Housing Finance: Potential Reforms to Mortgage Markets

Key Points

• The actions taken in the aftermath of the Great Recession allayed the economic burdens of the financial crisis, but the housing market still remains vulnerable to systemic problems that have not been effectively addressed.
• While access to credit was justifiably tightened following the financial crisis, evidence suggests that new restrictions and standards may be excessively hindering homeownership growth.
• Since 2008, the secondary mortgage market has seen a significant withdrawal of private capital and a greater involvement of Fannie Mae and Freddie Mac. Several proposals have outlined fundamental overhauls to restore the presence of private capital, but policymakers must reform the market to foster competition and accountability without sacrificing stability and liquidity.

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Housing Finance: Potential Reforms to Mortgage Markets

Background

The mortgage finance system can be broken down into two entities that work together: the primary mortgage market and the secondary mortgage market. The primary market is where mortgage originators, such as banks, directly finance borrowers with loans. The secondary market, meanwhile, consists of institutions that provide mortgage originators with liquidity primarily by buying their mortgages and pooling them as mortgage-backed securities. These institutions sell these securities, which are insured against default, to investors, who then own the claim to the principal and interest payments from the packaged mortgages. The secondary market includes groups like Fannie Mae and Freddie Mac, chartered as Government-Sponsored Enterprises (GSEs), and ensures that mortgage originators have a steady amount of funds to finance new homebuyers. Ginnie Mae, a government-owned corporation, helps facilitate the secondary mortgage market by providing a guarantee on qualifying securities. Ginnie Mae specifically provides a guarantee with the full faith and credit of the government on securities backed by mortgages insured by federal programs, such as the Federal Housing Administration and Department of Veterans Affairs. This government backing reduces the risk on mortgage-backed securities, attracting more investors to the market.

Figure 1: Mortgage Market Operation

Changes in Housing Finance Since the Financial Crisis

In 2008, Fannie Mae and Freddie Mac faced the risk of insolvency as the subprime mortgage crisis unfolded. In order to stabilize the GSEs, the government placed Fannie Mae and Freddie Mac into conservatorship through a $187 billion investment in the form of Senior Preferred Stock. Since 2008, however, the housing system has not been overhauled in the same ways as other parts of the financial sector. While the steps taken eight years ago to bolster the secondary mortgage market were viewed as short-term emergency actions, the market still has not undergone significant reform.

As a result, the amount of private capital backing the secondary mortgage market has immensely decreased. As of December 2014, the federal government backed 70 percent of mortgages in the market, two-thirds of which is attributed to Fannie Mae and Freddie Mac. While this number marked a decline from the 90 percent of mortgages backed by the government in 2009, it still far exceeded the government’s historical involvement. Indeed, during the two decades prior to the Great Recession, about 50 percent of mortgages were backed by private capital.1

This decline in private mortgage securitization has caused banks to keep more of the new mortgages not sold to the GSEs on their balance sheets, increasing their exposure to the risk of mortgage defaults. Moreover, mortgage lenders have increased lending requirements to mitigate the risk associated with lingering economic uncertainty since the financial crisis. Lenders have specifically increased credit score and down payment standards for prospective borrowers.2

Figure 2: Shares of the Market for New Single-Family Residential Mortgages, by Guarantor or Holder

Source: Congressional Budget Office based on data from Inside Mortgage Finance.

To promote a greater contribution of private capital in the secondary mortgage market, lawmakers have implemented new policies for the mortgage GSEs. They decreased the limit of high-cost area mortgages that Fannie Mae and Freddie Mac are allowed to purchase from $729,750 to $625,500. Additionally, they increased the GSEs’ guarantee fees—fees that mortgage-backed security providers charge as insurance against losses—so that, by January 2014, the GSEs’ average guarantee fee on new mortgages had increased from 20 basis points of a loan’s principal to 55 basis points. Lawmakers hope these actions, along with other policies, will enable private institutions to better compete with Fannie Mae and Freddie Mac and draw more private capital to the market.3

The Federal Housing Administration (FHA), a government agency that provides insurance for some mortgages, has grown in its involvement since the financial crisis. The FHA insures mortgages with less stringent requirements such as lower down payments, so it is instrumental in financing loans for many first-time mortgage borrowers. While the FHA insured just 4 percent of new mortgages in the years before the crisis, it insured about 12 percent of new mortgages in 2013.4 Due to the rising mortgage delinquencies in the buildup to the financial crisis, the FHA has increased mortgage insurance premiums and underwriting standards since 2008.

