There are three moving forces that are central to understanding the 
role of Government-sponsored institutions in the mortgage market. 
Understanding these forces helps clarify the features of the GSEs that 
are most important and should be preserved. Briefly, these forces are:

  1)  The 30-year, fixed-rate, pre-payable mortgage likely would not 
        exist without Government support.

  2)  The original and still most important support provided to the 30-
        year fixed-rate loan is the encouragement, by regulation and 
        capital standards, to depositories and the GSEs to hold these 

  3)  Securitization of mortgages through a standardized process lowers 
        mortgage interest rates by a substantial amount. Securitization 
        by Wall Street has never been nor should be expected to be 
        similarly successful.

    Each of these forces is discussed in detail. There is one more 
important feature, only recently learned, that makes the GSEs more than 

  4)  Without the Government-sponsored institutions, Ginnie, Fannie, 
        and Freddie, the current financial crisis would be much worse 
        than it has been.

1.  The special role of the 30-year, fixed-rate, prepayable residential 
    The 30-yr fixed-rate pre-payable mortgage is a creature of the 
Federal Government. This loan design was created by Government fiat by 
FHA in 1934. Prior to its introduction, residential mortgage loans in 
the United States had terms of 5 to 10 years and were not amortizing--
they were what we would today call balloon loans, simple short-term 
copies of the ordinary bonds issued by Government and corporations, 
which paid interest regularly until maturity, at which time the 
principal amount was refunded.
    Other developed countries have also encouraged residential mortgage 
markets with amortizing long-term loans (20 to 30 years), but in all 
others (save one small special case, Denmark), these loans all have 
adjustable rates and re-price at least every 5 years. The United States 
is unique in supporting a residential mortgage that is long-term, 
amortizing, fixed-rate, and pre-payable. The pre-payability is a 
feature of State law in all 50 States.
    The 30-year fixed-rate mortgage created by FHA was intended to calm 
down both sides of the residential credit market and encourage the 
resumption of borrowing and lending. Real estate lending troubles were 
at the center of the sharp decline in economic activity that we call 
the Great Depression, though we cannot blame real estate ``bubbles''. 
Instead, it was the conscious and deliberate monetary policy of the 
time that led to a profound deflation (the price level fell 30 percent 
in 3 years between 1930 and 1933) that precipitated the decline in real 
economic activity.
    In addition to the sharp rise in unemployment caused by this 
decline in the price level, the deflation also disturbed the 
relationship between assets and liabilities of borrowers. The dollar 
(nominal) price of real assets and wages fell with the overall price 
level, while debts were denominated in dollars, and still owed in 
dollars. The deflation increased the real value of these nominal debts. 
The situation can be thought of as dollar prices of assets declining 
while dollar prices of debts stayed fixed, raising debtors' 
indebtedness. Or it could be thought of as real values of assets 
staying fixed while real values of debt rose. Expressed either way, 
borrowers were in trouble.
    Borrowers were in trouble because even if they were still employed, 
their dollar incomes fell 30 percent (unless they were Government 
employees, whose incomes stayed the same in dollar terms) along with 
the price level while the dollar obligations on their debts remained 
the same. Borrowers could not pay their mortgages nor could they 
refinance them.
    The FHA-insured 30-year mortgage succeeded in calming both sides of 
the market. Lenders were more willing to lend because FHA took the risk 
of default. Borrowers were more willing to borrow because the loans 
were long-term and did not require them to refinance before the loan 
was paid off in the way the earlier 5 to 10 year term, nonamortizing 
loans did. Both sides felt more secure.
    The biggest risk the Government was taking by insuring FHA 
mortgages was not the particular default risk, but the risk of a large 
change in the price level. It was the change--decline--in the price 
level between 1930 and 1933 that bankrupted borrowers, caused 
widespread default, and thus bankrupted banks too. It was anticipated 
at the time of FHA's creation that the price level would be stable 
long-term, because the dollar was still tied to gold. It was believed 
at that time that so long as we were on the gold standard, a serious 
inflation could not occur.
    Why was the Government willing to take on the risk of mortgage 
default when private insurers were not? A short and easy answer was 
simple desperation to get markets to resume borrowing and lending. But 
a deeper answer is that the insurer--the Government--also had control 
over the most important variable that could influence defaults (and had 
caused the eruption of defaults that had just occurred)--the price 
level. Anyone who borrows or lends in dollar (nominal) terms is betting 
on the future value of the dollar, which is the same as betting on the 
rate of inflation, to be determined largely by future monetary policy. 
Borrowers gain from inflation rates higher than expected, because 
inflation erodes the real value of their debt. Debtors lose from 
inflation higher than expected, because inflation erodes the value of 
their assets. Borrowers lose from deflation, because a deflation raises 
the real value of their obligations, while debtors gain. Some have 
suggested that the Fed has a mismatch issue (liabilities and assets 
have different durations). Of course the Fed has a mis-match issue; 
unlike others with a mismatch issue, the Fed has control over future 
rates of inflation, and consequently future interest rates.
    But a change that is very extreme in ether direction creates 
problems for lenders, especially leveraged lenders such as U.S. 
depositories, and thus the economy in general. If deflation is so 
extreme that borrowers can no longer meet their dollar-denominated 
obligations, as in the Great Depression, defaults by borrowers cause 
lenders to become insolvent. If inflation is so extreme that the equity 
of financial institutions is wiped out (because an increase in the 
long-run inflation rate lowers the value assets by more than it lowers 
the value of liabilities), as it was for many Savings and Loan 
Associations in the late 1970s and early 1980s, institutions again fail 
from insolvency. These two kinds of insolvencies are very different, 
but they both result in stress on the financial system when 
institutions cease to be trusted and cease to trust each other, and 
hence do not transact. Both kinds of insolvencies are (and were) the 
result of conscious, deliberate monetary policy.
    Thus, economies that are large and complex have never had, and I 
imagine never will have, truly laissez-faire credit markets because the 
single most important player, the monetary authority, has the power to 
redistribute wealth between borrowers and lenders, and more. In the 
United States, close to 70 percent of nonfinancial credit (nonfinancial 
credit is the sum of borrowings by businesses, households, and 
governments at all levels, with intermediaries netted out) is touched 
by Federal policy through an assortment of policy tools: the Federal 
Government's own debt, the tax-exemption of interest on municipal 
bonds, all borrowing intermediated through insured depositories, loans 
held by and guaranteed by the Government-sponsored enterprises 
(including the Farm Credit system), plus various other direct and 
guaranteed Government lending programs (including FHA and VA mortgage 
insurance and guarantees).
    This astounding figure--close to 70 percent of nonfinancial 
credit--has prevailed since at least the end of WWII. The chart below 
shows the layers from 1960 to 2004. The bottom layer is tax-exempt 
municipal debt. The second layer is the U.S. Treasury's own debt. The 
third layer represents debt intermediated through government credit 
programs, including GSE debt and securities, plus all other Federal 
agency debt plus loans guaranteed and insured by the government. The 
fourth layer represents credit intermediated through insured deposits, 
with holdings of three lower layers--Treasuries, municipals, GSE debt 
and securities, and other loans insured or guaranteed by the U.S. 
Government netted out. The top layer represents debt intermediated by 
organizations with no special tax treatment and no guarantees, and 
consists mainly corporate bonds, other corporate borrowings, plus some 
non-depository consumer credit. In 2004 the total touched by Federal 
policy was roughly 120 percent of GDP, with total nonfinancial credit 
equal to 200 percent of GDP. Thus, as of 2004, the fraction of 
nonfinancial debt touched by Government programs was about 60 percent, 
slightly lower than the historical average, which is closer to 70 
percent. For earlier data, see the 1986 Economic Report of the 
President, page 191.


