[Senate Hearing 112-341]
[From the U.S. Government Publishing Office]
S. Hrg. 112-341
HOUSING FINANCE REFORM: SHOULD THERE BE A GOVERNMENT GUARANTEE?
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING A GOVERNMENT GUARANTEE IN HOUSING FINANCE REFORM
__________
SEPTEMBER 13, 2011
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
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, 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
(ii)
C O N T E N T S
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TUESDAY, SEPTEMBER 13, 2011
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 2
Senator Menendez
Prepared statement....................................... 19
WITNESSES
Richard K. Green, Director and Chair, USC Lusk Center for Real
Estate, University of Southern California...................... 3
Prepared statement........................................... 31
Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy
Studies, American Enterprise Institute......................... 5
Prepared statement........................................... 38
Dwight M. Jaffee, Booth Professor of Banking, Finance, and Real
Estate, University of California............................... 6
Prepared statement........................................... 47
Adam J. Levitin, Professor of Law, Georgetown University Law
Center......................................................... 8
Prepared statement........................................... 51
Additional Material Supplied for the Record
Prepared statement submitted by the Securities Industry and
Financial Markets Association.................................. 58
(iii)
HOUSING FINANCE REFORM: SHOULD THERE BE A GOVERNMENT GUARANTEE?
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TUESDAY, SEPTEMBER 13, 2011
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:03 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I will call this hearing to order. I
would like to thank our witnesses for joining us today. This
will be the tenth housing finance reform hearing held by the
Committee, and the need for a Government guarantee has been an
undercurrent in nearly all the topics we have covered so far.
Before the Great Depression, homeowners often had short-
term or balloon mortgages they would roll over or renegotiate
at the end of the term. But when there were runs on deposits
and credit tightened, those homeowners had few opportunities
for financing and were forced to sell their homes or enter
foreclosure if they could not pay off the remainder of the
underlying loan.
Since the Great Depression, our housing market has been
built around a structure that involves the Government. Entities
such as the GSEs, FHA, and Ginnie Mae, the TPE market, which
Senator Reed explored in his Subcommittee, and the widely
available 30-year fixed-rate prepayable mortgage all rely on a
Government role to some extent. 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 if a Government role is eliminated
completely.
Returning to the housing system we had before the Great
Depression would not be an optimal outcome. Rural States like
South Dakota could suffer from a lack of credit and higher
prices. With low population densities and housing turnover
rates, access to a national mortgage market could be
constrained depending on where investors were willing to put
their money.
Without a Government guarantee, interest rates would likely
increase across the country, but it is unclear by how much.
When I have asked financial analysts and academics about this,
the answers range from a quarter of a percent to 3 percent. At
the high end, using today's rates, that would mean a monthly
payment on a $200,000 mortgage would increase from about $975
to more than $1,350.
The 30-year fixed-rate mortgage would also likely take a
different form and require substantial downpayments and higher
interest rates, restricting the number of borrowers to a small
number compared to today. If we use recently issued private
label securities as a guide, the average downpayment was as
high as 40 percent, according to testimony submitted for one of
our previous hearings.
Since there has been a Government role in the mortgage
market for close to 80 years, completely eliminating a
Government guarantee would result in significant changes to the
current market.
We have four witnesses who have written extensively on this
topic, and I expect that they will help us navigate their
arguments for and against a Government guarantee as well as the
benefits and risks of a guarantee in good and bad economic
times.
While there is not a single-bullet answer to some of our
housing problems, this discussion will help us better
understand how individual families and communities might be
impacted.
With that, I will turn to Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
Mr. Chairman, thank you for calling this hearing. Today's
hearing I believe will examine what is probably the most
important question for housing finance reform. Can our mortgage
market operate efficiently without a Government guarantee? How
the Committee answers this question will, I think, dictate how
we approach housing finance reform legislation.
If the Committee decides that the housing market needs a
Government guarantee, then it is likely that housing finance
reform will be largely a debate over how to structure the
guarantee. Reform will be easier but also less significant
because we will essentially be preserving the status quo.
However, if the Committee decides that the housing market
can and should function without a Government guarantee, reform
will then focus on how to transition to a private market. In
that case, housing finance reform will be a bold undertaking
that will fundamentally reshape how this Nation finances home
ownership.
While some say there is no need for bold reform, I believe
that all options should and must be on the table. Misguided
housing policies pursued by the Federal Government and
implemented by the GSEs played a significant role in causing
the financial crisis. Therefore, the Committee I believe should
determine whether other models of housing finance are more
efficient, more sustainability, and less likely to impose
losses on taxpayers than the current system.
It is my hope that today's hearing will help the Committee
begin to understand clearly the real benefit and cost of
providing a Federal guarantee in housing finance. Regrettably,
explicit and implicit Federal guarantees were often viewed as
ways to subsidize home ownership without incurring a cost to
the taxpayer. The implicit, so-called cost-free guarantee of
Fannie Mae and Freddie Mac has already soaked the American
taxpayer for over $170 billion, and it is climbing. The Federal
Housing Finance Administration estimates that the total cost
could more than double even over the next 2 years.
It is clear that the old way of doing things failed on a
massive scale. Failed. The question now is whether we have
learned anything from that experience. I look forward to the
hearing.
Chairman Johnson. Before we begin, I would like to briefly
introduce the witnesses that are here with us today.
Dr. Richard Green is the director and chair of the USC Lusk
Center for Real Estate at the University of Southern
California.
The Honorable Peter J. Wallison is the Arthur F. Burns
Fellow in Financial Policy Studies at the American Enterprise
Institute. Mr. Wallison is also the former General Counsel for
the U.S. Treasury Department.
Dr. Dwight Jaffee is the Willis Booth Professor of Banking
Finance and Real Estate at the University of California,
Berkeley.
And, finally, I would like to welcome Professor Adam
Levitin, a professor of law at the Georgetown University Law
Center.
Thank you all for being here with us today. I will remind
you to keep your statements to 5 minutes. Your entire written
testimony will be entered into the record.
Dr. Green, please proceed.
STATEMENT OF RICHARD K. GREEN, DIRECTOR AND CHAIR, USC LUSK
CENTER FOR REAL ESTATE, UNIVERSITY OF SOUTHERN CALIFORNIA
Mr. Green. Thank you, Chairman Johnson and Senator Shelby,
for allowing me to be part of this distinguished panel today.
My name is Richard Green, and I am director of the Lusk Center
for Real Estate at USC.
As you know, I have been asked to discuss whether the U.S.
mortgage market requires a Federal guarantee in order to best
serve consumers, investors, and markets. My answer to that is
yes. I will divide my remarks into four areas:
First, I will argue that the United States has a history of
providing guarantees, either implicit or explicit, regardless
of its professed position on the matter. This phenomenon goes
back to the origins of the republic. It is in the best interest
of the country to acknowledge the existence of such guarantees
and price them appropriately before, rather than after, they
become necessary.
Second, I will argue that in times of economic stress, such
as now, the absence of Government guarantees would lead to the
absence of mortgages.
Third, I will argue that a purely private market would
likely not provide a 30-year prepayable fixed-rate mortgage. I
do not know that this is a particularly controversial
statement. What is more controversial is whether such a
mortgage is necessary, and I will argue that it is.
And, finally, I will argue that in the absence of Federal
guarantees, the price and quantity of mortgages will vary
across geography. In particular, rural areas will have less
access to mortgage credit that urban areas, and central cities
will have less access than suburbs.
Let me begin with the point that the U.S. has a long
history of providing ex post--after the fact--guarantees as
well as other guarantees.
One could reasonably argue that the United States was born
from a bailout. One of the most famous compromises in U.S.
history was the deal negotiated among Hamilton, Jefferson, and
Madison for the new Federal Government of the United States to
assume the Revolutionary War debts of the Continental Army and
the individual States. This was followed by explicit guarantees
for bonds that helped build the Transcontinental Railroad, and
I could give other examples, but most recently, of course, we
have many private institutions that have received Federal
backing, including commercial banks who benefited from FDIC and
TARP; the purely private investment banks who benefited from
TARP; issuers of asset-backed securities who benefited from the
Term Asset-Backed Securities Loan Facility, or TALF; and, of
course, the Government-sponsored enterprises.
In light of the fact that the Government cannot credibly
commit to no bailout policies, no matter what one thinks about
the principle of Government guarantees, as a practical matter
it makes sense to recognize them explicitly and to price them.
The second point is that in times of economic stress, debt
markets do not operate in the absence of Government guarantees.
Beginning with the Great Depression, the United States has
faced at least five periods when private debt markets largely
shut down. Liquidity was so absent that spreads were not only
wide, but they were difficult to measure because of the absence
of transactions. These included the Great Depression, the
double-dip recession of 1979-81, the savings and loan crisis,
the Long Term Capital Management crisis, and the Great
Recession of 2008-09. Again, in each of these instances, it was
Government coming in with a guarantee program of some form or
another that allowed some restoration of liquidity and debt
markets. Most recently, of course, we have had this with the
fact that the Government-sponsored enterprises have become
wards of the State and as such have been able to continue
lending. It is frightening to think what might have happened to
the housing market, already in very sick shape, had Government
guarantees or had the GSEs not been there. As much as we might
dislike them, one might argue that what they are doing
currently is crowding out the private market. But if we look at
parts of the private market where GSEs are not permitted to
operate, we see an absence of lending in those markets, or at
least it is very difficult to get a loan in those markets.
The third point is that in the absence of guarantees, I do
think it unlikely that we would see a 30-year fixed-rate
mortgage. The reason this mortgage is important is because it
allows households to hedge two things: it is allowed to hedge
interest rate risk against a long-term assets--a house is a
long-term asset--but also human capital risk. By being
prepayable the U.S. mortgage allows people to move when they
have job opportunities in one part of the country or another.
This is a hedge that I do not think is sufficiently thought
about and is particularly important.
And the final point is that I think in the absence of
Government guarantees, you would see the private sector cherry-
pick certain markets over others. The problem with rural
markets and central city markets is they are thin markets.
There are not a lot of transactions. And it makes it very
difficult to judge valuations in these markets, which makes
them relatively unattractive for lenders. As a consequence,
what Government guarantees allow is for everybody to
essentially pool insurance, and as such, for everybody to get
access to mortgage credit.
Thank you.
Chairman Johnson. Thank you, Dr. Green.
Mr. Wallison, please proceed.
STATEMENT OF PETER J. WALLISON, ARTHUR F. BURNS FELLOW IN
FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE
Mr. Wallison. Thank you, Mr. Chairman, Ranking Member
Shelby, and Members of the Committee. The question is: Should
there be a guarantee in our housing finance system? And my
answer is no.
I want to start with the question of the debt. We are all
very worried here in the United States, and certainly in
Congress, about the size of our debt. The CBO estimates that
debt at about $14.3 trillion now, to go to $23 trillion in 2021
under current policies. If we add to that the $7.5 trillion
that is agency debt--that's mostly Fannie Mae and Freddie Mac--
we are talking about a $30 trillion debt for the United States
in 2021. And if we guarantee mortgages or mortgage-backed
securities under some plans that have been proposed, we will
simply be increasing the debt even more. So this is a serious
problem for us, and we have to consider whether it makes any
sense to add to the debt by guaranteeing mortgages.
The next thing I would like to talk about is how we protect
the taxpayers. What we have found again and again is that every
time the Government has some sort of guarantee program or some
kind of program to stimulate housing through a guarantee, the
taxpayers get it in the neck. The taxpayers ultimately have to
pay for it because the Government has no way of pricing risk.
And to the extent the Government did have a way of pricing
risk, it is not able to do it because for political reasons. It
is very difficult to impose these seemingly arbitrary costs on
the various members of society. So what happens is that the
politics prevents the Government from getting compensated for
its risks, and as a result of that, whenever organizations like
the S&Ls fail or when Fannie and Freddie--which were also
running risks--fail, the taxpayers have to bail them out.
And, finally, I ought to add--and this is also quite
important in terms of the cost of the Government--when the
Government guarantees anything it creates competition for
Treasury securities, and that competition causes higher
interest rates for Treasury securities--again costing the
taxpayers. So there is no good reason to provide a guarantee,
if once again we are going to be burdening the taxpayers.
Actually, there was an interesting paper by some Federal
Reserve scholars recently estimating that there was an interest
rate increase of somewhere between 30 and 100 basis points in
Treasury debt because of a Government guarantee elsewhere.
The final thing I would like to mention is preventing
bubbles. One of the arguments for guarantees is to provide for
a steady flow of funds to the housing market, and yet when we
do that we are ignoring all kinds of other businesses--
automobiles or consumer credit or whatever it is--and focusing
on housing, and what we do there is we are taking away some of
the risks in housing. That creates more speculation,
overbuilding, overlending, and overborrowing. This creates
bubbles, and when they collapse we have tremendous losses.
Now, what are the reasons then for guarantees? One of them
is that institutional investors will not buy mortgage-backed
securities without a guarantee. This is not true. There are $13
trillion in fixed-income investments made by institutional
investors. They are looking for more fixed-income investments
of various kinds, and, of course, they take credit risk to do
this. They are now investing in bonds and often junk bonds.
What they need is more diversification. They want to be able to
invest in mortgages. But they are not going to invest in
Government-guaranteed mortgages because the yields are not
sufficiently high. We need a private system, with market-rate
mortgage-backed securities to attract institutional investors.
Another point is that there will not be, we are told, a 30-
year fixed-rate mortgage without a Government guarantee. That
is also not true. If you go on to Google and you put in ``jumbo
30-year fixed-rate mortgage,'' you find that there are many,
many offers out there, and a jumbo mortgage is not in any way
guaranteed by the Government. So you can get a fixed-rate 30-
year mortgage if you want one. You have to pay for it, but
people ought to pay for that. There is no good reason to
subsidize that mortgage. If we wanted to subsidize a mortgage,
it probably should be a 15-year mortgage, which would actually
allow people to accumulate some equity in their homes.
Finally, I will make one further point, and that is that
mortgage rates, we are told, will be lower if we have a
guarantee, and of course they will be. That is because the
taxpayers are taking the risk. If we price these things
according to their full risk, then the Government's rate would
be exactly the same as the private sector rate. But we are not
doing that. Instead, we are forcing the taxpayers to pay for
the risks that the Government is taking.
Thank you.
Chairman Johnson. Thank you, Mr. Wallison.
Dr. Jaffee, please proceed.
STATEMENT OF DWIGHT M. JAFFEE, BOOTH PROFESSOR OF BANKING,
FINANCE, AND REAL ESTATE, UNIVERSITY OF CALIFORNIA
Mr. Jaffee. Chairman Johnson, Ranking Member Shelby, and
Members of the Committee, I welcome the opportunity to talk
with you today about what is really the future form of the U.S.
mortgage market.
My comments compare what I believe are the two current and
primary options for replacing the GSEs: private markets versus
Government guarantees.
My research leads me to strongly endorse the private market
alternative. I recently carried out research that compared the
mortgage and housing market performance of 15 Western European
countries with that of the U.S. This comparison is relevant
because these countries systematically have very little
Government intervention in their housing and mortgage markets
compared to the United States. Indeed, none of them have any
entities that correspond in any way to our GSEs. Nevertheless,
on all statistical measures that I could find, the housing and
mortgage markets of Western Europe have outperformed those of
the U.S. over the last 10 to 15 years. My written testimony has
a detailed statistical table. Let me just point out the two key
findings.
First, the home ownership rate in the United States at
year-end 2009 was 67.2 percent, which is exactly the average of
the 15 European countries. Indeed, seven of the European
countries have higher home ownership rates than the United
States, and I emphasize with very little Government
intervention in those markets.
Second, the average interest rate on mortgages in those
countries is actually lower, in some cases by significant
amounts, than the United States rates. Quite remarkable.
Without any subsidies.
It is important to understand the source of the superior
performance in Europe, and I believe it is very simple. They
have extremely safe mortgages. The default rates in Europe even
today under, as we know, distressed conditions in those
economies, the default rates are remarkably low, and,
therefore, they do not have to have high premiums for default
risk.
I believe if the United States switched to an essentially
private market system, we would obtain exactly the same
benefits, and I would emphasize that having safe mortgages
would save us what otherwise I fear will be a future replay of
high default rates, high loan modifications costs, and high
foreclosure rates. And it is my opinion that the U.S. housing
markets would be much better without such costs facing us
again.
Let me now turn to the Government guarantee proposals, and
I am skeptical of these for several reasons. First, it is
commonly suggested that we currently have no private market
activity and that the proponents of these proposals see no
signs of recovery. To me this is Crowding Out 101. Of course,
if there are highly subsidized Government programs offering the
same service as the private sector, we will see no private
sector activity. But this offers, in my opinion, no evidence
that private markets would continue to fail if the Government
programs were removed.
A second common argument for the Government guarantees--and
we heard it from Professor Green--is the 30-year fixed-rate
mortgage. I strongly disagree. The 30-year fixed-rate mortgage
does not require Government guarantees or GSE activity in any
shape or form. The key point is that the risk an investor faces
in buying a 30-year fixed-rate mortgage is interest rate risk,
and neither the GSEs nor any of the Government guarantee
programs have any actions to mitigate that risk. That risk is
there in the marketplace, end of story.
Second, if you actually think of credit risk, private
market investors will think of a fixed-rate mortgage as safer
than an adjustable-rate mortgage. That is why we created the
fixed-rate mortgage back in the 1930s, because it is a safer
instrument. So there, again, the private markets will function
just fine with fixed-rate long-term mortgages. As Dr. Wallison
said, the markets are alive and well both in Europe and in the
United States where the private sector provides these
mortgages.
But most importantly, in terms of criticizing the
Government guarantee proposals, my fear is that any proposal
that actually gets enacted will put the Government in a first
loss position, and that inevitably the Government and taxpayers
and the borrowers will once again face the high costs of
mortgage defaults and cumbersome losses associated with them.
It is unfortunate, but the common experience with Government
guarantee programs is that the political process inevitably
leads to low underwriting standards, low premiums, subsidized
costs, which cause taxpayers and borrowers to put themselves
actually in harm's way.
Examples of this would include, for example, as you would
know, the National Flood Insurance Program where Congress has
recently had to make an appropriation for that.
Let me just close by saying that I understand that we have
a transition problem. How do we get to this nice private market
from where we are? And the answer is: Reduce the conforming
loan limits in a sequence of steps that will create an orderly
transition. October 1st you have your first opportunity. The
current temporary increase in the conforming loan limits are
scheduled to step down by almost $100,000. I hope that happens.
I believe it would be an excellent challenge to the private
markets to carry on.
Chairman Johnson. Thank you, Dr. Jaffee.
Professor Levitin, please proceed.
STATEMENT OF ADAM J. LEVITIN, PROFESSOR OF LAW, GEORGETOWN
UNIVERSITY LAW CENTER
Mr. Levitin. Mr. Chairman, Ranking Member Shelby, Members
of the Committee, in the perfect world, there would be no
Government guarantee of the housing finance system. It would be
a totally private system. And I want to make clear, I do not
disagree with Dr. Jaffee or Mr. Wallison on any of the problems
of a guaranteed system. A guaranteed housing finance system has
many concerns. But the truth is, there is no real alternative.
The fundamental problem with housing finance privatization
proposals is they do not work. Fully private housing finance
systems simply do not exist in the developed world. The choice
in housing finance is not a choice between Government guarantee
and no guarantee. That is a false dichotomy. The Government
inevitably bears the risk of catastrophic failure in the
housing finance system. There is not a housing finance system
in the developed world that does not either contain an explicit
guarantee, as in Canada, or an implicit guarantee, as in
Germany and Denmark, which happen to be the only other two
countries with widely available 30-year fixed-rate mortgages.
The real choice is not between a guarantee and no guarantee,
but instead between an implicit guarantee and an explicit
guarantee.
Despite all our best intents and declarations, the reality
is that if faced with the imminent collapse of the housing
finance system, the U.S. Government will bail out the system.
It is simply not credible that any Administration or Congress
will permit the U.S. housing finance system to collapse.
Prior to 2008, remember, Fannie and Freddie's obligations
were explicitly not guaranteed by the U.S. Government, and yet
they were bailed out. We simply have no ways of tying our hands
against bailouts, and indeed, we may not even want to. Put
differently, there is no way to guarantee against a guarantee.