Current Challenges in Housing Finance

In addition to the lack of private capital in the secondary mortgage market and its corresponding impact as discussed above, the housing industry faces many other challenges. While it was rational to tighten lending and underwriting standards in the aftermath of the subprime mortgage crisis, there are fears that the mortgage market may have excessively limited the flow of credit to potential borrowers. The net percentage of lenders that reported a tightening of credit standards—some of which was in response to new regulations—for residential mortgages sharply increased from 2006 to 2010. Although some lenders have begun to loosen standards for prime residential mortgages—loans given to homebuyers with strong credit—since the financial crisis, they have reported no comparable loosening of standards for other types of mortgages.5

Researchers estimate a borrower constrained by lack of wealth, low income or weak credit would be 30 percent less likely to become a homeowner due to the marginal effect of those constraints after the Great Recession, compared to 23 percent less likely prior to the Great Recession.6 Such market behavior restricts homeownership opportunities—a cornerstone of the American economy—for consumers with low credit scores or low incomes, who are disproportionately minority individuals. Furthermore, given previous studies’ contentions that certain borrowers have faced racial and ethnic discrimination, there are concerns that new developments with regards to tightened credit may further deepen discriminatory practices in the mortgage market.7

As tight credit has dampened homeownership rates, increasing student loan debt has put an additional burden on prospective homebuyers. From 2001 to 2013, the share of adults between the ages of 20 and 39 with student loan debt increased from 22 percent to 39 percent while the real average student loan debt increased over 75 percent.8 Under a new qualified mortgage rule, lenders must evaluate borrowers’ ability to repay loans by examining several factors such as their debt-to-income ratio. This provision has accentuated the growing impact of student debt on the housing market. Moreover, future homeownership growth greatly relies on homebuyers’ abilities to endure the lingering effects of the financial crisis on income growth and credit availability.

Potential Short-Term Solutions

One option for reducing the role of the GSEs and drawing more private capital is the implementation of an auction, in which Fannie Mae and Freddie Mac sell off a finite amount of guarantees for new eligible mortgages each year. Guarantees would be sold to those bidders—mortgage originators looking to sell loans—that value them the most and are thus willing to pay the highest fees. Over time, the GSEs would gradually decrease the amount of guarantees they auctioned off, limiting their presence in the secondary market.9

Another potential solution is the development of a market for deep coverage mortgage insurance. As laid out in its charters, the GSEs are required to obtain a credit enhancement on loans with less than a 20 percent down payment—or a loan-to-value (LTV) ratio greater than 80 percent.10 Most frequently, this enhancement takes the form of mortgage insurance, in which an insurer receives a premium from a borrower and pays out a claim to the GSE in the event of default. For example, on a 90 percent LTV (10 percent down payment), standard insurance may cover 25 percent, reducing the GSEs’ exposure to 67.5 percent LTV.

U.S. Mortgage Insurers (USMI) has proposed a deep coverage mortgage insurance mechanism, which would reduce the GSEs’ exposure to losses on low down payment loans to 50 percent LTV. On the 90 percent LTV loan as described above, deep coverage could insure 44.4 percent (compared to 25 percent coverage by standard insurance) to reduce the GSEs’ exposure to 50 percent LTV.

Potential Long-Term Solutions

In a report to Congress in 2011, the Obama administration laid out three possible options for long-term housing finance reform.11

Under the first option, private markets would be the primary source for mortgage credit. The government’s presence would be limited to insuring or guaranteeing mortgages for underserved borrowers with moderate- or low-income levels. The proposed Protecting American Taxpayers and Homeowners (PATH) Act, for example, would have curtailed the government’s role by checking the FHA’s activities and establishing the National Mortgage Market Utility to oversee a secondary market dominated by private capital. The nongovernmental group would also act as an intermediary to match mortgage originators with investors.12 On July 23, 2013, the bill was voted out of the Financial Services Committee.