    The level is even higher right now, with the Government owning 
large chunks of the equity in banks and investment banks, which were 
previously in the 30 percent of the credit market not tied to the 
Federal Government (mainly corporate bonds and other corporate nonbank 
borrowings) as well as other assets, but I have not toted up the 
numbers lately. Anyone who thinks that the United States has a laissez 
faire financial system is simply ignorant of the proportions of the 
Government role in credit markets.
    Only a country that is optimistic about its ability to control the 
price level long-term would consider encouraging or insuring a long-
term, fixed-rate, prepayable mortgage. The thrift crisis (which, in 
retrospect, looks fairly tame), demonstrated that such a policy could 
turn out to be costly, and costly as a result of the Government's own 
monetary policies. The thrift crisis did not occur because the people 
who owned and ran the thrifts were incompetent or witless. It was the 
result of deliberate policy choices on the part of the U.S. monetary 
authority to raise the rate of inflation above what had been previously 
expected. Thrifts were encouraged--by deposit insurance and capital 
requirements--to make the loans that policymakers wanted them to make. 
I am not suggesting that policymakers knew, when they encouraged 
lenders to make these loans, that they were going to raise the rate of 
inflation, but only that it was changes in Government policy with 
respect to inflation rates that ``caused'' the thrifts to become 
insolvent. The equity holders of the thrifts benefited from Government 
support in good times, and suffered from it when inflation rates rose.
    We have no evidence that a long-term fixed-rate residential 
mortgage loan would ever arise spontaneously without Government urging. 
Other developed countries that support long-term adjustable-rate loans 
have not spontaneously developed, in the private realm of the mortgage 
market, long-term fixed-rate loans for household borrowers. The 
development of such a loan has happened only once on a large scale, 
here in the United States.
    The point of this discussion about the uniqueness of the long-term 
fixed-rate residential mortgage and role of the Government in the 
credit markets is to demonstrate that pleas for ``free market'' forces 
in credit markets should be dismissed out of hand. The United States 
does not have a ``free market'' in credit, especially residential 
mortgage credit, nor does any other large or developed country. The 
most important innovations in the mortgage market in the last 80 
years--introduction of a long-term amortizing loan, creation of 
national liquidity facilities for regional lenders (Fannie Mae), 
introduction of a liquid secondary markets in mortgages (Ginnie Mae and 
Freddie Mac), and the contract designs to support loan servicing in 
securitized markets--were all undertaken by institutions that were 
either explicitly part of the Government or had important Government 
ties. The largest private innovations, adjustable-rate loans and 
subprime loans, cannot be said to be such great successes. Among the 
private innovations, the creation of credit scores appears the most 
constructive and successful.
    What about the possibility of giving up the long-term fixed-rate 
loan, and getting along with only adjustable-rate loans, as do nearly 
all other developed countries?
    At one point in the early 2000s, well before any hint of the 
subprime crisis but after the dotcom recession was over, Alan 
Greenspan, noting that long-term fixed-rate mortgages were a source of 
systemic risk in our financial markets, suggested that one way to 
eliminate this systemic risk was for borrowers to simply have 
adjustable-rate mortgages instead. He noted that ARMs have lower 
interest rates on average (which is true). The extreme public outcry 
made him abandon this suggestion with alacrity. People were not 
interested that Canada, the United Kingdom, France, Germany, and many 
other countries seemed to achieve high rates of home ownership despite 
having only adjustable-rate loans. (It turns out that Greenspan himself 
had a fixed-rate mortgage. Why? He said he liked the certainty. 
Bernanke has a fixed-rate mortgage also, same reason.)
    Americans are evidently comforted by their 30-yr fixed-rate loans. 
Long-term fixed-rate loans are more expensive than ARMs even when the 
credit risk is assumed by a Government-related entity such as FHA or 
Fannie or Freddie. This is because all residential loans are 
prepayable, and the lender or investor takes the risk of a prepayments 
arising from fluctuations in interest rates. Lenders thus charge a 
premium to cover this risk. It is not small: on average it is about 125 
basis points. Borrowers cannot disclaim their right to prepay a fixed-
rate loan, so the only way for them to avoid paying a premium for pre-
payability is to have a loan with an adjustable rate.
    Nonetheless, borrowers clearly prefer fixed rates. It appears that 
borrowers should only choose adjustable-rate loans when 1) they are 
sufficiently affluent that a substantial change in their mortgage 
payment would not seriously disrupt their personal finances (as in the 
jumbo market, which until recently was about half fixed rate, half 
ARMs), 2) when nominal interest rates are very high and the term 
structure is steep, making payments on ARMs far lower than on fixeds, 
as in the early 1980s, and 3) when borrowers are confident they will 
reside in a given house only for a short time. When interest rates 
fall, ARM borrowers overwhelmingly refinance from adjustable rates to 
fixed rates. Even in the present crisis, default and delinquency rates 
on fixed-rate mortgages are about half than those on ARMs, even in the 
prime market. This appears to be more of a self-selection phenomenon 
than the result of ARM resets. Anyone suggesting, as Greenspan did, 
that we abandon rather than accommodate the long-term fixed-rate 
prepayable residential mortgage would be in for serious grief. 
Americans now seem to regard the availability of long-term fixed-rate 
mortgages as part of their civil rights.
2.  The role of Government support in the continued existence of the 
        30-year fixed-rate residential mortgage.
    The original and still most important support provided to the 30-
year fixed-rate loan is that U.S. bank regulations encourage 
depositories to make and hold these loans. The GSEs were also 
encouraged to hold 30-year fixed-rate loans by being allowed low 
capital requirements on substantial portfolios of both whole loans and 
MBSs. Depositories and the GSEs still hold the majority of 30-year 
fixed-rate loans and mortgage-backed securities (MBSs) based on them. 
(Many depositories hold MBSs of loans they originated themselves and 
securitized through Fannie or Freddie.)
    The importance of depositories and the GSEs is readily apparent in 
the figures on the holdings of MBS. In particular, defined-benefit 
pension plans, which are by nature long-term investors, seem natural 
candidates to be holders of long-term mortgages, but they are not. They 
hold substantial amounts of Fannie and Freddie debt (straight bonds), 
but essentially none of the MBSs. Pension plans fund long-term real 
(inflation-adjusted) annuities. Evidently the prepayment risk of long-
term fixed-rate pre-payable loans, which fall in value when the rate of 
inflation rises, and prepay when the inflation rate (and interest 
rates) fall, is incompatible with this goal. Fixed-rate mortgages are a 
worse fit than plain bonds for insuring inflation risk because they 
fall in value more when the rate of inflation and interest rates rise, 
but do not enjoy a symmetric rise in value when interest rates fall 
because they instead prepay.
    Default risk in mortgages is largely diversifiable, but prepayment 
risk is not. Even in the current recession, the geographic variation in 
property value changes and defaults is substantial. By the OFHEO 
purchase-only indices (as of December, 2009), national house prices are 
down just over eleven percent from their high in early 2007. The census 
division with the largest decline is the Pacific, down 28 percent (on a 
seasonally adjusted basis), and the one with the smallest decline, West 
South Central, down 1.2 percent, is hardly down at all. Defaults are 
highly concentrated in the sand States (California, Arizona, Nevada, 
and Florida), which are suffering from a combination of the largest 
price declines as well as the largest explosions of subprime lending. 
(The combination is not an accident.) Aside from the current crisis, 
both real estate price changes and defaults have been geographically 
concentrated. When defaults are geographically concentrated, holding a 
nationally distributed portfolio diversifies much of this risk.
    On the other hand, prepayment risk is a systemic risk. Changes in 
interest rates influence the behavior of borrowers in all 50 States. 
Prepayment risk can be transferred to another party, but not 
eliminated. For example, when an investor buys Fannie Mae or Freddie 
Mac bonds, the interest paid on loans held in portfolio ultimately pays 
the interest on the bonds. Thus, the bondholders bear ordinary interest 
rate risk but not prepayment risk, and the equity holders of Fannie and 
Freddie bear the prepayment risk on the portfolio loans.
    Even REMICs (Real Estate Mortgage Investment Conduits) just re-
shuffle prepayment risk, they do not eliminate it. When a REMIC takes 
the form of being tranched (sliced) by prepayment priority, the 
earliest-paying tranche will perform much like a short-term bond, while 
the later-paying tranches will bear even more prepayment risk than 
would an ordinary, un-REMICed, untranched pool of mortgages. By 
contrast, in normal times, default risk is diversified away in a big 
national pool of loans.
    The systemic nature of prepayment risk brings us back again to the 
issue of where prepayment risk comes from. When interest rates fall, 
borrowers prepay and refinance. When interest rates rise, average 
mortgage life lengthens and existing mortgages and mortgage securities 
become less valuable. Interest rate fluctuations do not come primarily 
from random, uncontrollable forces, but from deliberate policy choices 
of the monetary authority. Inflation is, in the first analysis and the 
last analysis and most analyses in between, a monetary phenomenon. It 
is appropriate that the Government have some role in allocating and 
insuring this risk given that it has substantial control over it.
    By allowing federally related institutions to make and hold 
mortgages of this design, the taxpayers bear the systemic risk, both 
from prepayments and from unusual levels of defaults, (rare, but 
happening now). Taxpayers bear this risk through their liability for 
taxes to make good on the promises made through deposit insurance and 
guarantees behind Ginnie, Fannie, and Freddie, and deposit insurance. 
The benefits of this system accrue mainly to homeowners. Given that 
nearly all income taxes are paid by homeowners, and that nearly all 
homeowners begin their home ownership with a mortgage, it is mainly 
homeowners who benefit and also homeowners who bear the risk of the 
arrangement. Thus, the beneficiaries (homeowners) and the bearers of 
risk (the taxpayers) are ultimately the same folks, but at different 
points in their lives. This system gives people a hand up when they are 
young and cash-constrained, and has the potential to cost them 
something, more if they are big successes in making money, later in 
their high-earnings years if problems arise. It is not hard to imagine 
that most people regard this as a satisfactory tradeoff.
3.  The role of the GSEs in securitizing mortgages
    The GSEs promote liquidity and therefore low interest rates by:

  1)  standardizing mortgage terms,

  2)  standardizing loan servicing, and

  3)  standardizing mortgage-backed securities.

