[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

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


                 Available at: http: //www.fdsys.gov /



                  U.S. GOVERNMENT PRINTING OFFICE
73-756                    WASHINGTON : 2012
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing Office, 
http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202ï¿½09512ï¿½091800, or 866ï¿½09512ï¿½091800 (toll-free). E-mail, [email protected].  


            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

                              ----------                              

                      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?

                              ----------                              


                      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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    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









