Once we accept that any housing finance system has a
guarantee built into it, there should be little debate about
whether the guarantee should be implicit or explicit. An
implicit guarantee would result in a system that would
guarantee moral hazard, as private parties would have all of
the upside while the Government would bear the downside. An
implicit guarantee means that if things get rough, the
Government will bail out the system, but it will not have
priced for it.
An explicit guarantee has its problems, to be sure, as you
have heard. But an explicit guarantee can be priced and
structured to mitigate the risk. We may not get it perfect, but
we can at least try and mitigate the risk that it will be used.
That is not possible with an implicit guarantee. There is
simply no thing as a nonguaranteed housing finance market other
than in ideological fantasies.
Moreover, attempting to privatize the U.S. housing finance
system puts the entire economy at serious risk. Eliminate the
Government guarantee risks the flight of over $6 trillion from
the U.S. housing finance market, roughly half the dollars
invested in U.S. mortgages. Such an occurrence would be
catastrophic for the U.S. economy, as mortgages would become
unavailable or unaffordable for even prime borrowers.
Let me explain why privatization would result in a massive
flight of U.S. mortgage capital. Mortgage investment involves
two distinct risks, credit risk and interest rate risk. Most
mortgage investors assume only interest rate risk. They are not
credit risk investors. Investors in GSE and Ginnie Mae
securities and MBS assume only interest rate risk, not credit
risk. And investors in the now-defunct private label
securitization were functionally interest rate investors. Over
90 percent of private label mortgage-backed securities were
rated AAA at issuance. So the investors who relied on these
ratings understood the credit risk to be negligible.
What this means is that the overwhelming majority of
investors in the U.S. secondary market are not credit risk
investors. They are solely interest rate investors, and they
are unlikely to suddenly transform now, if ever, into credit
risk investors, but that is precisely what a privatized housing
finance system lacking a guarantee would do. It would require
all the investors to become credit risk investors.
To the extent that rate risk investors can be lured into
assuming credit risk, it will entail much higher rates of
return on the securities, which will mean much higher interest
rates on mortgages. And even then, it is doubtful that there
would be anywhere close to a sufficient volume of interest rate
risk investors willing to assume U.S. mortgage credit risk.
Theoretically, there could be as much as $6 trillion lost from
the U.S. housing finance system. Following the siren song of
privatization would put the entire U.S. economy in grave peril.
Now, it is true that the U.S. jumbo mortgage market
operates without a Government guarantee, but the jumbo market
is substantially smaller than the conventional conforming
market and jumbo securitization rates are also much lower,
which indicates that there is a limited supply of investment
capital for credit risk, even on prime jumbo mortgages. Most of
them are held on balance sheet by banks.
The jumbo market also benefits from the existence of a
guaranteed mortgage market in several ways. It is not a fully
private market. It picks up benefits from having the Government
guaranteed market.
In short, the jumbo market does not provide evidence that
there is sufficient private risk capital willing to take on
credit risk on U.S. mortgages. The bottom line is that when we
are considering a Government guarantee in the housing finance
system, we need to accept that there really is no such thing as
a nonguaranteed system. Every system that claims to be fully
privatized has an implicit guarantee. We saw this in Germany
and Denmark in 2008. Germany bailed out a number of its
mortgage lending institutions that issued covered bonds.
Denmark did the same thing. That means that even in those
systems that were supposedly fully private, that are held up as
paragons of private systems that produce 30-year fixed-rate
mortgages, we actually had an implicit guarantee that became
explicit.
We just have never seen a fully privatized housing finance
system and I think that we would be gambling with the U.S.
economy if we tried to embark on such an experiment.
Chairman Johnson. Thank you, Professor Levitin.
Doctor Green, what are the economic risks associated with
the absence of a Government guarantee for local communities
from both an urban and rural perspective, and how would private
investors decide to allocate their funds across the wide
variety of housing markets in the country?
Mr. Green. In my view, as I said in my testimony, the
problem facing rural markets and central city markets is you do
not see frequent transactions in these markets, and as a result
of this, we have seen difficulty in these markets attracting
capital in a wide range of areas. So, for example, it is very
difficult for central cities to attract grocery stores, even
though we see a high density of income in these places that
could support the grocery stores. So it ranges from the
commercial market to the residential market.
And the problem is, when you are making a loan, you need to
make a judgment about collateral, and the judgment about
collateral comes from comparables, being able to see large
numbers of sales. In suburban neighborhoods where you have
homogeneity, where you have a large number of sales, it is
pretty straightforward to determine what a house is worth and,
as a result of that, to be comfortable with collateral when you
are making a loan.
In rural areas and in central cities where the transactions
are rarer and where there is also more heterogeneity, so it is
hard to know whether one farm town is really the same as
another farm town or not, making judgments about valuations is
very difficult, and this judgment about valuation makes people
less prone to want to invest in a place. They consider it an
informational risk. And so if there is capital that flows to
these places at all, it is in less favorable terms than it is
in places where there is more homogeneity.
And so in the absence of a Government which sort of puts a
backstop on losses that one might find in these rural
communities and these central cities in the event of
catastrophic events, I think you would see substantial
differences in how these places are treated.
Chairman Johnson. Professor Levitin, both FHA and the GSEs
lost market share to private market products during the housing
boom. Why did the increase in private market participation not
create a more stable market instead of the breakdown we
experienced?
Mr. Levitin. The problem with the growth of the private
label securitization market in the 2000s was that it was
essentially an unregulated market. There were no marketwide
standards that applied on mortgage origination or
securitization, and what happened then was essentially a race
to the bottom, where private label securitizers competed to get
market share based on having ever looser lending standards, and
the GSEs found themselves in a losing market share and their
private shareholders were not real pleased to see that and
pushed the GSEs to try and compete more vigorously through
laxer lending standards and the result was we got in a race to
the bottom and we are all paying the price for that.
Chairman Johnson. Dr. Jaffee, in the late months of 2008,
the U.S. housing market was on the brink of collapse. Looking
back, what would the housing crisis of 2008 have looked like if
the Government had not taken over Fannie Mae and Freddie Mac?
Mr. Jaffee. I believe that by that time, there was probably
no option about saving Fannie Mae and Freddie Mac. I had
written as early as 2003 actually predicting exactly what would
happen, which was to say that the institutions, if nothing
else, were going to end with a liquidity crisis. They had
unbalanced interest rate risk. They had a huge maturity
imbalance in which a third of their liabilities came due every
year, even though they had very long-term assets, and it was
only going to require one morning in the financial markets in
which the current holders of Fannie Mae and Freddie Mac debt
said, we do not want to buy it any more, we do not want to roll
it over, and they would be, in effect, in a liquidity crisis
and have to be bailed out. So by that point, I think there was
no way around it.
Chairman Johnson. Mr. Wallison, your colleague Alex Pollock
called for countercyclical measures to help prevent or at least
protect against housing bubbles. Do you agree with his
suggestion, and would the private market adopt these standards
on its own?
Mr. Wallison. Yes, I agree generally with the idea that we
ought to have some sort of countercyclical process for
preventing the decline in mortgage standards. However, the
important thing to keep in mind is that if we have a Government
guarantee, we are assuring that there will be a decline in
mortgage quality standards because investors will no longer be
interested in whether the mortgages that are being guaranteed
are of good quality or not. That creates the race to the bottom
that Professor Levitin talked about. And we exacerbate that
because we increase the likelihood that weak mortgages will be
developed by having such programs as affordable housing
requirements for Fannie Mae and Freddie Mac, which caused them
to buy very weak mortgages. That was one of the causes--
probably the principal cause--of the financial crisis.
Chairman Johnson. Professor Levitin, without a guarantee,
could the private market pick up the remaining market volume?
If not, what would happen to the availability of mortgage
credit?
Mr. Levitin. Without the guarantee, the private market
simply would not pick up the volume of mortgage financing
needed to sustain the U.S. housing finance market, and the
result would be that a lot of people would be simply unable to
get mortgages, or if they were able to get a mortgage, it would
be at an extremely high interest rate. So we would really be
gambling--if we tried to privatize the system, we would really
be gambling with the entire housing finance system and taking
on a risk that we would end up in a crisis that looks actually
much worse than 2008.
I think it is important, though, that I say a word about
something that Mr. Wallison just said. Mr. Wallison just tried
to blame the Government's affordable housing programs for the
financial crisis in 2008. I know that is the position he
adopted in his FCIC dissent. I think it is important to state
for the record that it is a position that has been thoroughly,
thoroughly debunked and challenged by many other sources, and
if you just want to see an example of a real estate market that
tanked with no Federal involvement whatsoever, look at the
commercial real estate market.
The commercial real estate market had a bubble that tracked
the residential market almost to a T. The Federal Government is
not guaranteeing anything in the commercial real estate market.
The Federal Government does not have affordable commercial real
estate goals or any regulation thereof. That market also
tanked. Unless Mr. Wallison can explain what happened in the
commercial market, it is kind of hard to place the blame on the
Government's affordable housing programs for what happened in
the residential market.
Chairman Johnson. Mr. Wallison, do you have a response?
Mr. Wallison. Of course.
[Laughter.]
Mr. Wallison. That followed what happened in the
residential market. The residential market collapsed because of
the affordable housing requirements. Quite apart from being
debunked, as Dr. Levitin indicated, the data produced in my
dissent from the FCIC report showed that the Government bought,
through Fannie Mae and Freddie Mac and through other Government
programs, two-thirds of all the weak mortgages that were
outstanding. Some of the arguments that have been made are
that, well, Fannie Mae's mortgages, Freddie Mac's mortgages,
were better quality than other mortgages. Yes, that is true,
but Fannie Mae and Freddie Mac are insolvent. In other words,
they bought terrible mortgages; they had the power to acquire
good mortgages and they did not do it. They began this process
in 1992 when the affordable housing requirements were first
imposed. The numbers are very clear, if anyone were to read my
dissent from the report of the Financial Crisis Inquiry
Commission, Mr. Chairman.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Dr. Jaffee, according to economic research, how much of the
benefit generated by a Federal guarantee would actually go to
consumers in the form of lower interest rates and how much of
the benefit would go to the housing and banking industry? Have
you done some research in that area?
Mr. Jaffee. I have done some research----
Senator Shelby. OK.
Mr. Jaffee. ----and many of my academic colleagues have
done even more----
Senator Shelby. Yes, sir.
Mr. Jaffee. ----and I think the numbers are--there is a
broad consensus. Roughly speaking, the GSEs have probably been
receiving a subsidy of approximately 50 basis points a year in
terms of their ability to give guarantees that the markets
basically assumed were Government guarantees as opposed to what
they would have had to pay for, say, debt if they were private
firms, 50 basis points.
The available evidence on the loans at the margin between
conforming GSE available and above it, not GSE available, is
about 25 basis points and it suggests that approximately half
of the subsidy is going to the borrowers and half of the
subsidy is going into the pockets of either the shareholders or
the managers of the GSEs. And if you do the numbers, it comes
out exactly right. That is why the GSEs over many years were
able to report rates of return on equity at 30, 35 percent a
year, which was double what any other bank in the world has
been able to achieve.
Senator Shelby. Professor Jaffee, would you just comment a
little bit--you alluded to this--the idea of socializing the
risk and privatizing the profits----
Mr. Jaffee. Well, what----
Senator Shelby. ----what we do when we guarantee something
by the taxpayer, do we not?
Mr. Jaffee. Well, for sure, we do. I would say the GSEs
were the worst form of creating that because you created
entities that had fiduciary responsibilities to their
shareholders to maximize profits, and yet they quickly--in
fact, it is interesting. The concept of an implicit guarantee
was immediately adopted by the GSEs. If you go back and read
the record and history, by 1969, 1 year after Fannie Mae became
a GSE, and by 1971, 1 year after Freddie Mac became a GSE, they
were telling the world, do not worry. We have an implicit
guarantee. You can treat us as good as Government paper. And so
they were adopting that immediately.
Once you have an entity that has profit incentives and a
Government guarantee, the economics are very clear. You
maximize your size and you maximize your risk bearing as much
as you can get away with. Their whole history from 1968 to the
collapse was a progression of greater and greater risk taking.
Senator Shelby. Mr. Wallison, prominent bond trader Bill
Gross recently stated, and I will quote him, ``Without a
Government guarantee, as a private investor, I would require
borrowers to put at least 30 percent down and most first-time
homebuyers cannot afford that.'' Of course, I understand his
motive. You know, he is in the marketplace and he is a big bond
holder. Some have pointed to statements like this and argued
that most private investors will not buy mortgage-backed
securities without a Government guarantee. In your testimony,
you state that this is a myth disproved by the data. Would you
explain?
Mr. Wallison. Sure.
Senator Shelby. Yes, sir.
Mr. Wallison. The amount of fixed income investment by
institutional investors is $13 trillion. Of that sum----
Senator Shelby. Thirteen trillion----
Mr. Wallison. Thirteen trillion dollars.
Senator Shelby. That is not chump change, is it?
Mr. Wallison. That is not chump change. That is money that
is available to the mortgage market here in the United States.
Senator Shelby. OK.
Mr. Wallison. This purchase of GSE securities, however,
amount to $1.8 trillion, a very small portion of the $13
trillion, indicating----
Senator Shelby. Explain what you mean by G-series. That is
Government----
Mr. Wallison. GSE the Government----
Senator Shelby. GSE.
Mr. Wallison. That is Fannie Mae and Freddie Mac. Their
debt, $1.8 trillion worth of their debt, was bought by these
institutional investors, which indicates that these investors
are not particularly interested in Government guaranteed debt.
What they want is fixed-income securities that pay a market
rate----
Senator Shelby. Sure.
Mr. Wallison. ----and that is not what they have been able
to get as long as we have a Government-backed program. So the
idea should be to make privately insured mortgage-backed
securities now. That would make as much as $13 trillion
available to our housing market.
Senator Shelby. Dr. Jaffee, going back to you, if the
Federal Government were to provide a broad explicit guarantee
of mortgage-backed securities, then it would remove the need,
some people argue, for investors to perform their own due
diligence on the securities. Lack of due diligence, I think, is
a problem here. Could any systemic risk to the U.S. economy
arise if investors stopped doing their own due diligence on
mortgage-backed securities? In other words, they say, well, the
Government guarantees it. It is Fannie and Freddie. We are
going to get paid regardless. Have you thought about that?
Mr. Jaffee. Indeed, I have. Indeed, I find it remarkable,
given the distress that we are still going through, having had
an episode of terrible risk taking in the mortgage market, that
we are contemplating Government guarantee programs which, in my
opinion, will inevitably have the Government providing
insurance with low downpayment mortgages, with low premiums,
and that will actually induce the borrowers to once again put
themselves into risky positions and inevitably, just as it does
with floods, as it does with earthquakes, as it does with
hurricanes, we are going to find the Government has to bail out
these folks, and then Government then has to admit, we induced
them to do it and now we have to bail them out.
A private market, in my opinion, will do just the opposite,
and here I have to disagree with Professor Levitin, who
suggested that investors in these private label securities were
only concerned about the interest rate risk and somehow they
did not worry about the credit risk. Absolutely not true. The
structured finance format that underlies all private label
securitization has an equity tranche. It has a mezzanine
tranche. It has a B-level tranche, all of which are the
investors who have to put their money in the first loss
position.
In fact, it is quite remarkable. We never hear about those
guys. They did not get bailed out. They all took their losses.
These were hedge funds, they were mutual funds, they were
pension funds, and they took their losses and that is where the
equity losses were incurred.
In a new system, those investors, just as we see in Europe,
those investors are going to say, I am willing to take private
market risks, but I want safe mortgages, and I think that is
the transformation that we are going to have and that is why we
will not see another similar episode under a private system but
we would under a Government system.
Senator Shelby. Thank you.
Mr. Wallison.
Mr. Wallison. Yes, I just want to add that of course these
institutional investors will take credit risk. The idea that
they will not take credit risk is mad.
Senator Shelby. They are taking them every day.
Mr. Wallison. Of course. Thirteen trillion dollars that is
invested in bonds, including junk bonds--which is what they are
buying now because they do not have other investments--is
taking credit risk, and they would happily take credit risk on
mortgages which are generally, if good quality, very safe
investments.
Senator Shelby. Can I ask you a question, then, Professor--
--
Mr. Levitin. Of course, Senator.
Senator Shelby. I was getting to you. Thank you, though.
Mr. Levitin. Thank you.
Senator Shelby. You are very patient. Bailouts after Dodd-
Frank, and then you can get it. Professor Wallison, he was
talking about the debt which is confronting all of us here in
Congress right now and the American people. If we add the
agency debt, if we add the continuing hemorrhaging of Fannie
and Freddie, all this together, we are going to get up to $30
trillion worth of debt. Is the idea of a guarantee, which
ultimately lays the groundwork for a bailout, you know, in
other words, nothing is too big to fail, so to speak, is that
smart in our economy today, in the world economy, with Europe
reeling, we are reeling? Professor.
Mr. Levitin. Well, I think it is important to frame this
the right way, Senator.
Senator Shelby. Yes.
Mr. Levitin. The question is not whether we would put this
all on the U.S. balance sheet now or never. It is simply a
question of whether it goes on the balance sheet now or at the
time of the next crisis.
Senator Shelby. Wait a minute. It is either on the balance
sheet or off the balance sheet, but the guarantee is there, you
know, this whole idea--we sat here for years and talked about
there is no real guarantee of Fannie and Freddie. We knew
better than that. We knew better. So there is either implicit
or explicit. Right now, with Fannie and Freddie sitting in the
lap of the Government, of the taxpayers, it is very explicit,
is it not?
Mr. Levitin. Oh, I think it is very explicit, but I do not
think pretending that--if we did a privatization move and
pretended that there was no guarantee, I am not sure that the
market would be fooled.
Senator Shelby. OK.
Mr. Levitin. I think that, you know, we look back at when
we privatized Fannie Mae originally in 1968. That was to clear
it off they Federal balance sheet in order to pay for the Great
Society programs and the Vietnam war.
Senator Shelby. Wait a minute. You said we privatized it.
You mean we basically created a hybrid, did we not, a
Government Sponsored Enterprise. That is not privatizing.
Mr. Levitin. Well, it is--there was no explicit guarantee.
It was----
Senator Shelby. But it was implicit.
Mr. Levitin. It was implicit, which is exactly what would
happen if we tried to privatize it again. We cannot get rid of
an implicit guarantee. There is no way to do that. The nature
of the implicit guarantee is it exists whether----
Senator Shelby. As long as we have a Government Sponsored
Enterprise, I agree with you. We cannot get rid of it. But if
we were to spin off, period, and have the private markets
working, even step by step, we could get rid of it. But we
would have to have, one, the political will here to get rid of
it----
Mr. Levitin. It would take----
Senator Shelby. ----and I am not sure that is here yet,
but----
Mr. Levitin. I think it would take more political will than
we have ever seen from the U.S. Government. I think Professor
Green detailed it pretty well, the history of the U.S.
Government engaging in bailouts of nonguaranteed entities,
including most recently private institutions or banking
systems.
Senator Shelby. But I think you went back to the Hamilton
era of where we--did not the Federal Government assume the
States' debts incurred? That is a little different thing.
But you started to say something earlier. I want to be
courteous to you, as long as the Chairman will indulge me.
Mr. Levitin. That is very kind, Senator. Thank you. I think
there are two important points to make about diligence. First
of all, yes, Professor Jaffee is right. There were some credit
risk investors. But it is important that we understand the
scale of that because this is really an issue of scale.
Of the private label mortgage-backed securities, something
around 95 percent of them were rated AAA at issuance. That
means only about 5 percent of them were being purchased by
credit risk investors. Ninety-five percent of this market was
not looking to take credit risk. And when you look at who those
investors were, it is clear they have no ability to handle
credit risk. Consider what----
Senator Shelby. Like who, for instance?
Mr. Levitin. Chinese investment funds, for example. How is
it that--so Federal Reserve Chairman Ben Bernanke actually has
an article recently--he still publishes--pointing the extent of
which the funding of the U.S. housing finance system was coming
from foreign investors, particularly from East Asia. It is just
not realistic to think that a Chinese investment fund----
Senator Shelby. ----and why was it coming? Because they
were led to believe that we would never let them fail, in other
words, is that----
Mr. Levitin. That was part of it. They did not think there
was going to be any credit risk, and had there been credit
risk, they would not have invested because they have no way of
doing diligence on U.S. mortgages in any meaningful capacity.