All three factors help to produce a market of homogeneous securities 
that trade at a low cost in a liquid market.
    The first mortgage-backed securities (MBS) were created as part of 
a new Government program, Ginnie Mae, in 1968. At that time, they were 
called pass-through securities because they passed interest and 
principal payments on mortgage loans through to security holders. The 
Budget Task Force of 1968 was assigned responsibility for getting 
Fannie Mae's debt off the Federal budget to make the Federal debt, 
which had been growing fast in the 1960s, look smaller. Fannie began in 
1938 as a Government agency able to buy and sell mortgages from 
depositories, then in 1954 was reorganized as a cooperative among the 
lenders who sold mortgages to Fannie. The plan in 1968 was to 
reorganize Fannie into a stockholder-owned corporation, with stock that 
could be owned by the general public, not just by banks. To achieve 
this, the FHA mortgages on Fannie's books were packaged into securities 
guaranteed for timely payment of interest and principal by the full 
faith and credit of the Federal Government, to be sold to the general 
public. FHA loans were already federally insured, so the additional 
assumption of risk for the Government was de minimis.
    The creation of Ginnie Mae in 1968 lowered FHA borrowing rates by a 
startling 60 to 80 basis points. Given that the real (inflation-
adjusted) interest rate on FHA loans is in the range of 4 to 5 percent, 
this is a substantial, not trivial, reduction. The reduction in the 
interest rate was not the result of additional Federal assumption of 
risk, but of a genuine improvement in market design. The decline 
appears to be attributable to two things. First, by securitizing loans 
through Ginnie, lenders turned illiquid whole loans into liquid 
securities, which they were willing to hold at lower yields. Second, 
the existence of a national secondary market disseminated high-quality 
information about price and made the pricing of mortgages both lower 
and tighter nationwide. In sum, the additional cost of risk assumed by 
the taxpayers was tiny, but the benefits were substantial.
    The benefit was so obvious and large that the thrifts immediately 
wanted an institution to perform the same function for their 
conventional mortgage loans. (Fannie had traditionally done more 
business with commercial banks than with thrifts.) Thus, in 1970, 
Freddie Mac (The Federal Home Loan Mortgage Corporation) was created to 
securitize conventional mortgages. Freddie was organized as a 
cooperative among the thrifts, with ownership and governance through 
the Federal Home Loan Bank System, also owned and operated by the 
    FHA insurance for mortgages had introduced some uniformity in 
mortgage instruments as lenders met FHA standards in order to get FHA 
insurance. Freddie Mac further standardized the conventional mortgage 
market, which until then had many practices that differed by State. 
While some differences across States still remain (mainly with respect 
to loan foreclosure and its interaction with personal bankruptcy), 
mortgage lending rates are more uniform across States now than they 
were prior to the creation of Freddie.
    The details of the contracts created to make Ginnie and Freddie 
work well should command a great deal of respect. One of the issues 
securitization created was: who would do the back office work 
(servicing) on securitized loans and how could we assure it was done 
well? When the lender held the loan and serviced the loan, there was no 
conflict of interest. Separating servicing from ownership of whole 
loans was a challenge. The solution for Ginnie was to assign 44 basis 
points (0.44 percentage points) of interest, calculated as a fraction 
of the outstanding principal balance, as income to the servicer. Today 
we would call this an interest rate strip of 44 basis points. The 
creators of Ginnie knew well that this was more than servicing should 
cost, and intended for it to be. They predicted, correctly, that 
servicers would bid and pay for the right to collect the 44 basis 
points. The investment necessary to purchase the rights to the 
servicing (which tends to run about 1.25 percent of loan principal) 
would thus manifest itself in the price servicers would pay for 
servicing, which would represent the difference in the present value 
cost of servicing and the present value of the 44 basis point interest 
    The investment made by the servicer to purchase the interest/only 
strip becomes a hostage to exchange to assure the performance of the 
servicer. And of course, the longer the expected life of the loan, the 
higher the present value of the interest rate strip, so the servicer 
has a vested interest in preventing foreclosures on loans. Servicers 
were also required to collect money monthly from borrowers to be 
deposited into escrow accounts to pay homeowner property taxes and 
hazard insurance. This helped borrowers meet their obligations by 
turning the otherwise lumpy (from a time passage point of view) 
payments for taxes and insurance into smooth monthly payments. One of 
the stupidest features of the subprime lending debacle (and there were 
many) was that most subprime loans had no tax and insurance escrows. 
Yet the borrowers had quite low credit scores, indicating that they 
were struggling to keep their personal finances in order. These 
borrowers needed escrows more, not less, than prime borrowers.
    A further discipline to the secondary market is that Ginnie, 
Freddie, and Fannie all monitor servicer performance. Ginnie can simply 
seize a servicing portfolio (without compensation) and sell it to 
another servicer. Fannie and Freddie have the right to force a servicer 
who is not performing to sell its portfolio (usually at a loss, since a 
nonperforming portfolio will need some investments to be returned to 
satisfactory performance) to an approved servicer. This threat gives 
servicers another reason to maintain high standards of performance. 
Exercise of the threat is fairly rare.
    This set of contracts to support MBSs crafted ``by the Government'' 
has endured as the basic servicing contract on prime loans to today.
    Fannie Mae soon followed by creating securitization programs also 
after Ginnie and Freddie were up and running. Until 1970, Fannie had 
made a secondary market in mortgages only by buying them for its 
portfolio, and issuing bonds to fund them. Freddie Mac was focused 
entirely on securitization, and had only a small portfolio of loans 
(roughly $25 billion) until it was ``privatized'' in 1989 by FIRREA. 
Post-FIRREA, Freddie underwent a reorganization similar to that of 
Fannie in 1968, in that the thrifts were no longer Freddie's owners and 
directors, but Freddie's stock became public and traded on the New York 
Stock Exchange. Freddie quickly accumulated a portfolio nearly the size 
of Fannie's.
    Why can't Wall Street replicate the success of Ginnie, Freddie and 
Fannie? The presumption of Federal backing is not the only difference 
between them and Wall Street. There are other differences that are more 
important. Other differences are:

  1)  Ginnie, Freddie & Fannie all have standardized loan contracts.

  2)  All three all have standardized servicing agreements.

  3)  All issue large and homogenous pools of loans.

  4)  Wall Street securitizers do not take into account the benefits of 
        additional liquidity they could add to the rest of the market 
        by creating similar securities, in other words, they do not 
        internalize the benefits of additional liquidity to the rest of 
        the market.

  5)  Ginnie, Fannie, and Freddie all suppress inefficient information 
        production in the secondary market for its contribution to 
        market liquidity. Wall Street wants more unique securities, 
        more sources of disagreement, not fewer.

    Ginnie, Freddie and Fannie all have standards for loans they will 
securitize, for both loan structure and loan servicing. I have heard 
bank lobbyists complain that Freddie and Fannie have ``commoditized'' 
mortgage lending. Yes, yes they have, and with great benefits to 
mortgage borrowers. This standardization or commoditization lowers 
costs to borrowers and causes them little inconvenience.
    In contrast, Wall Street did not attempt to create any standards, 
and packaged many varieties of loan designs with varieties of servicing 
agreements and little by way of reporting conventions. At the June, 
2009 conference at the Federal Reserve Bank of Kansas City, a former 
subprime investment banker on a panel complained bitterly about the 
absence of a standard servicing and reporting agreements in subprime 
lending, and appealed for a Federal intervention to create one. When 
such an appeal comes to pass, there are no Republicans left.
    Wall Street is happy to securitize smaller pools, and eager to get 
deals done before customers disappear. Without the patience to assemble 
large pools from different lenders, liquidity in the secondary market 
later is sacrificed. Liquidity is further sacrificed by tranching the 
pools into even smaller and more unique securities, with the 
expectation that each security can find a home where the risk taste 
best aligned and its value is highest. Wall Street also values knowing 
which pieces are owned by whom, so that it can arrange deals when 
someone wants to buy or sell. (In Bonfire of the Vanities, there are 
characters described as earning their living out of simply knowing who 
owns which bonds. This is not entirely fiction.)
    When a new mortgage-backed security is created, there is 
potentially an externality for the entire MBS market. If the security 
is very much like existing securities, the entire market becomes a 
little bit more liquid. The entire market benefits from the additional 
liquidity. By being large entities with many outstanding securities, 
Freddie and Fannie internalize this externality. They do not want a 
novel security because it would not create the same liquidity benefits 
for the rest of the book. By contrast, the private-label securitizers 
are indifferent to creating more liquidity in the rest of the market. 
They are focused only on creating a security they can sell to someone 
today. Rather than seeking to make a market more liquid, investment 
bankers are instead always looking for ``a man with an ax''--an 
investor with a specific investment desire that can be carved out of a 
pool of loans, leaving a residue that must be packaged and 
affirmatively ``sold''.
    In additional important difference relates to how the GSEs suppress 
inefficient information production by limiting what information is 
disclosed about individual mortgage pools. Prepayment speeds differ by 
coupon and also with geography. Some areas are growing, others are 
contracting. Borrowers move and prepay more in growing markets than in 
stable markets. Some areas have higher turnover, and loans prepay when 
people move, Ginnie, Fannie, and Freddie's MBSs all efficiently 
suppress information about the location of mortgages in individual MBS 
pools. Ginnie and the GSEs keep the MBS market liquid despite some 
geographical differences in prepayment speeds by not revealing the 
geography of loans in any given MBS . . . Wait! What about market 
    More transparency is not always better. This can be understood 
easily in a similar arrangement seen in the municipal bond market. A 
structure used for promoting liquidity in the municipal bond market is 
a random call feature used for bonds that fund small but long-lived 
projects. Take a dam, for example. Bondholders are repaid from 
citizens' water bills. If the issue is large, such bonds are often 
structured in sets that repay at different times, for example, 10 
years, 11 years, and so on up to 40 years. For smaller projects, each 
slice may be too small to find a liquid market. Instead, the entire 
issue is given the same maturity, but a specified fraction of it is 
called at random for repayment each year. The investors buy many such 
issues, and thus have a good idea of when on average they will be 
repaid, and thus easily tolerate the uncertainty of individual issues, 
and value the greater liquidity.
    Suppose that right after the bonds were sold, the issuer spun the 
wheel to select the call date of each bond. Would it be efficient to 
release the information early, prior to the call? NO! Once the call 
dates were known, the bonds would degenerate into the tiny, illiquid 
serial bonds that the market was trying to avoid. What's more, the 
issuer and the investors agree that the best arrangement is not to 
reveal early. This is a clear case where the optimal level of 
information is not the fullest information.
    In principle, the value of a set of MBS could be either increased 
or decreased by revealing information that distinguishes them from one 
another. More pieces might accommodate a greater variety of investors 
with pieces precisely tailored to their risk tolerance. Or, it could be 
that liquidity concerns dominate, and that a larger, more homogeneous, 
more liquid market in MBSs tightens spreads and lowers prices. There 
are different ways of homogenizing risk, including pooling risk (MBSs 
vs. whole loans, even S&P 500 futures contracts vs. individual stocks 
in the S&P 500) (see information theorist Hal Varian's provocative 
ideas on subprime koolaid), providing ratings (professional opinions on 
risk to make clear where similarities lie), and providing insurance 
(assignment of risk to a professional evaluator of risk for a fee). 
Each has its pros and cons.
    The experiment to show which is more important in the market for 
MBS on conventional prime mortgages has been done: Some years ago 
Freddie Mac was persuaded (by Wall Street!) to reveal more about the 
geography of its MBS pools on the theory that this would make the 
pricing more ``accurate'' and securities more valuable. Since then, 
Fannie's securities (MBSs) have consistently sold for a slightly higher 
price than Freddie's because Freddie tells the market more about each 
one, and hence the Freddie MBSs are less perfect substitutes for each 
other, and a bit less liquid. The Fannie MBSs trade as if they are more 
alike because the market has no information with which to make 
distinctions among them. The really interesting thing is that the 
market unambiguously prefers the security about which it is less 
informed. Over the period since 1998, the current coupon yield for 
Freddie MBSs has been above that for Fannie MBSs by on average 3 basis 
points, (with a standard deviation of 1.5 basis points). From January 
1998 to December 2008, the yield on the Freddie security was never 
below that on the Fannie security. And this is despite the feature that 
the Freddie securities pay the security holder a few days earlier, 
which in principle should make them more valuable. Yes, more 
transparency makes the securities of lower, not higher, value, on 
average. Below are data from 1998 to 2008 on Fannie/Freddie yield 


    It is only three basis points on average, but it is a bitter three 
basis points, making business slightly less profitable for Freddie.
    So perhaps the Freddie securities are more ``accurately'' priced, 
but they are without question less valuable as a result because they 
are less similar. From a social point of view, the bottom line is in 
the pricing: the securities are less valuable when more transparency is 
provided, and all things considered, investors and borrowers both gain 
when the additional information is not disclosed. The losers are the 
market makers and those who would be in the know about who holds the 
different securities and make money trading in the secondary market 
based on their special knowledge. These are the same folks who created 
and made markets in subprime mortgage-backed securities.
    But surely not all detail should be suppressed. What kind of 
information should be suppressed, what kind should be transparent? To 
be efficiently suppressed, information should have the following 

    The information should be about factors that are not 

    The risks should not be too large.

    The risk should diversify away when investors hold a 
        variety of different issues.

    The arrangement of municipal bonds with random calls for repayment 
is ideal because the risk is perfectly diversifiable. The suppression 
of information about prepayments is not perfect, but it is an 
improvement over full information, says the market.
Even in the market for the U.S. Treasury's own securities there is a 
tension between giving Wall Street what it wants by way of maturity 
variety versus keeping borrowing costs low for the taxpayers. Wall 
Street always wants Treasury's new borrowings to be new securities, 
distinct from prior issues, so that the new bonds are not perfect 
substitutes for older ones. In many cases, what would be efficient is 
for Treasury to re-open an existing issue (especially if it is trading 
at a high price relative to the rest of the yield curve) and sell 
additional bonds into it. Wall Street intermediaries prefer a larger 
number of unique issues in order to keep trading spreads wide and to 
put themselves in the position of having superior information about who 
owns which bonds.
    Wall Street also fought the introduction of Treasury Inflation-
Protected Securities. IBankers complained that there is little trading 
in them (or was in the United Kingdom, where similar bonds existed 
already.) About this, they are right, the trading volumes are low. The 
volume is not low because there is no interest in these bonds, but 
because they such satisfactory assets that buyers just hold them, and 
do not trade them much. Nonetheless, on any given day, nearly all TIPS 
trade with a spread at the minimum tick--1/32, (one thirty-second of 1 
percent of par value) indicating that despite the low volumes, market 
markers feel they face very little risk in maintaining an inventory. 
The low trading volumes in combination with the narrow spreads do not 
mean this security is socially useless, but that it is especially 
    If the securitization operations of Freddie and Fannie were shut 
down, and all securitization was left to Wall Street, we would see a 
market in which:

  1)  Fewer mortgages will be securitized.

  2)  We will see a wider variety of types and sizes of securities.

  3)  Buyers will have to do more diligence before purchasing any given 

  4)  Market-making spreads will be wider.

  5)  Mortgage interest rates for borrowers will be higher.