They are at such an informational disadvantage that they simply
would not invest in that. They are not looking for credit risk.
They are looking--they can figure out what is going to happen
on U.S. interest rates, they think, but they have no idea what
is going on on the ground with U.S. mortgage lending and they
make no pretense of it.
Senator Shelby. Professor Green, maybe I can get to you on
the next round. Thank you.
Chairman Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. My thanks to the
panel for their testimony, which I have read.
Let me ask you, Professor Levitin, in the days before GSEs,
loans were generally renewed every 3 to 5--or due every 3 to 5
years and had to be refinanced all the time because lenders
were not willing to make 30-year commitments. So now we hear
that once the Government gets out of the way, private capital
will automatically enter the market and replace the
Government's position.
What assurances are there of that, that it will occur in a
timely fashion, considering that we have yet to see significant
private capital participation in, for example, the jumbo
mortgage market or significant private capital returning to the
mobile home market? What if we eliminate, as some suggest, the
GSEs and we turn out to be wrong about private capital coming
back to fund 30-year loans?
Mr. Levitin. There is absolutely no reason to believe that
private capital would immediately step up, even if it would
eventually step up. And there is really not good reason to
believe that it would eventually step up in sufficient volume.
If we are wrong about this, we have a financial crisis on our
hands that far exceeds that in 2008.
Senator Menendez. And one of the challenges I see is what
if we completely eliminate the GSEs, as some are proposing? By
how much do you think the cost of a mortgage would go up for
the average middle-class family trying to buy a fairly modest
home?
Mr. Levitin. Actually, giving you a precise estimate is
outside of my particular area of expertise, but I would
expect--you heard a range of estimates. I have actually, I
think, heard a higher estimate from Bill Gross, the head of
PIMCO, which I think he said something around the range of 400
basis points. I do not want to quote him on that, though. But
we would see that--we could potentially see a significant
increase not just in interest rates but also in downpayment
requirements. And you put those together, and we could see a
large number of American families simply shut out of the
mortgage market.
Senator Menendez. And then----
Mr. Levitin. And I am sorry. I want to make one other point
with that. If that happens, that causes a precipitous collapse
in housing prices, which then triggers further defaults, and we
can end up in something of a death spiral.
Senator Menendez. And, of course, those costs would be
significant over the life of a loan.
Dr. Green, do you have any views on this?
Mr. Green. Well, it is not so much the cost as the
availability of the product per se. So, again, it is really
hard because making an apples-to-apples comparison is very
difficult.
Mr. Wallison discussed the fact that you can go on Google
right now and get a jumbo loan, you will see a lot of people
offering jumbo loans. But I am kind of wondering whether he has
actually tried applying for one of them in the last 6 months.
I did a refinance on my house on a 30-year jumbo, and it
was very striking to me because when my wife and I got our
first mortgage when we had our jobs for a year and all we had
in the bank was a downpayment and that was it, it took like 2
days to get approved. It took us 4 months to get approved on
our jumbo non- cash-out refinance. And I do wonder about
whether our housing market can actually transact if it takes 3
to 4 months in order for a loan to get approved.
So there is a lot of stickiness in the process as well. How
that exactly translates into a price I am not exactly sure. But
if you say 50 basis points plus it is going to take you another
2 to 3 months to get your mortgage, that is a very different
kind of calculation than just saying 30 to 40 basis points.
Senator Menendez. Currently, small lenders such as
community banks or mortgage brokers are able to participate in
the mortgage market by selling loans to Fannie and Freddie
without having to go through one of the big banks to accumulate
enough loans to create a securitization pool. What would the
various reform proposals do to the ability of small lenders
such as community banks or mortgage brokers to compete in the
mortgage market? Would this be a concentration of the market in
the hands of a few players? Professor?
Mr. Levitin. I think we would like--if we took the
privatization, which I want to emphasize again is really an
implicit guarantee route, I think that we would see
concentration being the order of the day. And the reason I
believe that is if you look at what happened in the private
label securitization market, it did not have a long life during
which it was, you know, a sizable market. But as that market
grew in the 2000s, the move that happened was investment banks
started to create integrated origination to distribution chains
where they would purchase--they would have their own loan
originators, and they would have their own securitization
conduits. The move was to integration, and that integration
move would really try and push out any other competitors on the
origination front, your community banks, your credit unions,
and I think that we would see them really losing business if we
moved to a privatized or really implicitly guaranteed market.
Senator Menendez. Thank you.
Mr. Chairman, I would ask unanimous consent that my
statement be entered into the record at the beginning of the
hearing.
Thank you Mr. Chairman for scheduling this hearing
whose topic in my view goes straight to the heart not
only of Government support of the housing market, but
also to the question of what our values and priorities
are as a Nation. I look forward to getting America's
housing finance system back on track, which is why I'm
also looking forward to my Housing hearing tomorrow
afternoon on New Ideas in Refinancing and Restructuring
Mortgages. As families back in New Jersey, whether they
own their homes or they are renting, are struggling
through these tough times, we need to make sure that
they have access to 30-year fixed-rate mortgages. I
don't think we should give up on the American Dream of
home ownership because of the current housing market
setbacks. As we consider various options for ensuring
that taxpayers are protected, I hope we recognize that
with the private securitization markets still badly
broken, Government currently needs to play a role in
ensuring that these affordable housing objectives are
still met so that America's well-qualified middle class
families can still get mortgages when it comes time to
buy a home and raise their families. Given that the
housing market has not done as well as expected, I
think now would be the wrong time to withdraw that
Government crutch that has been one of the only things
holding up the housing market. That's why I believe
allowing higher loan limits to expire would be a
preventable mistake and why I hope this Committee will
support the bipartisan Homeownership Affordability Act
introduced by myself and Senator Johnny Isakson to
maintain those limits temporarily. We extended them
last year when the housing market was bad, and I don't
see why we wouldn't extend them again given that the
housing market has gotten worse since that time a year
ago and 42 States would take a hit to their housing
markets if we allow the limits to go down. So I look
forward to addressing that, and I look forward to your
testimony.
Chairman Johnson. Yes, it will.
Senator Corker.
Senator Corker. Thank you, Mr. Chairman, and I thank each
of you for your testimony. You know, a lot of people talk about
gridlock here in Washington, rightfully so, and I was just
thinking as I listened to the testimony of three professors
that we are certainly creating another generation of gridlock
among students in America. And in order to sort of bring maybe
people together on a couple of issues, because we are probably
going to have some housing legislation, I hope, during this
Congress.
Would it make some sense, to sort of bring the two bookends
together with the middle, to at least look--at the end of this
month we have got the qualified--the mortgages, the ceiling
dropping from 729 down about a hundred grand. Would it at least
make some sense to allow that to go ahead and occur and see if
we can backfill that with private demand instead of continuing
the policy that we have right now? The two guys on the end. I
know the guys in the middle say yes.
Mr. Green. So as a Californian I should not say this, but I
think it absolutely would be a worthwhile experiment, and it
would test whether Professor Jaffee or I is correct about this,
but yeah. You know, I have no disagreement with the idea that
if you are going to have a guarantee, that it should be limited
to middle-class mortgages. I do not know exactly how to define
that, median price of a house plus some small increment.
Senator Corker. Professor Levitin.
Mr. Levitin. I do not disagree. I think that is actually a
reasonable approach today, and let us see what happens if we do
this as a small scale and do not take away the guarantee
altogether but see what happens if we ratchet it down.
Now, I would emphasize, though, remember that the current
level of the guarantee is much higher than it had been even a
few years ago.
Senator Corker. Right. I think there is probably going to
be an attempt to try to not let that drop, and I just
appreciate the fact that even though both of you have advocated
for keeping GSEs in place and that type of thing, you would at
least agree that dropping that down and seeing if we can
backfill that with private sector demand makes some sense at
this moment. It seems to me that what has happened is people
reacting to some very draconian bills--maybe they have been put
forth in the House--instead of saying, well, you know, probably
where we are today, we are way too dependent on Government, and
we ought to reach a place that at least is less dependent. I
think people could agree on that. And maybe some steps to try
to backfill would make some sense, which brings me to a second
point.
A lot of people say the TBA market will not work without
GSEs, but we have corn futures and oil futures and pork belly
futures. I mean, is there any reason to believe that without a
Government guarantee you could not still sell into the forward
market as long as you had certain credit criteria?
Mr. Levitin. Well, you do not need the Government guarantee
per se to have a TBA market. What you need is standardization.
A Government guarantee standardizes credit risk. It is----
Senator Corker. Well, but it does not have to be that way,
and I think what we have seen actually, because the private
investors have been on strike, is a movement toward some
standardization. So if we had some standardization in the
marketplace, we had some industry criteria that people adopted,
you are seeing the TBA market could function easily.
Mr. Levitin. If everyone complied with that, and we have
not seen that develop yet.
Senator Corker. But that is something that, again, I think
much of what we do here is to try to create the environment and
let the private sector generate the risk--or take the risk. Do
you agree with that, Dr. Green? These other guys I know pretty
well, so I know what they are going to say.
Mr. Green. I think you would have to somehow come up with a
mechanism where investors would have confidence that people
really are meeting the standards, and in light of the way that
we are finding out about how mortgages not only were
underwritten but the way documentation has been maintained and
so on, I think the market is a very, very long way from having
that kind of confidence. The standards have to stick in order
for that to work.
Senator Corker. So if a Democrat and a Republican came
forth with some legislation to step down over time the loan
limits and to create a TBA market by actually creating some
standards, some industry standards, our two bookends, for lack
of a better word, would think that would be a methodical and
thoughtful way to try to prime the market.
Mr. Levitin. I want to be clear in the way I am supporting
this and the way I want to have some caveats with it. I think
yes, as a general matter, that is a very reasonable approach.
We would want to see exactly what would happen if private
capital would step up. But I think it is also--the devil is
often in the details.
Senator Corker. Sure.
Mr. Levitin. And what the standards are is, I think, going
to be rather tricky. It is one thing if Congress imposes
standards. It is another thing to have industry develop
standards. And one thing we saw in the private label
securitization market was incredible heterogeneity. They did
not come up with homogenized products because they did not want
them, because if you can compare apples to apples, you get
better competition, and that means smaller margins.
Senator Corker. I appreciate it. I got the caveats, and I
understand all of us keep those caveats.
Let me ask one last question. I know my time is short here.
There is no question that we subsidize the housing industry.
Does anybody disagree with that? I mean, with the home mortgage
deduction and--so here is--I actually spent a lot of my life
trying to help lower-income citizens own housing as a civic
endeavor, not as a business. And it seems to me that what we
have done with our housing policy is we subsidize housing so
much that we actually drive the price of it up. So, you know,
it seems to me that as a social policy in our country, we would
rather people have lesser amounts of indebtedness than more
amounts of indebtedness. But what we do with our housing policy
by subsidizing housing the way we do, we drive the price up; we
lower the cost of loans, but we drive the loan amount up. And
it seems to me that unintentionally, you know, with good
intentions, we have actually done some pretty perverse things
in our society as it relates to housing, and that we would be
so much better off to actually price the risk as it really is
and to not do what we do in our country by driving up prices. I
wonder if you all might just comment on that briefly. And,
Peter, I know you want to say something.
Mr. Wallison. I agree, of course. We do that. And, in fact,
the 30-year fixed-rate mortgage is a perfect example of that.
We subsidize that mortgage because we think it is a good idea.
What it does is reduce the monthly payment. The reduction in
the monthly payment allows people to buy a bigger and more
expensive house. Eventually, they have less equity in their
homes. It is not good policy. If a person wants to do it, that
should be available. But the real cost of it should not be
subsidized.
Senator Corker. Does anybody disagree with the fact that
that is exactly what we have done in our country? Nobody
disagrees.
So, Mr. Chairman, I just think as we had one witness talk
about the fact that those with good credit through the GSEs
allow those people with bad credit to get loans at the same
amount, I think that was a pretty interesting comment.
I think to have people of such huge philosophical
differences to say what has just been said is something that we
should address and realize that as a country we have done some
really perverse things as it relates to housing policy and
really caused people to have more indebtedness than they
otherwise would have.
Chairman Johnson. Senator Merkley.
Senator Merkley. Thank you very much. I am fascinated by
this conversation because you all study the housing market and
mortgages day in and day out, but you reach such dramatically
different conclusions.
Mr. Wallison, I think you stated several times that a
guarantee induces a race to the bottom in terms of the quality
of underwriting because investors no longer have a reason to be
discriminating, if you will. Let me just test that against a
couple items.
The first is there was huge private money that was put into
private label securities and into subprime pools, and done so
by private investors, and yet it was extremely risky,
incredibly poorly underwritten. Doesn't this work against the
argument that private investors are studying the quality of the
mortgage investments and driving, if you will, the quality?
Mr. Wallison. Much of that investment was, as we know,
rated AAA, and as Professor Levitin suggested, that for those
buyers may have given them the idea that they were not going to
be taking major credit risk. The problem with a Government
guarantee, as we all know, is it creates moral hazard, and that
means that you do not really worry about whether the mortgage
that you are buying or the mortgage-backed security that you
are buying is going to fail. That is the real danger.
Now, what we know about what happened with the AAA
securities, the private label securities, is that they were--
when the bubble was growing--it was very easy for someone to
look at those securities and say, ``Gee, there are not many
defaults going on here. These are not as risky as you would
imagine subprime mortgages would be.'' And the reason for that,
of course, is when a bubble is growing, housing prices are
going up, and people who cannot afford to pay their mortgages
can simply refinance or sell the house and not suffer any
losses. So investors thought they were really getting a good
deal here--high yields, AAA securities. That is the sort of
thing that was created by the Government having come in in the
first place and pumped a lot of money into this bubble.
Senator Merkley. Well, I think the first line of your
answer was that the investors did not discriminate because they
had a AAA rating. And indeed that points to a whole different
issue and problem that none of you have raised up here on the
panel, which is that even sophisticated investors used the
rating system because they cannot get otherwise to the details.
Unfortunately, our raters could not get to the details either,
and there are these terrible stories of individual employees
going to their bosses and saying, ``I cannot get loan level
details, and you are asking me to rate this security.'' And
they are saying, ``Well, too bad. This is what you have got,
and this is how we make our money, and so rate it.'' And we
have not really addressed that yet in terms of our efforts on
housing policy.
I worry that we may be taking a few of the wrong lessons.
My colleague has left--Senator Corker. He pointed out we did
some terrible things. But I think the argument should not be
about what we did from 2003 through 2008 in terms of the role
of mortgages, but it should be about the model we had before
2003. In other words, before we allowed liar loans, teaser-rate
exploding interest loans, prepayment penalties to lock people
into this--all practices that we have now banned here, and it
is good that we did ban them. They introduced a whole--talk
about if you track the predatory practices and you track the
influence on the bubble, that would have had a huge factor. But
really what our argument is, we know those things were a
mistake. What we should be looking at is that period from post-
World War II up through 2003 and how the mortgage market worked
then and keep the baby while we are throwing out the bath
water, if you will.
And so in that sense, are we, in fact, pulling the right
pieces of the debate in terms of trying to design the mortgage
market of the future? Or are we misusing the period of 2003
when these predatory practices were allowed as really an
argument against the previous period? Mr. Levitin.
Mr. Levitin. Sure. You have to ask what changed in 2003,
what went wrong, and I think we can point at several things,
but one of the factors that I think certainly deserves some
attention is the erosion of consumer protection laws. Prior to
the 2000s, we actually had a fairly robust web of consumer
protection laws on the State level. You know, they were not
standardized, they varied, their application varied, but they
still existed. And that put some brakes on some of the more
aggressive lending tactics.
One thing that happened was that we had really an
aggressive campaign of Federal preemption by the Office of the
Comptroller of the Currency and the Office of Thrift
Supervision to preempt the State consumer protection laws
without substituting any equivalent Federal protections.
Preemption makes a lot of sense if you are going to have a
national standard. But when you preempt without having any
standard, then you just end up with a regulatory vacuum. That
opened the door for really having the race to the bottom. As
long as those standards were in place across the whole market,
it limited the ability for the GSEs really to get in and ensure
a rate war. And I think it is important that we think of the
GSEs as insurance companies, and a common problem in insurance
regulation is that you can get a rate war where insurers start
competing for market share by charging ever lower premia
relative to risk. And when that happens, it leaves
undercapitalized insurers.
I just want to turn to one thing that Mr. Wallison said. He
raised the moral hazard point, which exists in any insurance
system, but the thing is we know ways to deal with moral
hazard, that is, having deductibles and having copayments, the
standard things that you have on consumer insurance policies.
We can have those kinds of features on a Government guarantee.
But we can only do that if it is an explicit guarantee. If it
is an implicit guarantee, we do not have any protection against
moral hazard. If we are worried about moral hazard, we really
actually have to have an explicit guarantee and then try and be
smart about how we do it.
Senator Merkley. Explicit guarantee with firm regulatory
standards avoids the challenges that Mr. Wallison was speaking
to.
My time is up. I will just mention two things. I cannot ask
for a response now, but one is we subsidize mortgages in so
many different ways, with the home mortgage interest deduction,
potentially with downpayment assistance to get people into
loans, this informal guarantee of securities, and I would be
very interested in following up afterwards with any data that
compares the return on the investment in these different forms
of subsidies.
Thank you.
Chairman Johnson. Senator Warner.
Senator Warner. Thank you, Mr. Chairman, and I wish I had
been here for the beginning of the hearing, and I think as
Senator Corker mentioned, this is a spirited area where we are
going to have to find some common ground.
I would concur with the basic notion that I imagine many of
my colleagues have said. At this point we have got--whatever we
think about GSEs, the percentage now is too high. How do we do
this--how do we--whether we completely unwind or partially
unwind--do it in a way that does not totally disrupt?
I guess one of the questions I would start with, Dr.
Jaffee--and it is good to see you again, Peter. We spent a lot
of time together in discussions on Dodd-Frank. If we look at a
nonguarantee system--and then, frankly, I would like to hear
everybody on this. Some folks have pointed to the European
covered bond approach. But aren't we frankly seeing, somewhat
to Professor Levitin's position, that while there is no formal
guarantee in the covered bond approach, you have this implicit
guarantee with these large financial institutions that become
too large to fail so you are back into a quasi-Government
guarantee, whether explicit or implicit?
Mr. Jaffee. Well, I am very pleased you asked that because
I was hoping to have an opportunity to indicate how much I
disagree with Professor Levitin's position on that. I believe
there is no evidence of any implicit guarantees or bailouts of
any European banks relating to their covered bond issues. Those
bonds are all rated AAA. They have been rated AAA from the day
they were issued. I know of no down-rating of any of them.
At the key point of the crisis, there was a temporary
liquidity blip where some investors simply got worried, and so
the spreads on these bonds are typically 20 basis points above
the sovereign debt of those countries. I suspect today they are
below the sovereign debt of some of those countries. But those
20 basis points blipped up to 75 basis points. Not a huge
amount. The European central bank said this is wrong, the bonds
are completely safe. They bought a few of them, and the spreads
went right back down to the 20 basis points.
The system worked with very safe mortgages, and the whole
system agrees on that. The borrowers understand that you have
to have downpayments, you have to have the income, and you
cannot expect to default. It is not a system in which you hand
off the key if the prices do not go your way. The bankers
understand that they are going to be the--they are going to be
holding these bonds on their balance sheet, but issuing them
with covered bonds, with dedicated debt. And the Government
understands that the system is going to work because they do
not want the costs of foreclosure and default as we have just
faced here. And the system does work. It has worked perfectly
throughout this period, and I know of no problems.
The problem here in the United States, I will just quickly
say, is that agencies like the FDIC have stood in the way of
American banks creating these, and the FDIC's position is if we
get a bank in trouble, we do not want them to have issued a lot
of covered bonds because the mortgage assets are then dedicated
to those bond holders, and we, the FDIC, think that is going to
make our life tougher. That assumes that those mortgages would
have been there in any case. That is not what happens in
Europe. The mortgages that we securitize are actually held on
the balance sheet. They are very safe, and the covered bond
system works. And I hope we move----
Senator Warner. Thank you. Other comments on this, please?
Yes, everybody, if we could.
Mr. Wallison. Well, I will just make a comment.
Senator Warner. Relatively quickly, because I would love to
get in one more question before my time is up.