    The only beneficiaries of this alternative system would be the 
intermediaries. Both investors (ultimate holders of the MBS) and 
homebuyers would be worse off. And of course, if Ginnie is still 
standing (I have heard no pleas to dismantle Ginnie except from AEI), 
more business will go to FHA and Ginnie.
    Without Freddie and Fannie, it would be in the interest of mortgage 
lenders to create a consortium or cooperative amongst themselves to 
securitize mortgages. It would be an organization much like Fannie or 
Freddie today, but perhaps more successful in resisting the lure of 
subprime securities. Both Fannie and Freddie were run conservatively in 
their co-op days. But I do not expect mortgage lenders to be able to 
create such an organization. First, there is a conflict of interest 
between large lenders, who could securitize at least some loans 
themselves, vs. smaller banks, who would likely have to sell loans to 
the larger banks for securitization; that conflict is larger now than 
when the largest bank had only 1 percent of all bank assets (roughly 
1989). All lenders would benefit, but the small banks would benefit 
more and the large banks less, thus, strategically, the large banks 
have an interest in blocking a co-op. This appears to be the conflict 
of interest that inhibited the Federal Home Loan Bank system from 
creating a third GSE. We should not imagine that a co-op created among 
the banks would be free of Federal responsibilities, because the 
members would all be insured depositories.
What about the portfolios?
    F&F both have substantial portfolios of loans. Their portfolios are 
close to three-quarters of a trillion dollars each, and the difference 
between the interest earned on the portfolio and interest paid on the 
bonds that fund the portfolio is their largest source of income. I do 
not have a strong opinion on how large the F&F portfolios should be. 
But experience tells us that any attempt to whittle down the GSE 
portfolios will raise mortgage interest rates at least temporarily. In 
addition, decreasing the size of Fannie and Freddie's portfolios will 
not lead to a reduction of risk exposure by the Federal Government, the 
goal of most who advocate such changes. Instead, it would largely 
result in an increase of holdings of mortgages and MBS by depositories.
    In other words, the 30-year fixed-rate loans are not likely to 
leave the Federal umbrella, but only move to another place under it. 
Reducing the portfolios would not be without pain for the mortgage and 
housing markets. Even in the early 1990s, when the mortgages held by 
the dismantled insolvent thrifts had to find new homes, mortgages rates 
were clearly elevated by this displacement. It seems unlikely that 
policymakers would choose any time soon to force F&F to divest their 
portfolios, as this would just depress mortgage values and force 
already beleaguered banks to mark down their assets once again. If the 
portfolios of F&F are to be whittled down, the least disruptive option 
may be to simply not have them buy any more loans for portfolio. As 
loans in the existing portfolios mature, the portfolios will shrink.
    One caution on dismantling the portfolios of Fannie and Freddie 
comes from looking at who is in favor of this policy. The main 
proponents, not only of dismantling the portfolios but eliminating 
Fannie and Freddie altogether, are the large commercial banks, the 
other natural home for mortgages. The large banks are in the best 
position to be able to securitize mortgages in F&F's absence (thought 
the market would not likely be as efficient, because securities would 
not be as standardized and homogenous). They expect, correctly, that 
smaller banks would have to sell mortgages to them to access the 
secondary market. Theirs is the voice we hear in the Wall Street 
Journal. (I remain puzzled as to why the WSJ should be more 
enthusiastic about large commercial banks with unambiguous Federal 
support of deposit insurance than with other financial institutions 
with similar Government backing.) Another F&F combatant is the American 
Enterprise Institute, whose opposition is more understandable, since it 
is funded by contributions. It is important to remember that commercial 
banks are not exactly ``free market'' institutions, but owe much of 
their access to inexpensive funding to deposit insurance (which they 
pay for) and to Federal regulation.
    If Freddie and Fannie were as well-capitalized as the average mid-
size bank, they would be no more risky than the average mid-size bank. 
In retrospect, the risk taken on by Freddie, Fannie, and the largest 
commercial banks was substantially greater than that taken on by mid- 
and small-size banks, who seem to have avoided making or buying any 
subprime loans.
Covered Bonds
    Covered bonds, used by Denmark to fund its long-term fixed-rate 
mortgages, (and by some other countries to fund long-term adjustable 
rate mortgages) have been promoted as superior to asset-backed 
securities. The ``coverage'' of covered bonds is overcollateralization. 
In practice, they are nearly identical to asset-backed securities and 
to the arrangements we have had for many years, especially to Fannie 
and Freddie MBSs. Essentially, nothing is achieved with covered bonds 
that could not also be achieved with higher capital requirements for 
Fannie and Freddie. Covered bonds are, like asset-backed securities, 
backed by the cash-flows on a pool of assets, in the case of the 
mortgage market, a pool of mortgages. And covered bonds, like F&F MBSs, 
have more resources behind them than just the mortgages in their pools 
to cover losses.
    There are two differences between covered bonds and the MBSs issued 
by F&F, both essentially cosmetic. One is that the mortgages backing 
the bonds remain on the balance sheet of the issuer. Whether the assets 
are off the balance sheet is irrelevant so long as the MBS have 
recourse to assets on the balance sheet. F&F MBS do have such recourse. 
Another is that the pool of assets backing the covered bond is usually 
larger in principal value than the bonds themselves, so that the 
security is explicitly overcollateralized. The MBSs issued by F&F are 
implicitly over-collateralized because they are guaranteed against 
default by F&F, but not backed by any particular pool of loans. If the 
default losses on a given MBS were sufficiently large, F&F are obliged 
to make up the difference from reserves and other assets. All of the 
reserves against losses and equity of F&F are ultimately available to 
the MBS holders. Thus, in essence, F&F MBSs are already over-
    So long as the securities outstanding are MBSs guaranteed by F&F, 
and the experience on the mortgages behind them (in terms of defaults 
and prepayments) are well-disclosed, and the other assets are also 
fully disclosed, it should make no difference whether the securities 
are called covered bonds or MBSs or whether the recording of the 
securities is on the balance sheet or in some other section of their 
regular reports. Covered bonds are not ``the answer'' or even a very 
interesting suggestion, or all that different from what Fannie Mae & 
Freddie Mac have done lo these many years. The only interesting 
variation is how much ``coverage'' is desired. Coverage is essentially 
an issue of capital, leverage, and capital standards.
    Another disadvantage of covered bonds in the United States would be 
that where these bonds are used, they are issued by large banks. In 
countries that have only a few large banks, and essentially no small 
ones, this creates no comparative disadvantage. In the United States, 
with its many smaller banks, the small banks would have to either sell 
through the large banks or create a co-operative entity through which 
to sell covered bonds together. This cooperative entity would have to 
look a lot like either Freddie or Fannie.
    And finally, covered bonds are evidently not the panacea claimed by 
some. Both Spain and the United Kingdom use covered bonds to fund 
mortgages yet both were also fraught with problems in real estate 
lending in the recent crisis.
Do we need to return to substantial downpayments?
    Offering mortgages to borrowers with good credit histories but 
small downpayments was not the core of the financial crisis, instead it 
was offering any mortgage to people with poor credit histories, in 
large numbers, in concentrated areas. Even with the large decline in 
property values in some areas, borrowers with good credit who do not 
lose their jobs, become ill, or get divorced are very unlikely to 
default, even if their downpayments were slim. A careful study by 
Willen et al of all mortgages made in Massachusetts prior to the 1991 
recession found that only 6 percent of the prime borrowers who had 
negative equity defaulted over the next 3 years.\1\
    \1\ Christopher Foote, Gerardi, Kristopher, and Willen, Paul, 
(2008, June) ``Negative Equity and Foreclosure: Theory and Evidence'', 
Public Policy Discussion Papers, Federal Reserve Bank of Boston.
    Credit scores are a new feature in the mortgage market. They were 
hardly present in 1990, but almost universal by 1996. Prior to 1996, 
lenders mainly used high downpayments as their defense against default. 
What lenders learned with credit scores is that they could make even 
high LTV loans to borrowers with good credit, and these borrowers would 
keep paying even if their houses were underwater.
    A factor that made the subprime crisis worse than other housing 
crises is that the expansion of credit to a new, previously not-served 
set of borrowers was so large that it moved house prices. Prices have 
fallen most in areas where they rose most, and these are the same areas 
in which subprime borrowers were over-represented.
    At present, the prime mortgage book is in worse shape (higher 
delinquencies) than in most years, but still in much better shape than 
the subprime mortgage book. As of June, 2009, the ``seriously 
delinquent'' rate for prime conventional mortgages (either held by or 
securitized through Freddie or Fannie) is 3.2 percent, while the rate 
for securitized subprime loans is 23.7 percent. And of course, the 
prime book is only performing as poorly as it is because of the 
contraction in real activity caused by the subprime mess and the 
subsequent bank panic.
Ownership Structure
    There are many possibilities for the structure of Fannie and 
Freddie going forward. Some can be easily ruled out as undesirable, 
while others area worth more study.
    Among the possibilities are:

  1)  A single entity with Government ownership and control as for FHA 
        and Ginnie Mae.

  2)  A cooperative among lenders, as Fannie and Freddie once both had.

  3)  A cooperative among borrowers, similar to the organization of the 
        Farm Credit System or the Credit Union system, or even to 
        borrower-owned and controlled mutual insurance companies.