Mr. Wallison. I have heard the same argument that you made,
Senator, and I do think it is a significant argument in the
sense that if the largest banks in the United States are
implicitly guaranteed in some way, then you might be creating a
system with covered bonds that, in fact, results in some sort
of Government backing.
However, the securitization system in the United States
does not involve that, and one of the really interesting and
valuable things about the securitization system is that anyone
can participate. You do not need a lot of capital to do it. So
the small banks can participate in securitizations as well as
the large banks, and they do not have to sell to the large
banks. They can also form cooperatives of their own in order to
take advantage of the high-quality mortgages that they are
creating.
So this is a complicated issue, and I would love to spend
some further time on it.
Senator Warner. Please.
Mr. Levitin. Very briefly, I just want to respond to what
Professor Jaffee said. If you look at page 8 of my written
testimony, I detail what happened in Germany and what happened
in Denmark where the implicit guarantee actually became
explicit, that Germany and Denmark both guaranteed the
liabilities of some of their covered bond issuers. And in
Denmark, yes, it was----
Senator Warner. That was at the beginning of the crisis,
wasn't it?
Mr. Levitin. That was in October 2008. And you can say,
well, that was just a response to liquidity. Well, whatever it
was, it showed that the Government would intervene to hold up
this market, whether because of credit risk or liquidity. Now,
it may be a guarantee only for catastrophic risk, but that is a
guarantee right there. And, you know, in Denmark, it was not
formally a guarantee of the covered bonds. It was a guarantee
of the issuers. But because there is recourse to the issuers,
that means that it functions as a guarantee of the covered
bonds.
Mr. Green. To some extent I was going to say what Professor
Levitin just said, but the other point is that Germany and
Denmark are heavily regulated mortgage markets, and, you know,
Government intervention could take many forms, and one of them
in that if the Government says you may only do mortgages that
have certain features to them, I would call that pretty serious
Government intervention. So the idea that there is a mortgage
market that does not have Government involvement is a statement
I have a problem with.
The other thing is the Danish mortgage bonds have a feature
that is very friendly to consumers, and I think it is worth
thinking about. But, again, it means that the default rates are
going to be low, which is that consumers can basically buy
their mortgage back at the market value of the mortgage at any
time. That is one of the attractive things about it.
In the U.S. context, what that would mean is if you are in
Corona, California, where house prices have fallen 70 percent
and the market judges that, therefore, your mortgage's value is
only worth 30 percent of the par value, you as the borrower can
buy it back and sell your house and actually be at least at
water if not above water. And that is an attractive feature,
but that is a very consumer-friendly feature that, again, is
the result of Government decisions about how these things were
designed.
Senator Warner. Thank you, Mr. Chairman. The only thing I
would just ask, I hope as we explore this area--and I know
today was about Government guarantees, and I would look forward
to kind of continuing and trying to get educated on this. I
would love to see us look not only at the European model, but I
would also like us to see what has become an article of faith
and something I would like to make sure there is still a
product in terms of a 30-year loan. I do think there are a lot
of lessons that we can learn from our neighbors to the north in
Canada where we did not have the kind of expectation around the
Canadian market, the pricing around mortgages, the motion more
that they were 15-year rather than 30-year. I really hope we
will kind of get a chance to dig into all these things because
I do think, whether we like it or not, this crisis' overhang
continues to be with us. I do not think we have sorted through
it well, and I think we ought to look at all the options on the
table. Thank you for giving me this question.
Chairman Johnson. Senator Vitter.
Senator Vitter. Thank you, Mr. Chairman, and thanks to all
of our witnesses.
Let me ask you all this question: It seems to me in the
last decade the implicit guarantee by Fannie and Freddie was
certainly closely related, a major or a significant cause of
the decline in underwriting standards. They are not a
coincidence, I do not think. If that is the case, how would we
move to an explicit guarantee and somehow move in the opposite
direction regarding real underwriting standards? That seems
pretty uphill, pretty unnatural.
Mr. Green. Sure, well, I think it is worth thinking about
how Fannie and Freddie behaved, again, before the crisis. If
you look at how they did underwriting through, let us just say,
the late 1990s, it was pretty robust underwriting. They had
models that related FICO score, loan-to-value ratio, income,
reserves, time in job, et cetera, to default probability. And
they came up with cutoffs as a result of that, and they stuck
to that quite well for a very long period through their
existence.
I think there was a long period of time when they had the
implicit guarantee where they had robust underwriting.
What seemed to happen is roughly in 2003 or 2004 they were
losing market share to the private market. If you look at
Federal flow of funds reports, this is pretty clear. And
shareholders were screaming, and this is the problem, and so
they followed the market in in having their underwriting
standards deteriorate.
But that said, one of the mechanisms they used was buying
AAA tranches of subprime mortgages, and they should not have
done that, and somebody should have stopped them from doing
that. But, on the other hand, there was also somebody buying
lower tranches of these things as well, and these somebodies
were people like Lehman Brothers. And there was an
understanding--you know, I think Professor Jaffee is correct,
that we said, OK, you make these risky bets and you lose and
you are done, OK. But after Lehman Brothers collapsed, what we
had is other investors in these lower tranched securities, and
we did not let them fail because we decided the systemic risk
for doing so would be too great.
So I think to pin it all on the implicit guarantee is very
difficult because we went for so many years having it with
pretty good underwriting.
Mr. Wallison. Let me contradict what I just heard because
it is not true at all that their underwriting was good, after
1992, especially after the affordable housing requirements were
imposed on them. If you look at the data, you can see Fannie
Mae and Freddie Mac were buying subprime and other low-quality
loans right through the 1990s, and by the year 2000, in fact,
Fannie Mae was offering a no-downpayment loan. Large
proportions of their loans were 3-percent downpayment or less.
In other words, they were already the cause of the decline in
underwriting standards, and that eventually infected the
private markets. But in the end, we had 27 million subprime or
other low-quality loans in our financial system; that was half
of all mortgages and two-thirds of those weak mortgages were on
the books of Fannie Mae and Freddie Mac and other Government
agencies, all of which, of course, were backed by the
Government.
So it is a very important relationship that you have
pointed out between a Government guarantee and poor-quality
mortgages because the investors in those mortgages do not care
about the quality of the mortgages as long as they have a
Government guarantee.
Senator Vitter. And before the rest answer, let me just
insert, I think another factor is the CRA-type mandate Congress
has put out there, which also has not changed. So I am just
wondering how we do not change that mandate, we move from
implicit guarantee to explicit guarantee, and all of a sudden
we expect underwriting standards to move in the opposite
direction. It does not strike me as very natural.
Dr. Jaffee.
Mr. Jaffee. Yes, well, that is exactly what I would have
wanted to say. I think it is inevitable that a switch to a
Government guarantee program is going to lead to lower
underwriting standards. I mean, the proposals that are
available publicly now usually start off with the right words.
They say, ``These are going to be prime mortgages, 20-percent
downpayment, very suitable income-to-debt ratios.'' And, of
course, then you could ask the question: Well, if they are so
good, why do we need a Government guarantee at all? But the
true answer--and if you now look in the details of these
proposals--is, well, no, we are also going to have a 10-percent
downpayment loan, and we will have a 5-percent downpayment
loan, but we are going to charge actuarial premiums. Well, that
is going to last for 2 minutes because as soon as the borrowers
say, ``Well, wait a minute. This is a Government program, and I
only have 10 percent down, and you are telling me that I have
to pay more on my mortgage than my fat cat friend. No way.'' In
all of the experience--I mean, the National Flood Insurance
Program is a classic example. Congress passed legislation that
on the surface of the words was perfect. There would be risk-
based premiums, it would be self-funding, all the right things.
And what do you discover? As soon as there is a big flood,
Katrina, they are $20 billion in the hole, and what you
discover is the premiums that--the agency now admits the
premiums were half of what they should have been. They had just
the opposite of risk-based premiums. They actually gave
benefits to people that had the most risk because they lived on
the Mississippi River. And I believe it is inevitable that that
is going to happen again.
Mr. Levitin. First, I would disagree about the statement
that the implicit guarantee was causing the underwriting
decline. The market leader in weak underwriting was the
nonguaranteed private label securitization market. Now, Mr.
Wallison points out that the GSEs were buying what he calls
``weak loans.'' I think we need to be careful about exactly
what we are calling weak loans because not every weak loan is
the same. My understanding of how Mr. Wallison kind of reaches
his figure is he is looking at loans that lack some--let us say
loan-to-value ratio, documentation, FICO score, or some
category like that, do not look like a perfect prime loan. That
is perfectly fine if he wants to count them that way. But there
is a difference between a loan that has, you know, a low LTV
and a high FICO score and limited documentation and a loan that
has high LTV, low FICO score, and limited documentation. Three
dings is much worse than one ding. And the GSEs were not buying
the three-ding loans. They were buying the one-ding loans. So
those were the three-ding loans, and that is where we really
saw the market go off the cliff. That was in the private label
securitization market.
Two other comments. I think it is important that we
remember the example of the FHA. There are plenty of problems
with FHA and how it is run, but FHA has an explicit guarantee,
it prices for it--not perfectly--but, you know, that market has
not tanked. And FHA ceded market share because it did not have
private shareholders trying to get in competing for market
share. That is what saved FHA.
Finally, on the Community Reinvestment Act, there is a
Federal Reserve study about the impact of the Community
Reinvestment Act on mortgage lending. I think it is probably
the best thing out there on this. And what it shows is pretty
clearly the most aggressive lenders were either not subject to
the CRA or the aggressive loans they were making were not--they
were not getting CRA credit for them because they were making
them outside of their CRA assessment area.
So, you know, I think it is a little difficult to pin the
blame on the CRA for the excesses of the private label
securitization market in particular.
Senator Shelby. Mr. Chairman.
Chairman Johnson. Senator Shelby has a closing observation.
Senator Shelby. Thank you, Mr. Chairman.
First of all, Professor, it is my understanding that the
Congressional Budget Office's recent estimates show that when
market risks are incorporated, FHA guarantees are underpriced
by almost $8 billion, for the record.
Now, where are we today? I think this has been a good
hearing, Mr. Chairman. I think that we have got some different
voices here, which we need. What is all this about and where
are we? We have got a horror movie. And what is a horror movie?
It is the GSEs, it is sitting in the lap of the taxpayers and
growing. By conservative estimates, I understand, the taxpayers
are going to eat a third of a trillion dollar, maybe a half a
trillion dollars. Are we going to repeat this again? Are we
going down that same road? Have we learned anything? I do not
know. You know, I think this is a healthy discussion. I hope we
have. But the CRA--I want to pick up on Senator Vitter. I tried
to repeal the CRA right here in this Committee, because what we
are doing, we are telling the market to make these loans for
political reasons. Loans should be made on risk. I mean, it is
nice to have a home. You know, we pushed the home ownership to
the limit. We pushed the deal where, oh, they had equity in
their home because prices were rising and they were borrowing
second mortgages on this, home equity loans. It helped the
economy temporarily.
So we got that horror movie where we are, and I hope we
will not repeat it. Is it going to be tough political answers?
I do not see any quick answer to this. But I hope we do not go
down that same road. God, I hope and pray.
Thank you, Mr. Chairman.
Chairman Johnson. Before I close, I would like to correct a
statement made early in this hearing. Congress did not
appropriate $20 billion to the Flood Insurance Program. This
may be the confusion of the Flood Insurance Program with the
supplemental appropriations for FEMA.
I would like to thank the witnesses for joining us today.
This issue of the Government guarantee is one that will
continue to weave itself into all our discussions about the
future of the housing finance system. It is clear that our
priorities for market access, liquidity levels, and the types
of mortgage products available will help our options going
forward.
The hearing record will remain open for 7 days if Senators
would like to submit statements or additional questions for the
record.
This hearing is adjourned.
[Whereupon, at 11:37 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF RICHARD K. GREEN
Director and Chair, USC Lusk Center for Real Estate, University of
Southern California
September 13, 2011
Chairman Johnson and Senator Shelby, thank you for allowing me to
be part of this distinguished panel today. My name is Richard Green,
and I am the Lusk Chair in Real Estate and the Director of the Lusk
Center for Real Estate at the University of Southern California, where
I am also Professor of Policy, Planning and Development and Professor
of Finance and Business Economics.
As you know, I have been asked to discuss whether the U.S. mortgage
market requires a Federal guarantee in order to best serve consumers,
investors and markets. I will divide my remarks into four areas:
(1) I will argue that the United States has had a history of providing
guarantees, either implicit or explicit, regardless of its professed
position on the matter. This phenomenon goes back to the origins of the
republic. It is in the best interest of the country to acknowledge the
existence of such guarantees, and to price them appropriately before,
rather than after, they become necessary.
(2) I will argue that in times of economic stress, such as now, the
absence of Government guarantees would lead to an absence of mortgages.
(3) I will argue that a purely ``private'' market would likely not
provide a 30-year fixed-rate prepayable mortgage. I think this is no
longer a particularly controversial statement; what is more
controversial is whether such a mortgage is necessary--I will argue
that it is.
(4) I will argue that in the absence of a Federal guarantee, the price
and quantity of mortgages will vary across geography. In particular,
rural areas will have less access to mortgage credit that urban areas,
central cities will have less access than suburbs. Condominiums already
are treated less favorably than detached houses, and this difference is
likely to get larger in the absence of a guarantee.
Before discussing the substance of my remarks, I should make some
disclosures. First, I worked as a Principal Economist and then Director
of Policy Strategy for Freddie Mac between September of 2002 and
January of 2004. Part of my compensation for that work was restricted
shares in the company. I never sold my shares in Freddie Mac, and I
have no expectation of ever seeing them have material value. I think it
appropriate that common shareholders were substantially wiped out by
the Government conservatorship of the company. Second, I have performed
research with two Fannie Mae employees, Eric Rosenblatt and Vincent
Yun, for an academic paper. The only compensation I received for this
was intellectual satisfaction. Finally, when the Fannie Mae Foundation
was publishing Housing Policy Debate, I received compensation for
reviews I wrote for the publication.
I. The United States Has a Long History of Providing Ex Post (After the
Fact) Guarantees, As Well As Other Guarantees
One could reasonably argue that the United States was born from a
bailout. One of the most famous compromises in U.S. history was a deal
negotiated among Hamilton, Jefferson, and Madison for the new Federal
Government of the United States to assume the Revolutionary War Debts
of the Continental Army and the individual States. While Jefferson
would later write that he regretted the compromise (probably because he
saw Virginia as a net loser on the deal), it helped bind the States
together. Moreover, because of Hamilton's financial acumen, Assumption
probably allowed States and the Continental Army to pay less in
interest costs than they otherwise might, and so allowed the country to
begin on a strong financial footing. \1\
---------------------------------------------------------------------------
\1\ Ron Chernow, Alexander Hamilton, The Penguin Press: New York.
Ch. 16.
---------------------------------------------------------------------------
The Transcontinental Railroad also received financing at least in
part because of Government guarantees (as well as direct subsidies).
While the railroads were built by private companies (the Central
Pacific and the Union Pacific), capital costs were financed by bonds
that were explicitly backed by the Federal Government. While the
backing was explicit, the equity investors in the railroads were not
required to pay guarantee fees; profits were privatized while risk was
socialized. In the end, the shareholders of both railroads lost their
investments, but somehow the managers, including Coliss P. Huntington
and Charles Francis Adams, obtained and retained great wealth.
More recently, of course, we have had many ``private'' institutions
receive Federal backing, including commercial banks (who benefited from
the Troubled Asset Relief Program (TARP) as well as the Federal Deposit
Insurance Corporation (FDIC)), the ``purely private'' investment banks
(who benefited from TARP), issuers of Asset Backed Securities (who
benefited from the Term Asset Backed Securities Loan Facility (TALF))
and, of course, the Government Sponsored Enterprises. While one might
argue that the GSEs have received more largess than the other private
institutions, the fact is the Federal Government has shown, again, that
it will intervene when large, systemically dangerous institutions are
on the verge of collapse.
Furthermore, we still don't know the full extent of Government
largess, because we don't yet know the potential cost of off-balance
sheet assets that commercial banks may be forced to repurchase because
of alleged misrepresentations.
In light of the fact the Federal Government cannot credibly commit
to no-bailout policies (after all, TARP was the creation of a
Republican administration), no matter what one thinks about the
principle of Government guarantees, as a practical matter it makes
sense to recognize them explicitly and to price them.
Recent evidence suggests that neither the public nor private
sectors is particularly good at pricing risk (although the FHA program,
which has performed remarkably well through the crisis, might be an
exception). The Government should thus begin by pricing risk
cautiously; perhaps more important, it should require institutions that
might benefit from guarantees to hold capital. While market
participants fear that higher capital requirements would raise costs to
consumers, (1) such costs may be appropriate and (2) they may be
actually be small. As financial institutions become less levered, their
required return on equity should fall. \2\ Indeed, because bankruptcy
is costly, a policy that reduces the probability of bankruptcy, such as
strong capital standards, could actually lower the total cost of
capital for lenders. As we unfortunately know too well now, though,
measuring capital is difficult, so guaranteed mortgage finance in
future should require both fees and robust capital standards.
---------------------------------------------------------------------------
\2\ Franco Modigliani and Merton Miller's eponymous and famous
theorem predicts that the total cost of capital to a firm should be
invariant to capital structure. F. Modigliani and M. Miller (1958)
``The Cost of Capital, Corporation Finance and the Theory of
Investment'', American Economic Review 48(3): 261-297.
---------------------------------------------------------------------------
II. In Times of Economic Stress, Debt Markets Do not Operate in the
Absence of Government Guarantees
Beginning with the Great Depression, the United States has faced at
least four periods when private debt markets largely shut down--
liquidity was so absent that spreads were not only wide, they were
impossible to measure owing to the absence of transactions: the Great
Depression; the double-dip recession of 1979-81; the Long-Term-Capital
financial crisis; and the Great Recession of 2008-09.
In the aftermath of the banking crisis of 1930-33, mortgage lending
shut down. As Ben Bernanke wrote in his classic paper \3\:
---------------------------------------------------------------------------
\3\ Ben S. Bernanke, ``Nonmonetary Effects of the Financial Crisis
on the Propagation of the Great Depression'' (1983). American Economic
Review, 73(3): 257-276.
because markets for financial claims are incomplete,
intermediation between some classes of borrowers and lenders
requires nontrivial market-making and information gathering
services. The disruptions of 1930-1933 (as I shall try to show)
reduced the effectiveness of the financial sector as a whole in
---------------------------------------------------------------------------
performing these services.
In other words, the banking crisis was principally a liquidity
crisis; lenders had a reluctance to make even good loans to each other.
The passage also underscores the more ubiquitous problem with financial
institutions: they are rife with incomplete markets. Even in the
absence of Government guarantees, financial institutions have
principal-agent problems, adverse selection problems, lemons problems,
and pooling problems.
The Hoover administration created the Federal Home Loan Bank System
and the Roosevelt administration created the Federal Housing
Administration, the Federal Deposit Insurance Corporation, the Home
Owners Loan Corporation and, later, the Federal National Mortgage
Association to restore liquidity.
And restore liquidity they did. Figure 13 in Son and Lee \4\ (which
graphs data from Goldsmith 1955 \5\) shows the sharp drop in liquidity
between 1930 and 1933, and how it is restored in 1934. The Federal Home
Loan Bank system was established in 1932, FDIC in 1933 and the Federal
Housing Administration in 1934. While one does not want to make post-
hoc ergo prompter-hoc arguments, one could argue that the new Federal
Institutions allowed for the possibility of price discovery, which in
turn brought about some restoration of liquidity.
---------------------------------------------------------------------------
\4\ Jin Son and Keun Lee (2010), ``Financial Crisis and Asset
Market Instability in the 1930s and 2000s: Flow of Funds Analysis''.
http://apebhconference.files.wordpress.com/2009/08/son-n-lee.pdf
\5\ Raymond W. Goldmith (1955), A Study of Savings in the United
States. Princeton University Press: Princeton.
---------------------------------------------------------------------------
More recently, the double-dip recession of 1979-1981 led to a
diminution of liquidity in the mortgage market. Between 1977 and 1982,
net lending from savings institutions, the primary source of mortgage
finance, dropped by 67 percent. \6\ At about this time, and not
coincidentally, Government Sponsored Enterprise lending expanded by a
factor by 3. GSE-backed Mortgage Backed Security lending quadrupled
during this time, and GSE portfolio lending more than doubled. Both
Savings and Loans and Fannie Mae were technically insolvent over this
period, but the Federal Government exercised forbearance, which could
be looked at as a whispered guarantee.