  4)  A shareholder-owned, profit making institutions, subject to 
        limitation on activity by charter and to regulation, as in 
        their old structure.
A Government program like FHA?
    FHA and Ginnie Mae are playing a large and important role right 
now, with a market share of originations in 2008 of 25 to 30 percent. 
For some years, FHA has operated at a disadvantage to the conventional 
market because of the rigidities inherent to being part of the 
bureaucracy. First, FHA originations are slower than originations that 
go through F&F. According to FHA's January 15, 2009, report on recent 
originations, average processing time was 2.5 months, roughly 10 weeks, 
from application to closing, even though most transactions used 
streamlined systems. FHA was slower to create automated underwriting 
systems, introducing them only after Freddie and Fannie both had 
systems in place.
    Second, FHA is more vulnerable to exploitive behavior on the part 
of lenders. Fannie and Freddie have more flexibility for discouraging 
exploitation by lenders. F&F can also adjust guarantee fees to reflect 
its experience with a given lender, while FHA insurance premiums are 
one-size-fits-all. There have been episodes of lender exploitation of 
FHA (seller ``gifts'' of downpayments to borrowers, implicitly raising 
the loan-to-value ratios and default rates) that required legislation 
to fix that would have been promptly corrected by internal policy 
adjustments at Freddie and Fannie.
    Third, Fannie and Freddie can innovate more nimbly than can FHA and 
Ginnie Mae. Both built automated underwriting systems (Desktop 
Underwriting and Loan Prospector) and only well after these were in 
place did FHA begin to work on such a tool. Even now, FHA lenders will 
often consult either DU or LP before approving even an FHA loan.
    Among the 6300 non-subsidized loans analyzed in the FHA closing 
cost study, nearly a thousand had explicit fees charged to borrowers 
for use of either DU or LP, (charges varied from $10 to $150). Such 
tools unquestionably speed the loan approval process. It is unlikely 
that FHA would have built such a tool without the nudge from Fannie and 
Freddie having built such systems.
    Pure Government ownership and operation for Fannie and Freddie is 
not a good idea. FHA and Ginnie Mae are both purely Government 
operations. The good features of their structures lie in their 
simplicity. They have strict constraints on what business they can and 
cannot do, and what loans they are allowed to insure and securitize. 
They are subject to maximum loan size limits that vary with property 
values in different areas, they can insure and securitize only the 
simplest loans (30-year fixed and simple ARMs), they can insure and 
securitize only new loans, no seasoned loans, and lenders from whom 
they will accept loans are subject to approval standards and to strict 
servicing guidelines. These limits have successfully constrained the 
risks that they take.
    But FHA and Ginnie Mae perform better because they compete with 
Fannie and Freddie, and match at least some of their innovations. If 
all of the securitizing entities were Government bureaucracies, the 
performance would not be as good as we get from a mix of the two.
A lender co-operative?
    Time was when F&F were organized as lender cooperatives. Fannie 
began as a Government agency in 1938, and was reorganized as a co-op, 
primarily of commercial banks, in 1958. It was reorganized again as a 
public company in 1968. Freddie was a co-op among the thrifts, run by 
the Federal Home Loan Bank Board, from its creation in 1970 until 
FIRREA in 1989. In 1989, the largest commercial bank in the United 
States had less than 1 percent of bank assets. While U.S. banking is 
still competitive today, it is considerably more concentrated now, and 
a handful of large banks now hold close to half of bank assets and do 
more than half of mortgage lending. The conflict between smaller banks 
and larger banks with respect to how the GSEs should be run would be 
greater now than it was in their former co-op days, and makes the 
lender co-op idea a worse structure for today than it was in the past. 
Any co-operative would be likely be dominated by the largest banks.
    There are good reasons not to allow the largest banks to run the 
GSEs to the disadvantage smaller banks. Smaller banks deserve an 
important place in our banking system. There is accumulating evidence 
that smaller depositories treat their customers in a less exploitive 
way than do newer, larger, and less regulated financial institutions. 
In particular, they are less inclined to exploit financial confusion on 
the part of borrowers. See Stango and Zinman, Buck and Pence, who 
examine evidence from the Survey of Consumer Finances, and Agarwal et 
al. on the mortgage counseling experiment in Illinois, and the FHA 
Closing Cost report, http://www.huduser.org/Publications/pdf/
    The spectacle Wells Fargo's recently exposed overdraft scam (re-
arranging the timing of presentations to maximize overdraft charges), 
described by the judge as manipulative and hidden in a facade of phony 
disclosures, should make us all wary of rules that would operate to the 
advantage of large banks. It seems hard to imagine that a small 
institution, one in which the executives and programmers at the bank 
know depositors personally, and look them in the eye regularly, could 
have put in place such an exploitive scheme.
How many GSEs should we have?
    One might think that with only two organizations securitizing 
mortgages, we would see tacit collusion and monopoly pricing such as we 
get when two gas stations sit on opposite corners.
    The gas station paradigm is instructive. If one station lowers its 
price, its rival across the street sees that price change at least as 
soon as any customer. The rival can respond right away by lowering 
price also. The first mover sells no more gas than the rival, he just 
sells the gas for less. Thus, there is no incentive to lower price when 
the rival sees the change at least as soon as the customers do.
    This paradigm does not fit F&F. Freddie and Fannie do not post 
their guarantee fees in the way that gas stations post prices. Each 
deal is negotiated, customized, and secret. The ultimate results are 
seen only in quarterly summaries of business activity. Thus, customers 
do know price before rivals do, and know many about the details about 
their own deals that are not known by rivals. Cutting price does 
generate more business. Two GSEs thus reach an outcome close to what we 
would expect from perfect competition.
    On the other hand, the more operators we have in the secondary 
market, the harder it is to maintain the standardization and 
homogeneity of securities that give us more liquidity and lower 
mortgage rates. Two GSEs appear to give the maximum benefit of 
standardization and liquidity, but still give us competitive pricing.
    In principle, the Federal Home Loan Bank system could have created 
a third securitizing GSE. It did not, despite some efforts in that 
direction. I imagine that the reason the FHLB system failed to create 
another securitizing GSE is that there are conflicts of interest among 
the members about how the entity should be structured, with larger 
institutions wanting more power than smaller ones. They have a 
collective action problem. They all would benefit from having their own 
securitization facility, but since some would benefit more than others, 
the plan is blocked by those who would get less. They cannot create a 
facility only for some members, and have been unable to negotiate their 
way to creating a facility appealing to all.
Ownership by private shareholders versus a borrower cooperative
    The new charters for Freddie and Fannie should 1) establish higher 
capital requirements for Fannie and Freddie, and 2) have different 
capital requirements for different lines of business, in particular 
higher-default risk business, and 3) price the Government guarantee. It 
seems unlikely that we can alter asset markets to entirely avoid price 
bubbles (we seem to have had them from time to time as long as we have 
had asset markets, and they can be produced in experimental settings 
too), either in the stock market or the housing market, and once upon a 
time, in tulip bulbs. But if our financial institutions are less 
levered, the bursting of a price bubble is of less consequence. The 
dotcom recession of 2001 was driven primarily by the fall in asset 
values after the world realized that the internet was going to deliver 
far more value to consumers than to sellers. The 50 percent margin 
requirement (think of it as a capital requirement) plus the centralized 
clearing arrangements that monitor account values continuously and 
cashes out accounts that fall below required margin limited the fallout 
of the decline in asset values. The decline in stock values hardly 
touched the banking system. Housing was hardly involved in that 
recession, as single family construction chugged right along. This 
tells us much about how to limit a contraction in one sector from doing 
damage to other sectors.
    Given the big decline in house prices beginning in 2007, it was 
inevitable that we would have a big decline in residential construction 
(the high prices resulted in over-building, and when soaring vacancy 
rates made the over-building apparent, prices fell). Residential 
construction is a sufficiently large fraction of real activity that its 
contraction by half would mean a recession, all by itself. Through the 
third quarter of 2008, more than all of the shortfall in GDP was 
attributable to the decline in residential construction. Did the credit 
crisis make things worse? Certainly, yes. On average, recessions that 
included banking panics have been worse than recessions without banking 
panics. The dotcom recession of 2001 involved no financial panic, 
mainly because the assets that fell in value (stocks) were held with at 
most 50 percent borrowed money, and even this money was subject to 
closely monitored margin rules. Higher capital requirements can make 
the popping of price bubbles less consequential.
    So we need higher capital requirements in financial institutions, 
and especially to turn pseudo-insurance companies (AIG and other 
writers of credit default swaps) into bona fide insurance companies, so 
that they are subject to capital regulation. That's the easy part.
What about shareholder ownership, as prevailed until the crisis?
    When then were taken over last summer, F&F were owned by private 
shareholders, both had stock traded on the New York Stock Exchange, 
both operated as profit maximizers subject to constraints in the form 
of capital requirements and restrictions on their business activities 
imposed by regulators, and some directors appointed by the president 
instead of by shareholders.
    Two problems arose with this arrangement. First, there was no force 
to help F&F resist buying pieces of subprime mortgage securities and 
whole Alt-A loans. They could not securitize these mortgages directly, 
but they were not precluded from buying the higher-rated pieces. They 
did buy Alt-A loans for portfolio securitized them also. Their prime 
books are suffering in the current conditions, but the crippling losses 
have come not from their traditional business but from the subprime and 
Alt-A exposure.
    Second, F&F both have outstanding research shops, and each had the 
resources to do more research for the benefit of borrowers, for 
example, by helping to develop clear and standardized disclosures. But 
their main contact was with lenders, and both thought of lenders as 
``their customers''. Until very recently, F&F were reluctant to do any 
research on disclosure or comprehension of mortgage issues by 
borrowers, and this was part of a general reluctance to ``get between'' 
lenders and the lender's customers, the borrowers. Even Web site tools 
making loans easier to analyze brought forth lender complaints from 
lenders that ``this was not their job''. Lenders attitudes have changed 
since then, and the lenders are now eager for any help on assuring that 
borrowers understand the deal. It would be good to institutionalize 
these changes in attitude before the current crisis is forgotten.
    As an example of work F&F did not do because the lenders were 
``their customers'' is became apparent in an episode involving yield-
spread premium analysis. When the first ``yield-spread premium'' 
disputes were being litigated, the data being examined in the case was 
made available to both plaintiff's and defendant's experts for 
independent research. One expert sought to cooperate with staff 
economists at one GSE, who eagerly began examining the data. 
Previously, the GSEs only had HUD-1 data on very-low-credit quality 
loans, and on small samples of standard loans. When the parent of the 
defendant, a big GSE customer, got wind of this activity, it was 
promptly halted.
    Seven years later, this data plus another important set of data 
collected by FHA for its Closing Cost Report has told the same story 
about how mortgage brokers price discriminate and exploit borrower 
ignorance of financial matters more aggressively than do direct 
lenders, especially than small depositories and credit unions, who 
treat their borrowers with more benevolence. It is not a story that 
makes Americans feel proud of how financial institutions treat their 
citizens, with minorities, the less-well-educated, and older people 
charged more than others, other things equal. The GSEs could have been 
at the forefront of this research. The economic staff was capable and 
eager, but leadership blocked their efforts. In mid-July, 2009, the 
Board of Governors of the Federal Reserve voted to prohibit all 
practices that tied agent compensation to the interest rate on the 
loan, essentially banning yield-spread premiums.
    So a serious issue is how to make sure, in the long run, not just 
while the crisis is in recent memory, that the GSEs have borrower 
interests, not lender and broker interests, close to their hearts. One 
possibility is a borrower-owned mutual. For example, the Hartford 
insurance company is a mutual insurance company, essentially owned by 
its insureds. However, insurance companies have another overlay of 
governance from the State regulation of insurance that assures they are 
adequately reserved. Credit Unions are another form of mutual 
organization, with depositors owning and controlling them. Credit 
Unions are among the most benevolent of our financial institutions. Not 
only do they set prices to merely cover costs, not to extract all the 
market will bear, but they reach out to borrowers to help them be 
better borrowers, weaning them from payday loans and excessive credit 
card debt. On the other hand, the credit unions' secondary market 
facilities, organizations that pooled loans from individual credit 
unions and took them to Fannie and Freddie for securitization, did not 
escape the lure of subprime. Like Freddie and Fannie, the credit unions 
did not make any subprime loans, but their secondary institutions did 
buy some subprime securities, and have losses as a result.
    Making the MBS guarantee explicit and charging for it could impose 
discipline. If the guarantee is priced, there must be a regulator to 
price it. And with the pricing will come guidelines as to what is 
allowed in the pools. While Government organizations that price loan 
guarantees are not perfect, they do not seem as vulnerable to 
deliberate underpricing in order to ``maintain a place in the market'' 
as Fannie and Freddie were, especially with respect to their Alt-A 
loans. FHA's market share fell into the low single digits, as the rest 
of the market boomed and moved into subprime. In retrospect, FHA's 
policies look quite sound. Turns out there was some logic to all that 
    The issue of organization and governance deserve more study. I do 
not know enough about where control of mutual insurance companies 
really resides, or even how credit unions are controlled, to offer a 
completely firm opinion on structure. It seems that a return to the 
structure where the GSEs are owned by outside shareholders but regard 
lenders are ``their customers'' is not a good idea. A change that puts 
borrower concerns ahead of lender concerns is in order. There are 
several ways to move in this direction, the issue is important and 
deserves more study.
The GSEs outside of single-family.
    Multi-family construction is generally less sensitive to the level 
of interest rates than single-family because owners of rental units are 
either individuals with accumulated wealth or corporate entities, for 
whom cash constraints are not so binding as on households. What 
volatility is present in multi-family construction seems to come from 
spurts of activity generated by new tax credit programs. Credit 
conditions for multifamily fluctuate with the likelihood that intended 
condominiums will turn into rentals.
    So far, Fannie Mae's multifamily book has not generated much by way 
of losses in this recession. Delinquency rates are up from historical 
levels, but by absolute standards, they are still quote low (0.36 
percent in April 2009, vs. 0.09 1 year ago). Freddie Mac's multi-family 
book is even better, with delinquencies at 0.12 percent vs, 0.03 
percent a year ago. But rental markets are softening, rents are down, 
vacancies are up, and collections down. Fannie's multi-family holdings 
are $174 bn, and Freddie's $91 bn.
    Freddie and Fannie's multi-family underwriting is conservative. 
Fannie requires a 125 percent debt-service ratio, 20 percent 
downpayment minimum, and makes 10-year loans. More than 50 percent of 
the multi-family book is now held in portfolio, but recent new 
production is mainly being securitized. Multi-family loans are not 
bundled with single family, but securitized in separate MBS.
    Fannie and Freddie provide about three-quarters of all multi-family 
lending, and the buildings they finance are occupied primarily by 
elderly and low-to-moderate income households.
    In all GSE activity, as well as in all activity in depositories, 
there is at least a small amount of subsidy coming from Federal 
backing, either explicit or implicit. The case for a GSE role is thus 
more difficult to make for multi-family lending than for single-family. 
On the other hand, given the success of both in underwriting these 
loans, there seems little reason to inhibit this activity.
    It is very difficult to make a case for the GSEs to have a role in 
commercial property lending. Underwriting in commercial property is 
more difficult than in either multifamily or single-family residential. 
In commercial property busts, the critical factor is nearly always 
slackening demand on the part of commercial renters, not the difficulty 
of obtaining credit. Given the heterogeneity of commercial properties, 
it does not appear that what the GSE's have to offer, other than credit 
with the Government's good name, would contribute very much.
How big a difference do Fannie and Freddie make?
    Most of the time, rates on mortgages that were eligible for 
purchase or securitization by Freddie or Fannie have been cheaper than 
larger, ineligible loans (``jumbo'' loans) by 25 to 40 basis points. 
When the credit crisis began, one of the early manifestations of it was 
a widening of the jumbo-conforming spread, out to 180 basis points 
(that's 1.8 percentage points) and higher. The gap still stands at 
about 100 basis points today (March, 2010).