---------------------------------------------------------------------------
\6\ See, Flow of Funds Accounts of the United States, Table F.1,
line 40.
We should note that mortgage institutions were troubled less by
credit risk than interest rate risk: Savings and Loans as well as
Fannie Mae had long-term mortgages on their balance sheets; they funded
these mortgages with short-term debt. The yield curve between 1979 and
1981 was highly inverted (in fact, short term rates were higher than
long-term mortgages by an unprecedented amount). One might take the
view that while financial institutions have control of credit risk,
they have no control over the short-term interest rate set by the
Federal Reserve System. In any event, investors were apparently more
comfortable with Freddie Mac and Fannie Mae's credit risk guarantees
than depositors were with Savings and Loans.
Most dramatic was the Long-Term Capital Management Crisis, which
was something of a rehearsal for the most recent crisis. When conduits
for commercial mortgages shut down, Fannie Mae and Freddie Mac
continued to lend. Anthony Sanders (no fan of GSEs) shows in a graph
that the spread between Jumbo and Conforming Mortgage widened from 10
to 40 basis points in the aftermath of the Long-term Capital Financial
Crisis.
Of course, in the current environment, the Government sponsored
enterprises, which are wards of the State, are the dominant sources of
mortgage lending. It is frightening to think where housing markets,
already at their weakest point since the Great Depression, would be in
the absence of the GSEs. While one might argue that the lack of other
lending arises from a private sector being crowding out by the public
sector, the segments of the housing market which are not eligible for
GSE purchases have very nearly shut down. According to Inside Mortgage
Finance, the prime jumbo mortgage originations have dropped by more
than \5/6\ since the peak, and in 2010 were at about \1/3\ the level of
any year before 2008.
Home equity lines of credit, which are an important mechanism for
the elderly to use housing wealth to smooth consumption, have seen
similarly dramatic drops.
III. The 30-Year Fixed-Rate Mortgage Might Go Away in the Absence of
Government Guarantees
There are two issues here: whether the U.S. long-term self-
amortizing mortgage requires some sort of Government support, and
whether it is important.
Counterfactuals are impossible to prove, but we do have some
evidence that the GSEs mattered to making the long-term mortgage
common. While such loans existed before the Home Owners Loan Corporate
made them the standard instrument in the United States, they were not
common. Moreover, as we look at other countries, we find that long-term
fixed-rate prepayable mortgages are rare. So far as I can tell, Denmark
is the only other country that has such mortgages, and while that
market appears ``private,'' it has heavily regulated, specialized
institutions that issue that bonds that fund mortgages. When these
institutions faced problems in 2009, the Danish government injected
liquidity into them. And while there is much to praise about the
Canadian mortgage systems, it too has Government involvement (most low-
downpayment loans are supported by Government mortgage insurance) and
is vulnerable to a particular type of risk: borrowers must roll over
their debt every 5 years or so. \7\ The current state of the commercial
real estate Market underscores that maturity defaults--defaults that
arise because borrowers cannot roll over debt when capital markets are
troubled--are just as bedeviling as payment defaults.
---------------------------------------------------------------------------
\7\ Thanks to Tsur Somerville of the University of British
Columbia for making this point to me about Canadian mortgages.
---------------------------------------------------------------------------
David Min has a nice explanation of why the 30-year mortgage is
good for consumers \8\:
---------------------------------------------------------------------------
\8\ See, http://www.americanprogress.org/issues/2010/11/
housing_reform.html.
There are three major arguments in favor of continuing to
---------------------------------------------------------------------------
emphasize the 30-year fixed-rate loan in the United States:
First, the 30-year fixed-rate mortgage provides cost
certainty to borrowers, which means they default far less on
these loans than for other products, particularly during
periods of high interest rate volatility.
Second, the 30-year fixed-rate mortgage leads to greater
stability in the financial markets because it places the
interest rate risk with more sophisticated financial
institutions and investors who can plan for and hedge against
interest rate fluctuations, rather than with unsophisticated
households who have no such capacity to deal with this risk and
who are already saddled with an enormous amount of financial
burden and economic uncertainty.
Third, the 30-year fixed-rate mortgage leads to greater
stability in the economy because short-term mortgages are much
more sensitive to interest rate fluctuations and thus much more
likely to trigger a bubble-bust cycle in the housing markets.
Indeed, there may be reason to believe that a primary cause of
the recent housing bubble-and-bust cycle was the rapid growth
of short-duration mortgages during the 2000s, which caused U.S.
home prices to become more sensitive to the low interest rate
environment created by Alan Greenspan's Federal Reserve.
I would add that the prepayable 30-year mortgage allows households
to duration match assets and liabilities. Most households have two
principal assets--their house and their human capital. Houses are long-
term capital assets--and as such their values are sensitive to real
interest rates. The 30-year mortgage allows households to hedge
interest rate risk. This hedge isn't free--long-term interest rates are
usually higher than short-term rates for a reason. But having the
option of the hedge helps household mitigate risk.
On the other hand, the ability to freely repay a mortgage allows
households to be mobile. If one needs to move from one State to another
to take a new job, free prepayment reduces the cost of such a move.
Once again, this option is not free--investors need to be compensated
for the risk they take--but it helps households better manage risk.
We at business schools teach the importance of hedging duration
risk. It is no less important for households than it is for financial
institutions. The 30-year fixed-rate prepayable mortgage is the
instrument that allows households to do so.
IV. In the Absence of a Guarantee, We Would Observe Differences in the
Price and Availability of Mortgage Credit Across Communities
Some housing markets have many fewer transactions than others. It
can be difficult to infer house prices, and therefore to assess
mortgage risk in these markets.
Brent Ambrose and Richard Buttimer \9\ write about how rural
markets, where houses trade infrequently, might be ill-served in the
absence of a guarantee:
---------------------------------------------------------------------------
\9\ See, Brent Ambrose and Richard Buttimer (2005), ``GSE Impact
on Rural Mortgage Markets'', Regional Science and Urban Economics,
35(4): 417-443.
our analysis confirm[s] that the conforming rural market is
closely tied to the conforming urban market, while the jumbo
rural market is less closely tied to the jumbo urban market. We
interpret this as evidence that GSE involvement in the rural
market, while a relatively small portion of the overall GSE
business, is, nevertheless, serving to provide rural conforming
mortgage borrowers with improved access to credit, especially
---------------------------------------------------------------------------
when compared to rural jumbo borrowers.
The problem rural markets face applies to central urban markets as
well. Lang and Nakamura show how thin markets in urban centers make
valuation more difficult and undermine liquidity in the lending market
\10\
---------------------------------------------------------------------------
\10\ See, W. Lang and L. Nakamura (1993), ``A Model of
Redlining'', Journal of Urban Economics, 33(2): 223-234.
---------------------------------------------------------------------------
A ruthless economist might argue that this simply means that rural
areas and central cities are obsolete places that ``deserve'' their
second class status for borrowing or lending. But when lending is
underprovided because of information problems, resources are being
wasted, and a well-tuned policy that allows for lending on favorable
terms can provide a more efficient outcome than the market alone.
There are times, moreover, when even the most attractive
neighborhoods for lending find themselves without easy access to
credit. We find ourselves at this such a time right now. Even though
lenders are advertising jumbo mortgages, borrowers are currently
finding it very difficult to obtain one.
To begin, the process is long--loan approvals are taking as long as
4 months, which essentially eliminates a spot market in housing.
Second, as with the case of rural and inner-city markets, appraisals
are an impediment to lending, because the thinness of markets is making
it difficult to determine appraised values. Third, the underwriting
standards have swung from being too lenient to being considerably
harsher than they were in the 1990s or even the late 1980s, which,
based on performance, was a period in which underwriting was strong.
For example, lenders are often looking for reserves equal to 10 percent
of the value of the house along with a 20 percent downpayment.
Perhaps such underwriting standards would be fine, were it not for
the fact that they would prevent a substantial number of households
from obtaining mortgage credit. As Peter Linneman and Susan Wachter
\11\ showed many years ago, the largest impediment to obtaining credit
is not so much the ability to make monthly payments as it is to obtain
a downpayment.
---------------------------------------------------------------------------
\11\ P. Linneman and S. Wachter (1989), ``The Impacts of Borrowing
Constraints on Home Ownership'', AREUEA Journal 17, 389-402.
---------------------------------------------------------------------------
Professor Jaffee has argued that other countries (including Canada,
Australia, and many European Countries) have home ownership rates as
high as the United States despite having more onerous terms for
borrowers, and that therefore the United States need not worry about
making mortgage funds more difficult to obtain. \12\
---------------------------------------------------------------------------
\12\ See, Dwight Jaffe (2010), ``Reforming the U.S. Mortgage
Market Through Private Incentives'', http://research.stlouisfed.org/
conferences/gse/Jaffee.pdf.
---------------------------------------------------------------------------
The problem with this line of reasoning is that the income and
wealth distributions in these countries are substantially more even
than in the U.S. For example, according to the OECD, the top half of
the income distribution in the U.S. has higher income than all but two
other countries (the Netherlands and Luxembourg), the bottom quintiles
income ranks 19th. The wealth distribution in the U.S. is even more
skewed than the income distribution.
If these differences in wealth and income reflected differences in
effort and talent, this would not be a source of concern, at least to
me personally. But we know that intergenerational wealth is an
important determinant of the income distribution, and we are a country
where for many generations not all of us had equal access to capital.
According to the Federal Reserve's Survey of Consumer Finances,
median wealth among non-Hispanic white families was $171,000 in 2007;
among nonwhite and Hispanic families it was $28,000. It is not a
coincidence that the home ownership rate for white households is more
than 20 percentage points higher than for the remainder of the
country--easier access to mortgage credit over the years allowed white
Americans to build wealth more easily than nonwhite and Hispanic
Americans. \13\
---------------------------------------------------------------------------
\13\ The Government itself discriminated against certain
neighborhoods based on racial characteristics for many years. The Home
Owners Loan Corporation and the Federal Housing Administration had maps
that green-lined neighborhoods that were considered desirable and red-
lined those that were not. Neighborhood ``desirability'' was determined
in part by its ethnic and racial make-up. In a recent law review
article, Thomas Mitchell, Stephen Malpezzi, and I (``Forced Sale Risk:
Class, Race, and the `Double Discount' '', Florida State University Law
Review, Vol. 37: 589-68 (2010)) moreover found that many African
Americans had their home equity stripped through partition sales and
sheriff's sales.
---------------------------------------------------------------------------
Differences in wealth--particularly home-owning wealth--from past
generations had an impact on successor generations. Dalton Conley has
used Panel Survey of Income Dynamics Data to show that the probability
of a child attending college can be largely predicted by two things:
whether her parents went to colleges, and whether her parents had home
equity.
It is doubtful that the private market on its own can redress this
inequality of wealth that arises not because of differences in effort
across people, but because of differences in how previous generations
were treated.
There are those who argue that it was the attempt to advance
mortgage credit to minorities that led to our current condition--I do
not accept that argument. The loans that have performed most poorly
were originated by institutions that were not covered by the Community
Reinvestment Act or the Affordable Housing Goals. Moreover, as Mr.
Wallison \14\ himself once noted, Fannie Mae and Freddie Mac did not do
a good job of advancing credit to minorities or low-income
neighborhoods. While this is to their discredit, it undermines that
argument that their troubles arose because they made too many loans to
underserved borrowers.
---------------------------------------------------------------------------
\14\ See, http://www.aei.org/article/23974.
---------------------------------------------------------------------------
Indeed, part of the problem is that institutions that received no
guarantee made no effort to assure their loans were suitable, and often
steered borrowers away from vanilla 30-year fixed-rate products toward
more dangerous products that were larded with fees. These were more
profitable in the short-term, but exploded in the slightly longer-term.
Such recent past behavior does not support the conclusion that
Government guaranteed loans are more menacing than those produced in
the purely ``private'' sector.
______
PREPARED STATEMENT OF PETER J. WALLISON
Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise
Institute
September 13, 2011
This testimony is in three parts.* First, I address a Government
guarantee for housing finance in the context of its adverse effects on
the U.S. debt picture, on U.S. taxpayers, and on the overall health of
the U.S. economy. In the second section, I address the arguments that
are generally made in support of a Government-backed system and show
that they are without merit. In the third section, I briefly discuss
how a fully private system for housing finance should be structured.
---------------------------------------------------------------------------
* The views expressed in this testimony are those of the author
alone and do not necessarily represent those of the American Enterprise
Institute.
---------------------------------------------------------------------------
I. Problems Associated With a Government Guarantee of the Housing
Finance Market Effect on U.S. Debt
Although the Government's overall debt position is not an issue
that is usually part of the debate on housing finance policy, the
fiscal position of the United States has deteriorated so seriously in
recent years that the question whether to increase the national debt in
order to support the U.S. housing market has now become highly germane.
The CBO recently estimated--even after the recent debt extension
agreement--that if current policies are pursued the national debt will
balloon from $14.3 trillion today to $23 trillion in 2021. Virtually
all proposals for U.S. Government assistance to the housing finance
market assume that it will involve an explicit Government guarantee,
but even if this guarantee is only implicit--as it was with the
Government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac--it
will make no significant difference except in the budget numbers. As my
AEI colleague Alex Pollock has pointed out, \1\ the off-budget debt of
the various Government agencies--primarily Fannie Mae and Freddie Mac--
currently totals $7.5 trillion, but the bailout of Fannie and Freddie
proved beyond question that this debt is every bit a part of the
Nation's debt as the securities are issued by the Treasury.
---------------------------------------------------------------------------
\1\ Alex J. Pollock, ``The Government's Four-Decade Financial
Experiment'', The American.com, July 13, 2011, http://www.american.com/
archive/2011/july/the-government2019s-four-decade-financial-experiment.
---------------------------------------------------------------------------
So, without any change in policies and without any further increase
in the GSEs' debt, the national debt will reach $30 trillion in 10
years. With this background, it is hard to believe that there is
actually a viable campaign to have the Government support the housing
market once again. At a time when Congress is having great difficulty
trying to reduce the debt by finding places where spending can be cut,
it is astonishing that some in the private sector can appear before
Congress to ask for yet more debt in support of the housing market, a
sector of the economy that could function perfectly well without any
Government backing.
Accordingly, in considering whether the Government should back
housing finance, the first consideration this Committee should have in
mind is whether it would be good policy at this time to add to the U.S.
Government's financial obligations.
Effect on the Taxpayers
There is no doubt that this campaign for Government backing, if
successful, will benefit certain groups--primarily the ones who are
doing the campaigning. However, there is one group--U.S. taxpayers--who
never seem to get a second thought when these campaigns are run.
Nevertheless, it is the taxpayers who inevitably have to bear the
burden of the subsidies that the Government hands out through its
support for housing finance.
The history here is consistent; the taxpayers are always left
holding the bag. There's an explanation for this: the Government is
never fully compensated for its risks. In the 1930s, for example,
Congress set up the Federal savings and loan system (S&Ls), insuring
their deposits--and giving them advantages over banks in attracting
funds--so that they could finance mortgages at low rates. In adopting
this program, the Government took substantial risks for the taxpayers'
account. S&Ls were expected to borrow money through short-term deposits
but make long-term mortgage loans, an obvious prescription for disaster
that only worked as long as interest rates were controlled by the
Government. When the capital markets were freed of controls, so that
funds could flow where they were most useful, the Government could no
longer maintain controls on interest rates, and the higher rates they
had to pay for funds drove many S&Ls into insolvency. The Government
could have been compensated for the risk it was taking on the S&Ls by
raising the premium for their deposit insurance. But this would have
raised the cost of their mortgage loans, defeating the purpose of the
S&Ls. So when the consequences of the Government's risks unfolded in
the 1980s the taxpayers had to pick up a $150 billion tab.
Parenthetically, it should be noted that even the interest rate
controls that made the S&L system work were another way of assessing
the taxpayers. The deposit rate ceilings limited what depositors could
earn on their savings, and penalized them even more directly when
inflation caused prices and market interest rates to rise in the 1970s.
Now the taxpayers are being assessed to bail out Fannie and
Freddie. These two Government sponsored enterprises (GSEs) became
insolvent because Congress materially increased their risks in 1992 by
requiring them to acquire what were called affordable housing loans.
These loans were to be made to borrowers at or below the median income
in the places where they lived. Initially, 30 percent of the mortgages
Fannie and Freddie were required to buy had to meet the affordable
housing goals. However, the Department of Housing and Urban Development
was given authority to administer the program, and by 2007 it had
increased the goals so that 55 percent of all mortgages the GSEs bought
had to be affordable housing loans. HUD also added subgoals that
required the purchase of mortgages made to borrowers who were 80
percent and in some cases 60 percent of the median income in their
communities.
It is of course possible to find prime mortgages among borrowers
who are at or below the median income where they live--and maybe even
borrowers who are at 80 percent or 60 percent of the median income--but
not when more than half of the GSEs' loans had to be made to borrowers
who frequently had blemished credit, lacked funds for downpayments and
did not have the steady incomes necessary to maintain home ownership.
Accordingly, in order to meet the affordable housing goals, Fannie and
Freddie had to take significant risks on mortgage quality, and those
risks--which turned into losses when the housing bubble deflated--
eventually caused their insolvency. Here is a quote from Fannie Mae's
2006 10-K that makes exactly this point:
[W]e have made, and continue to make, significant adjustments
to our mortgage loan sourcing and purchase strategies in an
effort to meet HUD's increased housing goals and new subgoals.
These strategies include entering into some purchase and
securitization transactions with lower expected economic
returns than our typical transactions. We have also relaxed
some of our underwriting criteria to obtain goals-qualifying
mortgage loans and increased our investments in higher-risk
mortgage loan products that are more likely to serve the
borrowers targeted by HUD's goals and subgoals, which could
increase our credit losses. [emphasis supplied.]
The GSEs' regulator, the Federal Housing Finance Agency (FHFA)
estimated several months ago that the losses these two firms will
eventually suffer will range from $221 billion to $363 billion, but the
continued deterioration of the mortgage market since that estimate was
made suggests that the taxpayers will eventually have to pay more than
$400 billion to make up the GSEs' losses.
Again, the Government could have been compensated for the risks it
was creating for Fannie and Freddie. It was well-known that they were
regarded in the capital markets as Government-backed, and for that
reason were the beneficiaries of low borrowing costs. Accordingly,
there were many proposals that the Government charge Fannie and Freddie
a guarantee fee, so in the event of their failure the Government could
have been compensated for the costs it would have to bear. But as in
the case of the S&Ls these proposals to compensate the Government and
protect the taxpayers were strongly opposed in Congress (and by the
GSEs themselves) because they would increase the cost of mortgages. So
in a very direct way the taxpayers are now paying for the risks that
the Government required Fannie and Freddie to take. The Administration
itself recognizes this problem. As it noted in its February 11
statement on housing finance policy, ``Political pressure to lower the
price of Government support increases the odds that the Government will
misprice risk and put taxpayers at risk.'' \2\
---------------------------------------------------------------------------
\2\ Departments of Treasury and HUD, Reforming America's Housing
Finance Market, 26.
---------------------------------------------------------------------------
The Government also imposes costs on the taxpayers because of its
lack of discipline in maintaining the necessary reserves for insurance
funds that are intended to pay for contingent losses when they occur.
Government loves to describe its policies as insurance--insurance
sounds so stable and sensible--but it doesn't do the one thing that
private insurers do to cover their risks: it does not maintain adequate
contingency funds. As the Government's funds accumulate, the argument
is made that times are different, that the fund is large enough, or
even that the industry paying the premium is strapped for cash or
investment capital. These pressures cause the Government to let it
ride, to refrain from collecting the necessary fees or premiums. This
has occurred with the National Flood Insurance Program, \3\ the Pension
Benefit Guaranty Corporation, \4\ the FHA, \5\ and the Federal Deposit
Insurance Corporation (FDIC).