    The still-gaping jumbo-conforming spread calls for further comment 
on our present situation. All of the discussion here has been about the 
role of Freddie and Fannie in normal times, and what they can 
contribute when markets are otherwise performing smoothly. Though there 
are signs of return to normalcy--house prices rose in May and June as 
reflected in both the FHFA house price indices and the Case-Shiller 
house price indices--the situation is still far from normal.
    In 2008, FHA insured nearly 30 percent of new mortgage 
originations, up from only 3 percent in 2006. In the first quarter of 
2009, Ginnie Mae did 26 percent of mortgage securitizations (FHA plus 
VA), Fannie and Freddie did the other 74 percent, and there were no new 
private-label securitizations. The FHFA Mortgage Interest Rate Survey 
has ceased reporting rates on adjustable-rate loans because there are 
not enough of these for statistical reliability. Corporate and 
municipal spreads are narrowing, but still wide. Lending standards of 
all kinds are more strict now than for many years.
    During the financial crisis, our Government-created mortgage 
institutions have made the difference between a bad recession and 
something much, much worse, especially with respect to housing. 
Essentially, credit has continued to flow, but almost entirely through 
FHA and Ginnie, Freddie, and Fannie. In 2008, mortgage originations 
totaled about $1.5 trillion, of which 89 percent were either FHA and VA 
or conventional, conforming, prime loans. The other 11 percent were 
mainly jumbo prime, with a sliver of subprime and Alt-A loans. Nearly 
all of these new originations were securitized. Loan securitizations 
were 74 percent Freddie and Fannie, and 26 percent FHA/VA. There were 
no private-label securitizations (data from Inside Mortgage Finance).
    While most of this discussion was about the operation of the GSEs 
in more normal economic environments, the role of the GSEs in the 
crisis deserves attention also. Their presence makes a bigger 
difference, not a smaller one, in times of great confusion and 
uncertainty in financial markets. One way of thinking about the wide 
credit spreads we see today is that rates are not necessarily so high 
for the usual borrowers, but that rates for the Government are 
unusually low. It is a great irony of the crisis that although it was 
caused by United States policies (with contributions from the United 
Kingdom and a few others), it provoked a great increase in the world's 
desire to hold U.S. Treasury bonds.
    Evidently the world has more confidence in the ability of the U.S. 
Government to collect the eventual taxes to refund its own bonds than 
it has in the ability of individuals and businesses to repay their 
debts. There is an element of irrationality in such beliefs, because 
the very borrowers who are deemed less credit-worthy as individuals or 
businesses are the same as those who will pay the taxes to refund the 
bonds. It makes sense for the Government to use its superior standing 
in the credit market to make credit flow to non-Government entities. 
There are no structures more successful for doing this than the housing 
credit institutions we created in the twentieth century. Mere 
depositories would have done much less. Such a role was not 
contemplated for them (with the exception of FHA, which was created in 
a crisis specifically to make credit flow).
    Nonetheless, they have served and made the crisis less painful than 
it otherwise would have been. Thus, in deciding what to do about them 
as we go forward, we should acknowledge another advantage to their 

Q.1. In your testimony you state that pre-purchase counseling 
has been shown to reduce the likelihood that a borrower will 
default. You advocate increased funding from both the public 
and private sectors to make financial counseling more available 
to borrowers before they buy a home.