---------------------------------------------------------------------------
\3\ ``FEMA Administrator Craig Fugate says the debt results partly
from Congress restraining insurance rates to encourage the purchase of
coverage, which is required for property owners with a federally backed
mortgage. . . . `It is not run as a business,' Fugate said. Congress'
Government Accountability Office said in April that the program is `by
design, not actuarially sound' because it has no cash reserves to pay
for catastrophes such as Katrina and sets rates that `do not reflect
actual flood risk.' Raising insurance rates or limiting coverage is
hard. `The board of directors of this program is Congress,' Fugate
said. `They are very responsive to individuals who are being adversely
affected.' '' (Thomas Fink, ``Huge Losses Put Federal Flood Insurance
Plan in the Red'', USA Today, August 26, 2010.)
\4\ As of the end of FY2010, the Pension Benefit Guaranty
Corporation (PBGC) reported a deficit of $23 billion. ``In part, it is
a result of the fact that the premiums PBGC charges are insufficient to
pay for all the benefits that PBGC insures, and other factors.''
Pension Benefit Guaranty Corporation, ``2010 PBGC Annual Report,''
www.pbgc.gov/about/ar2010.html (accessed January 14, 2011).
\5\ Barclays Capital estimates that the FHA has drastically
underpriced the risk of its guarantees and could face losses of up to
$128 billion. Barclays, ``U.S. Housing Finance: No Silver Bullet'',
December 13, 2010.
---------------------------------------------------------------------------
Recent FDIC experience is fully consistent with Congress's
reluctance to collect the necessary premiums in any insurance program.
When the deposit-insurance system was reformed in 1991 in response to
the failure of the FSLIC, Congress placed a limit on the size of the
fund that the FDIC could accumulate to meet the demands of a future
crisis. Since 1996, the FDIC has been prohibited by law from charging
premiums to well-capitalized and stable institutions. As a result,
between 1996 and 2006, institutions representing 98 percent of deposits
paid no deposit-insurance premiums. In 2009, FDIC chair Sheila Bair
observed: ``An important lesson going forward is we need to be building
up these funds in good times so you can draw down upon them in bad
times.'' \6\ Instead, once the bad times hit, the FDIC became insolvent
and was forced to raise its premiums at the worst possible moment,
thereby reinforcing the impact of the down cycle.
---------------------------------------------------------------------------
\6\ Center on Federal Financial Institutions, ``Federal Deposit
Insurance Corporation'', August 10, 2005, www.coffi.org/pubs/Summaries/
FDIC%20Summary.pdf (accessed January 14, 2011). See also, Congressional
Budget Office, ``Modifying Federal Deposit Insurance'', May 9, 2005,
``Currently, 93 percent of FDIC-insured institutions, which hold 98
percent of insured deposits, pay nothing for deposit insurance.''
---------------------------------------------------------------------------
Finally, it should be noted that to the extent that Government
guaranteed mortgage-backed securities (MBS) are available they compete
with Treasury securities. Many investors prefer them to treasuries
because they represent virtually the same risk but offer a higher
yield. Under these circumstances, the Treasury must pay a higher rate
of interest than it would otherwise have to pay if there were no
competition in the market. A recent Fed paper suggested that by
purchasing GSE MBS (and thus taking those securities out of competition
with the Treasury 10-year note) the Fed had reduced the interest rate
on the 10-year note by as much as 30 to 100 basis points. \7\ If
correct, this is an enormous amount and in effect another cost of a
Government housing finance guarantee that will have to be paid by the
taxpayers.
---------------------------------------------------------------------------
\7\ Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack,
``Large-Scale Asset Purchases by the Federal Reserve: Did They Work?'',
FRBNY Economic Policy Review, May 2011, p. 41
---------------------------------------------------------------------------
Effect on the Economy as Whole
Bubbles are a familiar phenomenon in any economy. They occur in the
prices of many commodities from time to time, and even occur in the
stock market, but they are particularly pervasive and long-lived in
housing. In the last 30 years, there were housing price bubbles in 1979
and 1989--each of which lasted about 3 or 4 years--and a gigantic 10
year bubble between 1997 and 2007. There is good reason to believe that
these housing bubbles are the result of Government involvement in
housing finance.
Among the purposes of past Government support for the housing
market was to assure a steady flow of funds for housing. There is no
particular reason why housing--as opposed to any other area of the
economy--might require a steady flow of funds. Automobiles, food and
other retailing, mining, high tech, and corporate finance generally do
not require steady flows of funds and have survived and prospered quite
well.
However, one of the effects of Government support for a steady flow
of funds to housing is that it lowers the financing risks for the
homebuilders and others in the business of producing housing. Lowered
risks encourage more homebuilding activity, because it reduces the
likelihood of loss in the event of a market downturn. This, in turn,
encourages speculation and increases the likelihood that housing
bubbles will develop. When these bubbles eventually deflate, the losses
they create represent a misallocation of capital that could have been
used more efficiently elsewhere. Occasionally, as in 2008, the losses
that occur as a result of a bubble's collapse can cause a financial
crisis. \8\
---------------------------------------------------------------------------
\8\ See, Peter J. Wallison, ``Dissent From the Majority Report of
the Financial Crisis Inquiry Commission'', January 2011, http://
www.aei.org/docLib/Wallisondissent.pdf.
---------------------------------------------------------------------------
The Government's role in housing finance also has a negative effect
on competition and thus reduces innovation and raises costs. The fact
that the Government cannot or will not price for risk should be an
important clue about the distorting effect its guarantee will have on
competition. For the reasons outlined above, the Government's charge
for supporting the housing market will be lower than the actual risk
would demand, so its backing operates as a subsidy.
This happened with Fannie and Freddie. Because they were seen as
Government-backed, they were beneficiaries of lower funding costs in
the market, and this allowed them to drive all competition from the
secondary mortgage market. As a result, until they were felled by the
affordable housing requirements, the GSEs' profits were extraordinarily
high and their efficiencies and innovations low. In addition, they were
not subject to market discipline because lenders did not believe that
as Government-backed enterprises they represented any significant risk.
Thus were Fannie and Freddie enabled to take the risks required by
the affordable housing requirements without any scrutiny by the private
market. The real costs to society appeared later. The same thing will
happen with any Government program that backs housing finance with a
guarantee of any kind, whether it covers the issuers of mortgage-backed
securities (MBS) or only the MBS. In both cases, competition will be
reduced and market discipline impaired.
Accordingly, apart from its adverse effects on the debt and the
taxpayers, Government support for housing finance also tends to
increase speculation in homebuilding and related activities, causing
housing bubbles, waste of capital resources, and impairment of the
benefits of competition. This reduces, rather than increases economic
growth and employment.
II. The Arguments Advanced in Support of Government Guarantees Have no
Merit
Having shown that Government guarantees for housing are
affirmatively harmful for the country's fiscal position, for taxpayers
and for the U.S. economy, I will now discuss the likely form that any
such guarantees will take, and the various reasons that the proponents
of Government guarantees advance to support of their position. These, I
will show, are without merit.
The Likely Form of a Government Guarantee Program
The spectacular failure of Fannie and Freddie has caused many
proponents of Government guarantees in housing finance to revise the
structure of their proposals. Instead of guaranteeing the issuers of
MBS like Fannie and Freddie, the new more sophisticated idea--including
Option 3 in the Administration's February 11 policy statement--is to
have the Government's guarantee attach only to the MBS and not to the
issuers. These plans would obligate the Government to pick up losses
only after the capital of an MBS issuer has been exhausted and would
require the issuer to pay a fee to the Government to cover the
Government's risks. This idea is presented as though it will prevent
losses similar to those that resulted from the operations of Fannie and
Freddie; the implicit suggestion is that if only the MBS are guaranteed
the Government's risks will be reduced and the likelihood of taxpayer
losses will be minimized.
This is an illusion, for several reasons. First, as noted above,
the Government cannot effectively set a fee to cover the taxpayers'
risks on the Government's program. Even if Government had the
incentives and capabilities to assess a proper fee, the assessment
would be seen and attacked as an unfair tax on housing or on the
borrowers who would have to pay higher interest rates. For example,
when the Office of Management and Budget suggested near the end of the
Clinton administration that Fannie and Freddie pay a fee for the
Government's risk on its implicit backing of their obligations, the
idea was immediately derided as a tax on home ownership, the
Administration was inundated with protests from the housing industry,
and the proposal was promptly abandoned.
Apart from whether the appropriate fee can be credibly established,
history shows that Congress does not have the political fortitude to
impose a fee that burdens homeowners or the housing industry. In
addition, it is fanciful to believe that the companies set up by the
Government to perform a Government mission will not be viewed in the
market as Government-backed. It is necessary only to point out that the
GSEs' charter says explicitly that they and their obligations are not
guaranteed by the Government, but when they became insolvent the
Administration immediately took them over and assured creditors that
they would be fully paid.
Similarly, as discussed above, even if the Government were to
impose a fee of some kind, the political process would--as it has in
the case of the FDIC and other ``insurance'' programs--soon stop the
accumulation of a reserve fund to cover eventual losses. So when the
losses actually occur, the taxpayers would be the ones to bear the
costs.
Nor is the problem solved--as many of the supporters of these
guarantee plans suggest--if the Government is liable for losses on
guaranteed MBS only after the issuer of the MBS has absorbed the first
losses and exhausted its capital. It is true that in this case issuers
will have an incentive to be cautious about risk taking, but the
Government guarantee eliminates an important element of market
discipline--the risk aversion of investors. The existence of a
Government guarantee will mean that no MBS buyer needs to be concerned
about the quality of the underlying loans or the financial stability of
the issuer. This is exactly analogous to the effect of deposit
insurance on risk taking by banks. As is well known, deposit insurance
permits bank depositors to ignore the risks a bank is taking--the
principal reason that so many banks fail. As in the case of deposit
insurance, Government backing of MBS will eliminate investor concerns
about both the financial stability of the issuer and the quality of the
mortgages underlying the MBS. The effect of this moral hazard is
certainly one of the lessons of the GSEs' failure.
The GSE experience also shows how difficult it will be to limit the
scope of any Government support program. The GSEs were seen as
providing advantages to the middle class, mostly in the form of lower
mortgage costs, and it was a natural impulse for Congress to want to
extend those benefits to other constituents. The affordable housing
goals were one example of such an extension, but so were the higher
conforming loan limits, adopted in 2008, which allowed Fannie and
Freddie to extend the benefits of their Government-backed low-cost
financing to borrowers who were not at all low income or in any way
economically disadvantaged. This is the way a legislature will work in
a democracy, and there is no reason to assume that any limitations
Congress might put on Government support of the mortgage market will
continue for very long. Government-conferred benefits provide subsidies
to certain favored groups, and Congress will always be attentive to
extending these subsidies to others.
Where moral hazard is present, regulation is imposed to protect the
Government and the taxpayers, and regulation of the issuers of the
guaranteed MBS is another prescription of the advocates of Government
guarantees. They argue that regulation will ensure that the issuers
have sufficient capital to cover the risks they will be taking and thus
to protect the Government and the taxpayers from loss. But experience
with bank regulation has shown that regulation does not prevent
excessive risk taking and does not ensure sufficient capital to cover
risks. Its effect, indeed, is almost the opposite. By increasing moral
hazard, it encourages risk-taking. Moreover, as shown by the recent
experience of the FDIC, which (despite prompt corrective action) has
suffered losses in the great majority of banks it has closed in the
last 3 years, regulators are frequently unable to determine the
financial condition of a regulated entity until it is too late. In
these cases, the taxpayers will once again end up taking the losses.
Accordingly, the structure of most proposals for Government housing
market guarantees will not provide any protection for the taxpayers. As
with Fannie and Freddie and the S&Ls, when the losses come in the
taxpayers will eventually have to pay the bill.
Nevertheless, the proponents of Government guarantees and their
congressional supporters argue that there cannot be a functioning
housing finance market without Government guarantees, and in the
discussion below I show that these arguments have no merit.
Institutional Investors
One of the most frequently heard arguments in favor of Government
guarantees is that institutional investors will only buy U.S.
mortgages, or MBS based U.S. mortgages, if they are backed by the
Government. On its face, this seems absurd, since in most advanced
economies the housing finance market operates effectively without
Government guarantees. Of course, if it were true that institutional
investors will not buy MBS without a Government guarantee, it would be
a weighty argument. However, it's a myth, disproved by the data, which
shows that institutional investors are not major buyers of GSE
securities.
According to the Federal Reserve's flow of funds data, nonbank
institutional investors had assets of $28 trillion in the fourth
quarter of 2010. About $13 trillion of this amount was invested in
fixed-income or debt securities--but only $1.8 trillion was invested in
U.S. Government-backed securities issued by Government agencies or by
Fannie and Freddie. Thus, even at a time when private housing finance
has not yet revived--and most of the investment in housing is flowing
through Fannie and Freddie or the Federal Housing Administration
(FHA)--less than one-seventh of the funds invested in debt securities
by institutional investors were invested in Government-backed GSE
mortgage securities.
Most likely, even these investments are only for liquidity
purposes--made by money managers who want some small amount of
Government securities that can be sold at any time in order to raise
cash, no matter what the conditions in the market. These investors hold
GSE securities because their yield is slightly higher than treasuries
of equivalent maturity. As discussed above, it should be noted that by
providing these investors with a security that carries a Government
guarantee--an alternative to a Treasury security--Congress is raising
the Treasury's interest costs, another cost levied on the taxpayers.
By contrast, at the end of 2010, nonbank institutional investors
had assets consisting of $2.6 trillion in both residential and
commercial whole mortgages. Whole mortgages are not guaranteed by
Fannie and Freddie or the FHA. This means that even after the financial
crisis, institutional investors held a larger dollar amount of
mortgages that are not backed by the Government than the mortgages that
are perceived as Government-guaranteed.
The Fed's flow of funds data also includes a $4.6 trillion category
called ``corporate and foreign bonds,'' which includes privately issued
mortgage-backed securities. Although this category is not further
broken down, the mortgage-backed securities within it would add to the
total of mortgage assets not guaranteed by the Government.
This data should have a profound effect on the question of whether
to replace Fannie and Freddie with another Government-backed system.
They show that nonbank institutional investors are not investors in
Government guaranteed debt (except for liquidity purposes) and prefer
private mortgages and mortgage-backed securities to Government-backed
instruments.
Who are these institutional investors, and why do they prefer whole
mortgages and private mortgage-backed securities over U.S. Government-
backed mortgage securities? The biggest members of this class fall into
three categories--life insurers ($5.1 trillion in assets), private
pension funds ($6 trillion) and mutual funds ($8 trillion). What these
institutional investors have in common is a desire for yield. Life
insurers and pension funds have long-term liabilities they have to
cover, and mutual funds function in a competitive environment in which
yield is important to retaining their investors. Privately issued
instruments provide market rates of return that allow these
institutions to meet their long-term obligations. U.S. Government
agencies, by contrast, don't pass this test. Their yields are low
because their interest rates, subsidized by the taxpayers, are lower.
That doesn't mean they have figured out how to escape from market
risk. Instead, as we know from experience, the taxpayers eventually
have to compensate for this risk through bailouts of Fannie and Freddie
and other Government housing finance ventures. This analysis is
confirmed by looking at who the buyers of Government-backed securities
actually are. In 2006, before the financial crisis, 11 percent of the
holders were foreign central banks, 23 percent were Federal, State, and
local governments and enterprises and their pension funds, and 21
percent were insured depository institutions. Thus more than 50 percent
of the demand for Fannie and Freddie mortgage-backed securities came
from U.S. and foreign governments, or from organizations the Government
controls or regulates. In other words, Government-backed mortgage
securities are primarily attractive to risk-averse institutions or
those with regulated capital requirements.
Thus, if we want U.S. and foreign institutional investors to invest
in our mortgage market, we should be looking to a private system of
mortgage finance, and not one run or backed by the Government. Private
U.S. institutional investors have $13 trillion invested in fixed income
or other debt securities. Much of this investment is going into
corporate debt, including junk bonds, because mortgages or mortgage-
backed securities yielding market rates are not available--and were not
available even in 2006. If there were good private mortgage-backed
securities available, institutional investors would be eagerly
investing in the U.S. housing market.
Increase in Mortgage Rates
Another argument in favor of a Government-backed system is that the
interest rates on mortgages will be lower than in a private system.
There is little question that a Government backed housing finance
system can deliver mortgages at lower rates than private systems, but
that's because the Government is taking risks for which it will not be
compensated. Instead, when the Government's losses show up, the
taxpayers are handed the bill. If the taxpayers were not the ultimate
insurer of the Government's risks, the rate on Government-backed
mortgages would be the same as private mortgages, because the
Government-backed loans would then reflect all the risks inherent in
the structure. Those who support a Government-backed system must
concede that it only provides lower rates because it puts the taxpayers
at risk.
The 30-Year Fixed-Rate Mortgage
Many proponents of Government guarantees in housing finance argue
that without a Government role in the housing market the 30-year fixed-
rate mortgage will not be available to American homebuyers. On its
face, this is not true, since anyone can go to the Internet and find
lenders offering jumbo fixed-rate 30-year loans--which, by definition,
have no Government backing. It is true that, at this point, a 30-year
fixed-rate mortgage is somewhat more expensive than a Government-backed
30-year fixed-rate mortgage, but the lower cost of the Government
mortgage simply means that the taxpayers are providing a subsidy to the
person who wants a Government-backed mortgage with these terms.
Anyway, history has shown--and simple economics would anticipate--
that a Government subsidy for a 30-year fixed-rate mortgage is not good
policy. The subsidy causes most borrowers to choose the 30-year loan,
since in general it offers a fixed, low monthly payment with a
Government-subsidized ``free'' prepayment option. Supporters, including
the Administration in its Option 3, point to the apparent stability it
provides to borrowers. This ``stability,'' however, carries with it
several serious deficiencies. A 30-year loan amortizes slowly, keeping
the homeowner's equity low and debt level high for a good portion of
the loan period. In other words, it increases the homeowner's leverage.
If the home is sold after 7 years (the average duration of occupancy),
the homeowner has not accumulated much equity. \9\ In addition, the
``free'' prepayment option encourages equity withdrawal through serial
refinancing.
---------------------------------------------------------------------------
\9\ See, for example, Peter J. Wallison, ``What's So Special About
the 30-Year Mortgage?'' Wall Street Journal, February 1, 2011,
www.aei.org/article/103092.
---------------------------------------------------------------------------
For these reasons, it is peculiar that the proponents of Government
backing are never asked to explain why the taxpayers should be
subsidizing a 30-year fixed-rate mortgage. This is not to say that this
mortgage should not be available, but only that homeowners who want
such a loan should not expect the taxpayers to subsidize its
availability. In today's market, it is available at a slightly higher
cost without a taxpayer subsidy.
The TBA market
Another frequently heard argument from the supporters of Government
backing for residential mortgage finance is that only with Government
backing can the To-Be-Announced (TBA) market exist. This is another
myth. First, however, it is important to put the TBA issue in
perspective. Just as commodity futures markets enable farmers to hedge
the price risk of their commodities, the agency TBA forward market
allows mortgage originators to mitigate their interest rate risk.
Today, originators of both agency and nonagency mortgages use the
agency market to hedge the risk of a change in interest rates between
the time that a mortgage rate is ``locked in'' and the time the
mortgage is actually closed and securitized. Reducing that risk has a
positive effect on mortgage rates, but it is only one of the elements
that go into the full cost of a mortgage. It would be dwarfed, for
example, by a \1/4\ point increase in overall interest rates. The
mortgage market could function effectively without a TBA market, but
total mortgage costs--the principal component of which is the interest
rate--would be slightly higher. Nevertheless, Government backing is not
a requirement for the TBA market, just as it is not a requirement for a
30-year fixed-rate mortgage.
It is perfectly possible for a TBA market to develop for private
MBS. This is because the TBA market function does not exist because of
a Government guarantee but because of a high level of liquidity in the
market--a large number of MBS that are regularly bought and sold. That
liquidity is created by a convention--an agreement--among market
participants about what they will accept as sufficient information
about a particular pool of MBS. That convention, embodied in the
Uniform Practices for the Clearance and Settlement of Mortgage-Backed
Securities--administered by the Securities Industry Financial Markets
Association (SIFMA) and otherwise known as the ``Good Delivery
Guidelines''--establishes that a seller and buyer in the TBA market
need only agree on six factors to confirm a trade: issuer, maturity,
coupon, price, par amount, and settlement date. \10\ For example, as
described in a recent paper by the Federal reserve Bank of New York,
``a TBA contract agreed in July will be settled in August, for a
security issued by Freddie Mac with a 30-year maturity, a 6 percent
annual coupon, and a par amount of $200 million at a price of $102 per
$100 of par amount, for a total price of $204 million.'' \11\
---------------------------------------------------------------------------
\10\ James Vickrey and Joshua Wright, ``TBA Trading and Liquidity
in the Agency MBS Market'', Federal Reserve Bank of New York Staff
Reports, Staff report no. 468, August 2010, p. 7
\11\ Ibid.
---------------------------------------------------------------------------
The limitation on the information available to the buyer makes the
agency MBS, in effect, ``fungible'' with other agency MBS already
outstanding and thus adds significantly to the liquidity in the market.
As also explained in the Federal Reserve paper: ``Paradoxically, the
limits on information disclosure inherent in the TBA market actually
increase this market's liquidity, by creating fungibility across
securities, and reducing information acquisition costs for buyers of
[agency] MBS.'' \12\
---------------------------------------------------------------------------
\12\ Id., p. 12
---------------------------------------------------------------------------
The existence of GSEs makes it easier for a TBA market to exist,
because it removes credit risk as one of the risks that market
participants must consider, but that is not essential for the TBA
market to function. If the mortgages on which MBS are based are all
relatively similar in quality--as they would be if certain minimum
standards existed--that, combined with mortgage insurance, would create
a private sector product not far off from an agency MBS. Then, all that
would be necessary for a private TBA market would be a large number of
MBS issuances and agreement on the same terms--issuer, maturity,
coupon, price, par amount, and settlement date--as the current
convention outlines for the agency TBA market.
Access to Capital in a Crisis
Finally, supporters of a Government-backed system argue that the
Government's involvement will keep the market functioning in the event
of another financial crisis. The Administration's February 11 report
expresses concern about whether--in a fully private market--there will
be sufficient access to mortgage credit during a crisis. The
Administration notes, ``absent sufficient Government support to
mitigate a credit crisis, there would be greater risk of a more severe
downturn, and thus the risk of greater cost to the taxpayer.'' \13\
This idea gave rise to the Administration's Option 2, which is a
private market with a Government backstop that would be invoked only in
the event of a financial crisis that makes credit unavailable for
housing.
---------------------------------------------------------------------------
\13\ Departments of Treasury and HUD, ``Reforming America's
Housing Finance Market'', 28.
---------------------------------------------------------------------------
However, if one assumes that some backstop is necessary, the
Federal Reserve has already demonstrated that it can liquefy the
housing market by purchasing MBS. The only question is whether the MBS
are of good quality. If the underlying mortgages meet the quality tests
outlined below, and include mortgage insurance, they would be of
sufficient quality so that the Fed could purchase them without taking
significant risks.
III. How a Private Market Would Be Structured
This testimony is not the place to describe in detail how a private
MBS market would work. However, in March 2011, my AEI colleagues, Alex
Pollock and Ed Pinto, and I issued a white paper \14\ in which we
responded to the Administration's February 11 statement and showed how
Option 1 in that Administration report--which discussed a private
market for MBS--would work. The white paper was based on four
principles:
---------------------------------------------------------------------------
\14\ Peter J. Wallison, Alex J. Pollock, and Edward J. Pinto,
``Taking the Government Out of the Housing Finance: Principles for
Reforming the Housing Finance Market'', AEI, March 2011, http://
www.aei.org/paper/100206.
I. The housing finance market--like other U.S. industries and housing
finance systems in most other developed countries--can and
should principally function without any direct Government
financial support
Under this principle, we note that the huge losses associated with
the savings and loan (S&L) debacle of the 1980s and Fannie and Freddie
today did not come about in spite of Government support for housing
finance but because of that Government backing. Government involvement
not only creates moral hazard but also sets in motion political
pressures for increasingly risky lending such as ``affordable loans''
to constituent groups.
Although many schemes for Government guarantees of housing finance
in various forms have been circulating in Washington since last year,
they are not fundamentally different from the policies that caused the
failures of the past. The fundamental flaw in all these ideas is the
notion that the Government can successfully establish an accurate risk-
based price or other compensatory fee for its guarantees. Many examples
show that this is beyond the capacity of Government and is in any case
politically infeasible. The problem is not solved by limiting the
Government's risks to MBS, as in some proposals. The Government's
guarantee eliminates an essential element of market discipline--the
risk aversion of investors--so the outcome will be the same:
underwriting standards will deteriorate, regulation of issuers will
fail, and taxpayers will take losses once again.
II. Ensuring mortgage quality, and fostering the accumulation of
adequate capital behind housing risk, can create a robust
housing investment market without a Government guarantee
This principle is based on the fact that high-quality mortgages are
good investments and have a long history of minimal losses. Instead of
relying on a Government guarantee to reassure investors in MBS, we
should simply ensure that the mortgages originated and distributed are
predominantly of prime quality. We know the characteristics of a prime
mortgage, which are defined in the white paper. They do not have to be
invented; they are well known from many decades of experience.
Experience has also shown that some regulation of credit quality
can prevent the deterioration in underwriting standards, although in
the last cycle regulation promoted lower credit standards. The natural
human tendency to believe that good times will continue--and that
``this time is different''--will continue to create price booms in
housing, as in other assets. Housing bubbles in turn--by suppressing
delinquencies and defaults--spawn subprime and other risky lending;
investors see high yields and few defaults, while other market
participants come to believe that housing prices will continue to rise,
making good loans out of weak ones. Future bubbles and the losses
suffered when they deflate can be minimized by interrupting this
process--by focusing regulation on the maintenance of high credit
quality.
III. All programs for assisting low-income families to become
homeowners should be on-budget and should limit risks to both
homeowners and taxpayers
The third principle recognizes that there is an important place for
social policies that assist low-income families to become homeowners,
but these policies must balance the interest in low-income lending
against the risks to the borrowers and the interests of the taxpayers.
In the past, ``affordable housing'' and similar policies have sought to
produce certain outcomes--such as an increase in home ownership--which
turned out to escalate the risks for both borrowers and taxpayers. The
quality of the mortgages made in pursuance of social policies can be
lower than prime quality--taxpayers may be willing to take risks to
attain some social goods--but there must be quality and budgetary
limits placed on riskier lending to keep taxpayer losses within known
and reasonable bounds.
IV. Fannie Mae and Freddie Mac should be eliminated as Government-
sponsored enterprises (GSEs) over time
Finally, Fannie and Freddie should be eliminated as GSEs and
privatized--but gradually, so the private sector can take on more of
the secondary market as the GSEs withdraw. The progressive withdrawal
of the GSEs from the housing finance market should be accomplished in
several ways, leading to the sunset of the GSE charters at the end of
the transition. One way would be successive reductions in the GSEs'
conforming loan limits by 20 percent of the previous year's limits each
year. These reductions would apply to conforming loan limits for both
regular and high-cost areas. This should be done according to a
published schedule so the private sector can plan for the investment of
the necessary capital and create the necessary operational capacity.
The private mortgage market would include banks, S&Ls, insurance
companies, pension funds, other portfolio lenders and investors,
mortgage bankers, mortgage insurance (MI) companies, and private
securitization. Congress should make sure that it facilitates
opportunities for additional financing alternatives, such as covered
bonds.
How a Private Market Will Attract Capital
The most important question for purposes of this testimony is how a
private market would attract capital. I have already discussed the size
of the institutional investor market, and shown that these investors
are not attracted by Government-guaranteed MBS, except for liquidity
purposes. Without any question, institutional investors will buy
mortgages that have attractive risk-adjusted yields. However, if we
want mortgage interest rates to remain low, we have to reduce the risks
associated with these loans. In that case, institutional investors will
not build in a large risk premium, which will add to mortgage costs.
One of the most effective ways to do this would be to specify
certain minimum terms for all securitized mortgages. These would
include a minimum downpayment of 10 percent, a borrower's FICO credit
score of at least 660 and a borrower's debt to income ratio in the
upper 30s. Even when these minimum criteria are specified, however,
institutional investors will want assurance about the overall quality
of the mortgages in the pool. One way to accomplish this is to create a
contractual structure in which the top tiers do not take losses on the
pool until the lower tiers are wiped out. This is the structure used in
many securitizations before the financial crisis and in the
securitizations that take place today.
In these offerings, the risk is mitigated by creating subordinated
tranches (or tiers) that take the first losses. Only if the losses are
greater than the size of those subordinate tranches will the top tiers
(normally rated AA or AAA) suffer losses. This is an effective system,
and could be attractive to institutional investors, but it has two
problems: first, if the quality of the mortgages in the pool is poor,
the subordinate tranches have to be thick (to absorb more expected
losses) and this will raise interest rates on the mortgages in the
pool; second, institutional investors do not have the facilities or
capabilities to underwrite mortgage pools, and because of the failure
of the rating agencies during the financial crisis institutional
investors are now reluctant to rely on rating agencies for assurance
about the quality of the mortgages in the pools. Therefore, another
assurance mechanism is necessary.
The best and most efficient system for this is mortgage insurance.
Under current state regulation of mortgage insurers, they are required
to hold at least half of their revenues in a reserve fund for 10 years,
an amount more than sufficient to deal with any foreseeable housing
downturn. In addition, they have the facilities and ability to do the
underwriting that institutional investors lack. It appears that if
mortgage quality is controlled so that only prime mortgages are
securitized, mortgage insurers can write insurance that covers losses
down to a loan-to-value ratio of 60 percent without increases in
mortgage costs that significantly exceed what Fannie and Freddie are
now charging. A system that provides for a minimum set of mortgage
standards, combined with mortgage insurance, could reduce the risk for
institutional investor substantially. This would permit interest rates
on the mortgages underlying the MBS to be competitive with any
Government backed system where the taxpayers are not compelled to
subsidize the risk.
A complete copy of the white paper, and its plan for a private
housing finance market, may be found at http://www.aei.org/paper/
100206.
This concludes my testimony.
______
PREPARED STATEMENT OF DWIGHT M. JAFFEE
Booth Professor of Banking, Finance, and Real Estate, University of
California
September 13, 2011
Mr. Chairman and Members of the Committee, I welcome the
opportunity to discuss with you today the future role of the Government
in the U.S. mortgage market. There is now a widespread consensus that
Fannie Mae and Freddie Mac--I will refer to them as the GSEs--should be
closed as soon as practical. It is thus timely to consider the best
means for replacing the mortgage market functions that have been
carried out by the GSEs.
Current discussions focus on two primary alternatives for replacing
the GSEs. The first alternative is to allow the private markets to
replace the existing GSE functions, with the possible addition of
expanding the FHA or a similar Government program with the goal to
augment the supply of mortgage funding for lower-income borrowers and
multifamily housing. The second alternative is to create a new
Government program that will provide investors in conforming mortgages
with an explicit Government guarantee against losses due to default.
My research leads me to a strong endorsement of the private markets
as the preferred alternative for two reasons. First, there is strong
evidence that the private markets are fully capable of carrying out all
mortgage market functions to a standard substantially higher than
actually experienced under the GSE regime. Second, experience indicates
that a program of Government guarantees of conforming residential
mortgages is highly likely to leave taxpayers, once again, to pay the
high costs of defaulting mortgages. I will now briefly explain the
basis for these conclusions.
I have recently carried out research that compares the mortgage and
housing market performance of the U.S. with that of 15 major Western
Europe countries. This is relevant because none of these European
countries provides an amount of Government assistance to their housing
and mortgage markets close to that provided in the U.S., and, in
particular, none of them has any institution comparable to our GSEs.
Nevertheless, the mortgage and housing markets of these countries have
significantly outperformed the U.S. markets on all available measures.
The attached Table 1 provides the full data from my research. The
first important fact is that the U.S. home ownership rate, 67.2 percent
at year-end 2009, is exactly equal to the average rate of the 15
European countries, with the home ownership rates of 7 European
countries actually exceeding that of the U.S. This is all the more
remarkable because the population density of these countries far
exceeds the U.S. and some of these countries--Austria and Germany for
example--have longstanding social traditions to postpone the date of
first home purchase.
Second, the average of U.S. mortgage interest rates has
significantly exceeded the corresponding average for the 15 European
the countries. The lower European mortgage rates are mainly the result
of the much lower default rates for European mortgages. Even with the
current financial distress in Europe, their mortgage default rates have
remained very low. The financial distress currently facing many
European banks is mainly the result of losses on construction loans and
sovereign debt, and not from home mortgages.
I expect private markets will deliver lower mortgage rates in the
U.S. for the same reason as in Europe. That is, private investors will
require the mortgage loans they purchase to be originated under high
underwriting standards. The decline in U.S. mortgage rates that will
result from greater safety will offset the pressure toward higher
mortgage rates that will result as the GSE subsidies are eliminated.
Equally importantly, the switch to safer mortgages will preclude any
future replay of the huge economic and social costs we are currently
facing from high foreclosure rates on risky mortgages.
As to the second alternative, proponents of new Government
guarantees for U.S. home mortgages often start by pointing out that the
private mortgage markets are currently moribund, and that they see no
mechanism through which the private markets can displace the current
dominant role of the GSEs. In contrast, I believe the current dominant
position of the GSEs is simply the result of crowding out, whereby any
entity with a Government guarantee will always displace comparable
private market activity. In my view, a private market revival will
follow rapidly once we remove the current GSE subsidies.
I would also like to shed light on two further issues--I would say
myths--raised by the proponents of expanded Government guarantees of
residential mortgages. The first issue is their contention that the 30-
year, fixed-rate, mortgage can exist only with a Government guarantee
program. This is in error for two reasons. First, the primary risk on
long-term, fixed-rate, mortgages is interest rate risk, and neither the
GSEs nor the proposed Government guarantees provide any protection
against this risk. Second, without even considering Government
guarantees, the credit risk on long-term mortgages is actually lower
than on, say, adjustable rate mortgages. The proof is that private
markets in the U.S. and Europe have long provided long-term, fixed-
rate, mortgages and at accessible interest rates.
The second issue raised by advocates of new Government guarantee is
that the guarantees are essential to the continuing existing of the so-
called TBA forward market for mortgage securitization. This is also in
error for two reasons. First, as long as the existing FHA and GNMA
programs exist, and most likely they will expand, the TBA market will
continue to exist. Second, and more fundamentally, the private markets
for hedging interest rate risk have proven highly satisfactory for
controlling the pipeline risk that arises in private label
securitization in the U.S. and covered bond issuance in Europe. I have
to add that the arguments to protect the existing TBA market primarily
reflect the wish of the vested interests in these markets to continue
to earn fees from running the market, while transferring the risk of
mortgage defaults to U.S. taxpayers.
I recognize, of course, that the U.S. housing and mortgage markets
are currently in a highly distressed state, and rapidly closing down
the GSEs would be inadvisable. There is, however, a very safe and
dependable mechanism to close down the GSEs, namely to reduce the
conforming loan limits in a steady sequence. For example, a reduction
in the conforming loan limits by $100,000 annually would basically
close down the GSEs in 7 years. This also has several additional
desirable features:
The GSE subsidies would remain on the smaller sized
mortgages for as long as possible.
The private market would anticipate the annual opening of
each new tier of the market.
The process could be stopped if it appeared the private
markets were not responding.
A very important first step would be to allow the recent temporary
increase in the conforming loan limits to expire as scheduled on
October 1 of this year.
I also recognize that other researchers and market participants do
not share my confidence in the private markets and they have proposed a
variety of Government guarantee plans to replace the GSEs. The least
intrusive of these plans proposes a temporary Government program of
catastrophe insurance, to allow the markets more time to stabilize,
before reverting to a fully private system. As it happens, catastrophe
insurance is a second area of my research focus and I am therefore
familiar with the successes and failures of the various Government
insurance programs.
In my opinion, the Terrorism Risk Reinsurance Act (TRIA) is
arguably the most successful of all the current Government insurance
programs. As you may recall, TRIA provides reinsurance against the
catastrophic losses that an insurer may suffer from providing terrorism
insurance on commercial buildings. It was enacted, following 9/11, to
provide insurers with the reinsurance that would allow them to provide
building owners coverage against losses from a terrorist attack. TRIA
has been successful in that the private market for terrorism insurance
is now active and efficient, with private insurers taking the first-
loss position for all events. Furthermore, taxpayer payments arise only
for the most extreme events where the insured losses would
substantially exceed the insured losses realized from 9/11. If a
catastrophe back-stop for the U.S. mortgage market is considered
critical, a TRIA-like plan could work well.
Unfortunately, I believe the actual plans for new Government
mortgage guarantee programs are likely to require the U.S. Government
itself to take the first-loss position, quite the opposite of providing
reinsurance against only catastrophic losses. This is the experience
with the National Flood Insurance Program on the Federal level and with
the California Earthquake Authority and the Florida Hurricane Fund on
the State level. While the authorizations for these programs all used
the right words--no subsidies, risk-based premium, sound capital,
etc.--in practice, they have all proven costly or ineffective.
Specifically, you will recall that, following Katrina, the National
Flood Insurance Program needed a $20 billion plus Federal appropriation
to cover its losses. The Florida Hurricane fund is similarly a ward of
the State of Florida. The California Earthquake Authority has had the
good luck of no major earthquakes, but it also has reached remarkably
few customers.
The common problem for these Government insurance programs is the
inability to maintain premiums at a true actuarial level. Instead,
inevitably, the underwriting standards and the premiums are reduced,
sooner or later leading to taxpayer costs. I fear a new Government
mortgage guarantee plan will follow this path, ultimately leading to
further taxpayer losses.
Not to end on such a somber note, let me say again I believe that
private markets can efficiently provide all the required mortgage
market functions, and that steady reductions in the conforming loan
limits is a safe and dependable means to make the transition.
PREPARED STATEMENT OF ADAM J. LEVITIN
Professor of Law, Georgetown University Law Center
September 13, 2011
Mr. Chairman, Ranking Member Shelby, Members of the Subcommittee:
My name is Adam Levitin, and I am a Professor of Law at the
Georgetown University Law Center in Washington, DC, where I teach
courses in structured finance, bankruptcy, and commercial law. I am
also a member of the Mortgage Finance Working Group sponsored by the
Center for American Progress, which has put forth a proposal for GSE
reform. I am here today, however, as an academic who has written
extensively on housing finance and am not testifying on behalf of the
Mortgage Finance Working Group.
As an initial matter, I want to be clear where I stand
ideologically on housing finance reform. In the ideal world, I would
unequivocally prefer to see the U.S. housing finance system financed
entirely with private capital. The Government's involvement in the U.S.
housing finance system carries with it serious concerns of moral hazard
and politicized underwriting.
I am nonetheless opposed to proposals to eliminate any Government
guarantee from the housing finance system. My opposition is based on
practical realities, not ideological grounds. It is important that we
not allow our ideological predilections get in the way of common sense.
Despite privatization's ideological appeal, there is a fundamental
problem with privatization proposals for the housing finance system:
they don't work. Indeed, fully private housing finance systems simply
do not exist in the developed world.
Following the siren's song of privatization would put the entire
U.S. economy in grave peril, as there is simply nowhere close to the
sufficient private risk capital willing to assume credit risk on U.S.
mortgages, even prime ones. The housing finance market is barely
stabilized with massive Government life support; it is no longer on the
operating table, but is in the financial equivalent of the intensive
care unit. Pulling the plug on the Government guarantee will kill the
housing market, not resurrect it. Eliminating the Government guarantee
risks the flight of over $6 trillion dollars from the U.S. housing
finance market--roughly half the dollars invested in U.S. mortgages.
\1\ Such an occurrence would be catastrophic for the U.S. economy.
---------------------------------------------------------------------------
\1\ Federal Reserve Statistical Release Z.1, Table. L.217, June 9,
2011.
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Along these lines, I wish to make five major points in my
testimony:
1. There is insufficient market demand for U.S. mortgage credit risk
to support the U.S. housing market absent some form of
Government guarantee.
2. The prime jumbo securitization market does not provide evidence
of the viability of a large-scale private securitization
market.
3. All five previous attempts at private mortgage securitization in
the United States failed because of the inability of investors
to manage credit risk in securitization.
4. There is no housing finance market anywhere in the developed
world in which there is neither an explicit nor an implicit
Government guarantee of at least catastrophic risk.
5. The choice we face is not guarantee versus no guarantee. It is
between an implicit and an explicit guarantee. A Government
guarantee is inevitable in the housing finance market, so it is
best to make the guarantee explicit and well-structured and
priced.