   LGiven the benefits that you have found to borrowers 
        from this counseling, do you support mandatory 
        counseling for borrowers using Federal Government 
        programs, like FHA, prior to them receiving a mortgage?

A.1. Pre-purchase housing counseling from independent, 
objective third-parties delivered in a timely manner and in a 
one-on-one setting is highly effective. The model is based on 
the commonsense notion that information is most effectively 
absorbed during a ``teachable moment.'' That is, the critical 
knowledge a family needs to navigate the mortgage market is 
delivered at a point in time when 1) they are most receptive to 
the information (because it is relevant to a near-term 
decision) and 2) they have enough time to act on the 
information. It is critical to distinguish between this kind of 
high-impact housing counseling and less effective models, such 
as a generic classes or online courses delivered moments before 
signing mortgage papers. This kind of ``check the box'' model 
does not empower consumers or inform their decisionmaking.
    Housing counseling agencies approved by the Department of 
Housing and Urban Development (HUD) are well-positioned to 
offer timely advice to home seekers and to first-time 
homebuyers. However, cuts to the HUD budget have endangered the 
infrastructure of nonprofit housing counseling programs. HUD 
funding is the backbone of the housing counseling program on 
which nonprofits leverage other private funding. For example, 
as a designated HUD Housing Counseling Intermediary, NCLR 
matches HUD funds with private, philanthropic, and local 
dollars 10 to one. Ideally, a well-rounded mix of funding 
streams would support a robust and independent network of 
private nonprofit housing counseling organizations. While many 
banks support housing counseling providers with grant funds, 
they have not put in place a fee-for-service model. Such a 
model would ensure counselors are compensated for delivering a 
mortgage-ready borrower that is less likely to default. Many 
housing counseling organizations also support having their 
clients pay a modest fee for receiving counseling. Most fees 
are determined on a sliding scale based on income and cover the 
cost of a credit report and materials. The housing counseling 
industry is at a critical juncture. We urge Congress to 
continue their long-standing support for a proven Federal 
program, and we urge the banking industry to make a more formal 
commitment to ensuring their clients have access to independent 
housing counseling services.
    Each year hundreds of thousands of first-time homebuyers 
enter the market. While all first-time homebuyers can benefit 
from a timely session with a certified housing counselor, HUD-
approved housing counseling agencies could not meet this demand 
on the current resources and financial infrastructure. We would 
support mandatory counseling for some mortgage programs so long 
as they were paid for by the industry members that stand to 
benefit and were supported by Federal funds. For example, we 
would support mandatory housing counseling for first-time 
homebuyers using Federal Housing Administration (FHA) mortgage 
insurance if FHA paid nonprofit counseling groups for producing 
a borrower less likely to default.\1\ Given FHA's high default 
rates attributed to seller-financed downpayment scams, 
counseling would have been a prudent investment for borrowers 
and FHA. To be clear, we recommend that FHA fees be 
administered separate from grant funding provided through the 
HUD Housing Counseling Program. FHA, Fannie Mae, and Freddie 
Mac should also consider incentives for borrowers to seek out 
counseling, such as discounts on interest rates, fees, and 
private mortgage insurance. NCLR made a similar recommendation 
to Federal regulators on the risk retention rule.
    \1\ Congress has invested millions of public dollars into creating 
a solid housing counseling infrastructure. Families that participate in 
pre-purchase counseling sessions are less likely to default on their 
mortgage, preventing foreclosures and future claims. However, since the 
removal of the housing counseling requirement, fewer borrowers seek out 
or are informed of this free service. For more information: Janis 
Bowdler, The Role of Federal Housing Administration Mortgage Insurance 
in Revitalizing Latino Homeownership, presented to 111th Cong, 1st. 
sess., 2009, http://www.nclr.org/index.php/publications/
revitalizing_latino_homeownership/ (accessed January 2012).
    In summary, NCLR supports mandatory counseling with 
adequate private and public resources to meet the demand. A 
mandate without an infrastructure sufficient to meet demand 
would create a vacuum that would quickly be filled by sham 
operations looking to take advantage of borrowers required to 
receive a service. The onslaught of foreclosure rescue scams 
should serve as a cautionary tale in this regard. However, NCLR 
is committed to working with Congress, HUD, and our partners in 
the mortgage industry to establish funding streams that support 
a robust, nonprofit pre-purchase housing counseling 
infrastructure. Finally, we underscore that to be effective, 
counseling must be delivered early in the home-shopping process 
(at minimum prior to signing a contract). With this as the 
foundation--timely, objective housing counseling readily 
available and supported by a robust mix of income streams--NCLR 
would support a combination of mandatory counseling and 
incentives for obtaining counseling for first-time homebuyers.


Q.1. The theory that the 30-year fixed-rate mortgage is always 
the best product for American consumers presupposes that 
Americans move into a home and live there for 30 years with one 
mortgage. In reality, Americans move often, and they refinance 
often. Other types of mortgage products offer lower interest 
rates and the ability to build wealth in a home more quickly. 
Even the adjustable rate products can be fixed for periods of 
time greater than the average time that Americans typically 
keep their mortgage.

   LGiven these facts of American life, would many 
        consumers be worse off if they purchase a 30-year 
        fixed-rate mortgage?

A.1. Did not respond by publication deadline.


Q.1. In a recent speech, Eric Rosengran, President of the 
Boston Fed, noted that ``the U.S. gets less effect from the 
movement of short-term, monetary policy interest rates compared 
to countries where the primary mortgage financing instruments 
are floating-rate loans.'' This suggests that the 30-year fixed 
has contributed to our weak economy because it has reduced the 
effectiveness of Fed monetary policy.

   LCould you provide us with some additional thoughts 
        as to how the effectiveness of U.S. monetary policy 
        might be enhanced if the United States were less 
        reliant on the 30-year fixed-rate mortgage?

A.1. Did not respond by publication deadline.

Q.2. The theory that the 30-year fixed-rate mortgage is always 
the best product for American consumers presupposes that 
Americans move into a home and live there for 30 years with one 
mortgage. In reality, Americans move often, and they refinance 
often. Other types of mortgage products offer lower interest 
rates and the ability to build wealth in a home more quickly. 
Even the adjustable rate products can be fixed for periods of 
time greater than the average time that Americans typically 
keep their mortgage.

   LGiven these facts of American life, would many 
        consumers be worse off if they purchase a 30-year 
        fixed-rate mortgage?

A.2. Did not respond by publication deadline.


Q.1. In your testimony you state that ``the 30-year fixed-rate 
loan potentially has some cost to taxpayers, but since 
taxpayers are virtually all homeowners too, there is nothing 
unfair about this situation.'' Unfortunately, missing from your 
analysis is the fact that when a mortgage is not repaid, the 
guarantee is not paid by homeowners to homeowners, but rather 
by taxpayers to the Wall Street banks and investors that hold 
the mortgage.
    Do you believe that such taxpayer bailouts of Wall Street 
investors are ``fair'' to U.S. taxpayers?

A.1. Any holder of a mortgage security, whether it is a bank or 
an individual investor, is just an intermediary. The only risk 
borne by these intermediaries who buy Government-backed 
mortgage securities is prepayment risk, and the returns they 
earn over the long haul are commensurate with the prepayment 
risk. All homeowners get the benefit of Government support to 
the mortgage market in the form of superior alternatives for 
home borrowing. The benefit is present at all times. The 
taxpayers bear the default risk, and pay taxes to cover it in 
increasing proportion to their incomes. I believe that nearly 
all taxpayers and homeowners regard this as a socially 
beneficial arrangement.