I. Lack of Market Demand for Mortgage Credit Risk
A mortgage carries two types of risks for investors: credit risk
and interest rate risk. Credit risk is the risk that the borrower will
default on the mortgage. Interest rate risk is the risk that interest
rates will either rise--in which case the interest rate the investor
earns on the mortgage will be below market--or that interest rates will
fall--in which case the mortgage will now be at an above market rate,
but with the borrower likely to refinance.
GSE and Ginnie Mae securitization divides the credit risk from the
interest rate risk. Investors in Fannie, Freddie, and Ginnie mortgage-
backed securities assume interest rate risk, but not credit risk. The
credit risk is retained by Fannie, Freddie, or Ginnie, which often are
insured for part or all of that risk, either through private mortgage
insurers or through FHA insurance and VA guarantees.
In contrast with the GSEs and Ginnie Mae, investors in private-
label mortgage-backed securities (PLS) assume both interest rate risk
and credit risk. Over 90 percent of PLS were rated AAA at issuance by
credit rating agencies. Investors who relied on these ratings
understood the credit risk on these PLS to be negligible because of the
quality of the underlying mortgages and various credit enhancements to
the PLS, such as senior-subordinate credit structures,
overcollateralization, excess spread accounts, and various types of
insurance.
What this means is that the overwhelming majority of investors in
the U.S. secondary mortgage market are not credit risk investors.
Investors in Fannie, Freddie, and Ginnie MBS are not credit risk
investors, and most investors in PLS did not perceive themselves as
assuming credit risk. Instead, U.S. mortgage investors are interest
rate risk investors.
Interest rate risk investors are very different types of investors
than credit risk investors. Investing in credit risk successfully
requires a different kind of diligence and expertise than interest rate
risk investment. A large portion of the investment in U.S. mortgages is
from by foreign investors. Chinese investment funds and Norwegian
pension plans, for example, are unlikely to seek to assume credit risk
on mortgages in a consumer credit market they do not know intimately.
But interest rate risk is something that foreign investors are far
better positioned to assume because it is highly correlated with
expectations about U.S. Federal Reserve discount rates.
Proponents of secondary mortgage market privatization would have
the Government guarantee completely eliminated, meaning that investors
would bear both interest rate risk and credit risk. \2\ There is no
evidence that there is a substantial body of capital eager to assume
credit risk on U.S. mortgages at any rate, much less at mortgage rates
that would not be prohibitively expensive for borrowers. Even if PLS
were structured to remove most credit risk from some securities, few
investors are likely to trust credit ratings on MBS in the foreseeable
future. What all of this means is that if the secondary mortgage market
were completely privatized, as much as $6 trillion in housing finance
investment--roughly half of the investment in the U.S. housing finance
market--would leave the U.S. market. The result would be a collapse on
a scale far worse than in 2008.
---------------------------------------------------------------------------
\2\ Notably some proponents of privatization would have a
Government regulatory role in the market. It is hard to fathom the
Government as regulating the market, but taking no responsibility then,
if the market collapses.
---------------------------------------------------------------------------
II. The Jumbo Market Does not Provide Evidence of the Viability of a
Large Scale Private Market
Mortgages that are too large to qualify for purchase by the GSEs
because of the statutory conforming loan limit are known as ``jumbo''
mortgages. There is a private securitization market in jumbo mortgages.
In the jumbo market, investors assume both interest risk and credit
risk. Advocates of privatization have suggested that the existence of
the jumbo market is proof that a securitization market can function
without a Government guarantee.
The existence of the private jumbo mortgage securitization market
is does not demonstrate that there is sufficient private risk capital
to support the entire U.S. housing market. The jumbo market is smaller
and benefits from the existence of the Government supported market. The
shape of the jumbo market in fact indicates that there is a quite
limited demand of credit risk on U.S. mortgages, and certainly not
enough to sustain the entire market absent a Government guarantee.
The jumbo market overall is substantially smaller than the
conforming market. From 2001-2007, there were roughly two times as many
dollars of conforming loans originated as jumbo loans, and in sheer
origination dollars, the jumbo market has never comprised more than a
quarter of the U.S. market. \3\ Jumbo loans are more expensive than
conforming loans; currently there is around a 60 basis point spread
between jumbo and conforming rates, despite jumbos often being of
higher credit quality. While some of that spread (which at times has
been as small as 20 basis points) is a function of the GSE guarantee,
it is also a reflection of limited demand for U.S. jumbo mortgages--
meaning a limited demand for credit risk. If all U.S. mortgage
investors were willing to assume credit risk, we should tighter credit
spreads between prime jumbos and conventional conforming loans, and
investors would be willing to assume the credit risk on jumbos for the
additional return.
---------------------------------------------------------------------------
\3\ Inside Mortgage Finance, Mortgage Market Statistical Annual.
---------------------------------------------------------------------------
What's more, the securitization rate for jumbo loans is
substantially lower, which has resulted in a much smaller amount of
jumbo mortgage-backed securities issued than GSE MBS. (See Figures 1
and 2). Jumbos lower securitization rate is itself strong evidence of
limited investor demand of credit risk on U.S. mortgages--at least at
interest rates less than those borne on subprime loans.
Proponents of privatization also ignore that the jumbo market does
benefit from a Government guarantee indirectly in multiple ways. The
jumbo market has long aped the standards set by the GSEs in the
conforming market, including amortization, maturity lengths, and
appraisal standards. Indeed, the real benefit of the GSEs was not in
terms of cost savings through efficiency or the Government guarantee
but in standard setting; but for the GSEs, the 30-year fixed-rate
mortgage would likely not exist. The standardization achieved by the
conforming market has enabled the jumbo To Be Announced (TBA) market,
which lets borrowers lock in their interest rates months before
closing. The jumbo TBA market piggybacks on the existence of the highly
liquid conforming TBA market. Whether this would continue absent a
Government guaranteed TBA market is questionable.
Finally, the stability of housing prices in the jumbo market
benefits from the Government guarantee in the conforming market.
Housing prices of nearby properties are highly correlated. The ability
for buyers or owners to obtain financing or refinancing significantly
affects property values, so to the extent that the Government guarantee
has stabilized the conforming market and thus bolstered the property
values of properties with conforming mortgages, there is a spill-over
that benefits properties with jumbo mortgages. The systemic stability
that comes from the Government guarantee has benefited the jumbo
market. Indeed, the virtual disappearance of the jumbo market following
the financial collapse in 2008 draws into question whether this market
is in fact viable; the spill-over benefits from the guarantee in the
conforming market have not been enough to resuscitate the jumbo market.
The jumbo market demonstrates that there are some investors who are
willing to assume credit risk on U.S. mortgages. But investors in the
vast majority of the $6 trillion plus in U.S. mortgage securities
outstanding are interest rate investors, and it is difficult to imagine
them transforming into credit risk investors over several years, much
less immediately. Sufficiently high yields will no doubt lure some of
them into accepting credit risk-but that translates into much higher
mortgage interest rates, which in turn increases the credit risk on the
mortgages. And even higher yields will not be sufficient to induce
investors who have no interest in assuming credit risk to buy into the
U.S. mortgage market. The fundamental problem with any housing finance
privatization proposal is that there just isn't sufficient capital
interested in credit risk on U.S. mortgages. Ideology cannot substitute
for market demand.
III. We've Tried This Five Times Before Without Success\4\
Privatization advocates pay little attention to the history of
housing finance in the United States, but it holds a cautionary tale.
The United States has had four previous experiences with private
mortgage securitization. These experiences have been long-forgotten,
but it is important to note that every time it ended in disaster, as
did the fifth experiment, that of private label mortgage securitization
in the 2000s. There is little reason to believe that a sixth charge of
the Light Brigade will be more successful.
---------------------------------------------------------------------------
\4\ This section of the testimony derives from Adam J. Levitin and
Susan M. Wachter, ``The Rise, Fall, and Return of the Public Option in
Housing Finance'', in Regulatory Breakdown? The Crisis of Confidence in
U.S. Regulation, Cary Coglianese, ed. (University of Pennsylvania
Press, forthcoming 2012).
---------------------------------------------------------------------------
The U.S. did not develop a national secondary mortgage market until
the New Deal. By the mid-nineteenth century, however, deep secondary
mortgage markets were well-established in both France (the State-
chartered joint-stock monopoly Credit Foncier) and the German states
(cooperative borrowers' associations called Landschaften and private
joint-stock banks in Prussia and Bavaria), and ``[b]y 1900 the French
and German market for mortgage-backed securities was larger than the
corporate bond market and comparable in size to markets for Government
debt.'' \5\ Although there were significant design differences in the
European systems, they all operated on a basic principle-securities
were issued by dedicated mortgage origination entities. Investors
therefore assumed the credit risk of the origination entities. Because
these entities' assets were primarily mortgages, the real credit risk
assumed by the investors was that on the mortgages.
---------------------------------------------------------------------------
\5\ Kenneth A. Snowden, ``Mortgage Securitization in the United
States: Twentieth Century Developments in Historical Perspective'', in
Anglo-American Financial Systems: Institutions and Markets in the
Twentieth Century, Michael D. Bordo and Richard Sylla, Eds. 261, 270
(1995).
---------------------------------------------------------------------------
The European systems were successful because they ensured that
investors perceived them as free of default risk. This was done through
two mechanisms. First, there were close links between the mortgage
origination entities and the state. Mortgage investors thus believed
there to be an implicit state guarantee of payment on the securities
they held. Second, and relatedly, the state required heavy regulation
of the mortgage market entities, including underwriting standards,
overcollateralization of securities, capital requirements, dedicated
sinking funds, auditing, and management qualifications. \6\
---------------------------------------------------------------------------
\6\ Id. at 271-273
---------------------------------------------------------------------------
There were attempts to import the Credit Foncier model to the U.S.
in both the 1870s and 1880s. Mortgage companies that originated and
serviced the loans, pledging them against ``debentures . . . issued in
series backed by specific mortgage pools.'' \7\ These attempts failed
as the originators often violated their stated underwriting standards
and securitized only the lowest quality collateral. \8\
---------------------------------------------------------------------------
\7\ Id. at 278.
\8\ Id. at 279.
---------------------------------------------------------------------------
A third attempt at establishing a private secondary market was
undertaken in the 1900s by New York title guarantee companies, which
expanded beyond title insurance into mortgage and bond credit
insurance. \9\ The title companies originated mortgages, insured them,
and then sold debt securities backed by the mortgages. The favored form
were participation certificates that allocated the cash flow from the
underlying mortgage pool in proportionate shares, much like later
Fannie Mae/Freddie Mac Pass-Thru Certificates. \10\ These participation
certificates thus created a secondary market in mortgages. The
purchasers of the participation certificates believed that they were
assuming the credit risk of the title company that insured the
mortgages, rather than the borrower, so they were not particularly
concerned with the quality of the mortgage underwriting.
---------------------------------------------------------------------------
\9\ James Graaskamp, ``Development and Structure of Mortgage Loan
Guarantee Insurance in the United States'', 34 J. Risk and Ins. 47, 49
(1967).
\10\ Id. at 49-50; Snowden, supra note 5, at 284.
---------------------------------------------------------------------------
As defaults in the housing market rose in 1928-1934, the guaranteed
participation certificate market collapsed. Poor regulation and
malfeasance by the title companies made it impossible to weather a
market downturn. The title companies were thinly capitalized and
routinely violated their underwriting standards, and engaged in
assorted other shenanigans that resonate of the excesses of the 2000s
market. \11\
---------------------------------------------------------------------------
\11\ Graaskamp, supra note 9, at 51; Snowden, supra note 5, at
285.
---------------------------------------------------------------------------
In addition to the guaranteed participation certificates, another
type of secondary market instrument emerged in the 1920s, the single-
property real estate bond. Whereas participation certificates were
issued against a pool of mortgages, single-property real estate bonds
were backed by a single building, a distinction roughly analogous to
that between securitization and project finance. Single-property real
estate bonds were used to finance large construction projects, such as
the skyscrapers of New York and Chicago. \12\ This system too collapsed
in a series of scandals in the 1920s and '30s that made clear that
underwriting standards had long been ignored. Their enduring legacy of
the single-property real estate bonds is the Trust Indenture Act of
1939, the preamble to which is an indictment of the industry's
practices.
---------------------------------------------------------------------------
\12\ Snowden, supra note 5, at 286.
---------------------------------------------------------------------------
Finally, in the 2000s we saw an explosive growth of private-label
mortgage securitization. PLS great from 21 percent of MBS issuance in
2003 to 56 percent--a majority of the market--in 2006. PLS operated in
a largely unregulated space and underwriting standards quickly
collapsed. The growth in PLS ate away at the GSEs' market share, which
encouraged the GSEs to be more aggressive in their underwriting. This
competition between the GSEs and the unregulated PLS market proved
fatal to the entire financial system. \13\ Early American secondary
mortgage markets share two critical commonalities with each other and
with the PLS market in the 2000s. First, they were virtually
unregulated, and what regulation existed was wholly inadequate to
ensuring prudent operations. And second, they all suffered from an
inability to maintain underwriting standards, as the loan originators
had no capital at risk in the mortgages themselves, regulation was
scant, and investors in the mortgage-backed bonds lacked the ability to
monitor the origination process or the collateral. In contrast,
successful European structures, ``were either publicly financed or
sponsored and were subject to intense regulatory scrutiny.'' \14\ The
historical evidence strongly indicates that both a Government guarantee
and a robust, market-wide regulatory system is necessary to ensure a
stable, liquid secondary market.
---------------------------------------------------------------------------
\13\ Regarding the causes of the housing bubble and its collapse,
see, Adam J. Levitin and Susan M. Wachter, ``Explaining the Housing
Bubble'', 100 Georgetown Law Journal (forthcoming 2012), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401.
\14\ Snowden, supra note 5, at 263.
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IV. All Developed Countries Implicitly or Explicitly Guarantee Their
Housing Financed Systems
A truly private housing finance system is a pipedream. It simply
does not exist in any developed country and never has. Every developed
country either explicitly or implicitly guarantees some part of its
housing finance system. In some countries, like Canada, the guarantee
is explicit--and priced--and the market is regulated to protect the
Government from excessive risk exposure. In other countries, the
guarantee is implicit. It is difficult to prove an implicit guarantee;
the very nature of it is that there is no clear proof. One can look at
spreads between mortgage debt and Government debt, for example, but
that is not necessarily conclusive. Indeed, in the United States, GSE
debt was explicitly not guaranteed by the Federal Government . . .
until it was.
Proponents of privatizing the housing finance system and
eliminating the Government guarantee will generally point to Germany
and Denmark as examples of housing finance systems without a guarantee
that have widely available long-term, fixed-rate mortgages. \15\
Unfortunately, this view of the German and Danish housing finance
systems is incorrect. Germany and Denmark both turn out to have been
latent implicit guarantee cases prior to October 2010, at which point
they became examples of explicit guarantees.
---------------------------------------------------------------------------
\15\ E.g., Peter J. Wallison, ``A New Housing Finance System for
the United States'', Mercatus Center Working Paper No. 11-08, at http:/
/mercatus.org/sites/default/files/publication/wp1108-a-new-housing-
finance-system-for-the-united-states_0.pdf, at 10 (``Neither Denmark
nor Germany backs any part of the mortgage financing system, which
seems to work well because of the regulatory assurances of mortgage
quality.'').
---------------------------------------------------------------------------
In October 2008, Germany created a Teutonic TARP known as the
``Special Fund Financial Market Stabilization,'' or SoFFin (its German
acronym) to bail out its banks. SoFFin provided nearly =150 billion to
support ten financial institutions' liabilities, including those of one
issuer of covered mortgage bonds and of three Landesbanks (another type
of German mortgage lender). \16\ Germany was not prepared to allow even
one of its numerous covered bond issuers to fail, even though any
single issuer was arguably not a systemically important financial
institution.
---------------------------------------------------------------------------
\16\ See, Bundesanstalt fur Finanzdienstleistunsaufsicht, ``Annual
Report of the Federal Financial Supervisory Authority'', (2008),
available at http://www.bafin.de/cln_152/nn_720486/SharedDocs/
Downloads/EN/Service/Jahresberichte/2008/
annualreport_08_complete,templateId=raw,property=publicationFile.pdf/
annualreport_08_complete.pdf.
---------------------------------------------------------------------------
Denmark also announced a broad guarantee of all deposits and senior
debt issued by its banks in October 2008. \17\ Denmark has a robust
mortgage lending system financed by covered bonds--bonds issued by
banks against mortgage collateral held on balance sheet. Formally, the
Danish guarantee did not apply covered bonds, only to the deposits and
senior debts of the banks that issued them. The functional reality of
this arrangement, however, was to guarantee the covered bonds by
guaranteeing that the issuers would have sufficient assets and
liquidity to meet their covered bond payment obligations so that the
covered bondholders would never have to look to their cover pools of
collateral for recovery.
---------------------------------------------------------------------------
\17\ See, Neelie Kroes, ``Guarantee Scheme for Banks in Denmark'',
European Commission Memorandum, State Aid NN51/2008--Denmark, available
at http://ec.europa.eu/community_law/state_aids/comp-2008/nn051-08.pdf.
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There is no housing finance system in the developed world in which
there is neither an implicit nor explicit guarantee, much less one
which ensures the widespread availability of long-term, fixed-rate
mortgages.
V. The Inevitability of a Guarantee Means It Should Be Explicit and
Priced
The lack of a formal guarantee in good times is no guarantee
against the application of a formal guarantee in bad times. Housing
finance is simply too central to the economies of developed countries
and to their social stability to permit market collapse. Put
differently, there's no way to guarantee against a guarantee.
Therefore, it's better to accept that we are going to be living
with a guarantee sooner or later--whenever the next crisis occurs--and
to design a system that properly prices for it now. In 2008, the market
saw that when threatened with collapse, the U.S. Government blinked.
And despite Congress's best efforts and Dodd-Frank's no-bailout
provisions (which still leave the door open for sub rosa bailouts),
it's hard to believe that if threatened with massive economic collapse,
the U.S. Government wouldn't bail out the financial system again. As
distasteful as bailouts are, we as a society are simply too scared of
the potential consequences of not bailing out the system to find out
what would happen.
What this means is that if we are really serious about avoiding
moral hazard, we actually have to have an explicit guarantee and price
for it. Counterintuitively, an explicit and properly priced guarantee
is the best protection against moral hazard. Otherwise, we will find
ourselves in the next crisis with a private system that is suddenly
guaranteed by the Government, and which has never had to pay for it,
despite everyone in the market knowing that if things get really bad,
Uncle Sam will come bail them out.
It is thus important to recognize, however, that the Government is
not assuming more risk with an explicit guarantee. Instead, an explicit
guarantee is just formalizing what the market assumes and hopefully
pricing for it.
Conclusion
Try as we may, we cannot escape either history or the reality that
the U.S. Government will always bail out its housing finance system if
it gets into trouble. We did that in 1932-34. We did it with the S&Ls
in the 1980s. We did it again in 2008. Catastrophic risk in housing
finance is inevitably socialized, so it is best to recognized that
truism and adapt our regulatory system to mitigate the risk. Pretending
that it won't happen again is hardly a solution.
We do not have to like the existence of a Government guarantee in
housing finance. But the choice we face is between an implicit and an
explicit guarantee, not between a guarantee and no guarantee. All
Government guarantees have clear problems--moral hazard because the
Government holds the credit risk, while private parties hold the
upside, and the danger of politicized underwriting. There are ways to
try to guard against both problems. For example, moral hazard can be
alleviated through use of deductibles and copayments--have first-loss
private risk capital or loss splitting between the Government and
private capital. Administrative structures can guard against
politicized underwriting. Those risk mitigants, however, require an
explicit guarantee.
For better or worse, though, we need to accept that some form of a
Government guarantee, even if only for catastrophic losses, is required
in our housing finance system. The unique nature of housing finance as
an enormous asset class that affects a wide swath of citizens and
economic and social stability means that no U.S. Government will permit
the market's collapse: it would be economic and political suicide. The
question then is not whether there should be a guarantee--we have one
whether we want it or not--but how it should be structured.
Additional Material Supplied for the Record
PREPARED STATEMENT SUBMITTED BY THE SECURITIES INDUSTRY AND FINANCIAL
MARKETS ASSOCIATION