Figure 3: Mortgage Market under the PATH Act

The second option would take the basis of the first option—a government pullback—but add a government guarantee mechanism. This backstop would ensure credit access during instability in the housing market. While the mechanism would be limited to minimal activity during normal economic conditions, it would have the capacity to expand and manage a larger portion of the market should private capital draw back during periods of financial instability. To implement this backstop, the government could set its guarantee fee higher than those of private options so that it would only be competitive in a market lacking private capital. Another option would be for the government to reduce the amount of public insurance sold to private sources during stable economic times but increase it during times of volatility.

Figure 4: Mortgage Market with Government Guarantee Mechanism

Under the third option, the government would supplement the first option with reinsurance for securities of a given segment of eligible mortgages. The government would sell reinsurance for an explicit guarantee fee to sources of private capital, which would bear the primary credit risk.

Figure 5: Mortgage Market with Government Reinsurance

Both the backstop mechanism in option two and the catastrophic reinsurance in option three can be classified as hybrid securitization systems. The proposed legislation by Senate Banking Chairman Tim Johnson and Senator Mike Crapo in 2014 would have implemented a hybrid securitization system. The Johnson-Crapo bill would replace the GSEs with a federal insurer that would provide a backstop for eligible mortgage pools that held private capital in a 10 percent first-loss position.

In addition to those options outlined in the 2011 report to Congress, the Urban Institute has proposed a model to support homeownership growth and minimize government risk exposure. Under the model, an entity, Ginnie Mae 2.0, would absorb the necessary operations of the GSEs and manage these operations alongside the current functions of Ginnie Mae. Ginnie Mae 2.0 would provide a catastrophic-risk federal guarantee on conventional mortgage-backed securities and require that mortgages carry a private-credit enhancement before passing through the secondary mortgage market or a government agency.13

Assessment of Potential Short-Term Solutions

An auction in which the GSEs sold limited guarantees presents significant potential benefits. By having bidders compete for guarantees, the GSEs could charge a fee closer to the real market price rather than a predetermined estimate, leading to greater efficiency. Nevertheless, such an auction would carry the operational difficulty of discerning differences in credit risk among mortgages. The auction would have to control for such variations by tracking loan characteristics such as LTV and credit score. Failure to do so may cause the GSEs to provide guarantees on risky mortgages without receiving sufficient fees.14

Meanwhile, analysis estimates the premium for deep coverage mortgage insurance to be 18 basis points (higher than that of standard coverage), while the guarantee fee charged by the GSEs would decrease by approximately 33 basis points. Despite the premium increase, a borrower would save about $8 per month on a $225,000 loan and anywhere from $2,000 to $2,500 over the life of such a loan. Additionally, deep coverage insurance would provide GSEs nearly twice the coverage they would get with standard insurance, thereby decreasing the amount of committed capital needed to mitigate risk exposure by about 75 percent.15 The development of a deep coverage mortgage insurance market, however, relies on an increase in private capital, which would allow insurers to offer more coverage and offset the GSEs’ reduction of capital.

Table 1: Illustrative Example of Impact on the Average Portfolio Loan ($225,000)

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	Standard Coverage Mortgage Insurance	Deep Coverage Mortgage Insurance	Net Impact
Estimated Premium Rate (bp)	65	83	18
Estimated Total GSE G-Fee (bp)	64	31	(33)
Total Borrower Payment ($)	$1,182	$1,174	($8)
Estimated Total Lifetime Payments ($)	$15,737	$13,442	($2,295)

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Source: Milliman, Inc.

Assessment of Potential Long-Term Solutions

Each of the long-term options for reform discussed above poses different benefits and challenges to the housing sector.

Among the benefits of the first option are its reduction of perverse incentives and direct taxpayer exposure to private losses. Without a government backing, the private sector is less susceptible to the moral hazard of taking on unnecessary levels of risk. Additionally, taxpayers would only be exposed to the risk of loans guaranteed by the FHA and other programs rather than the national mortgage market at large. Supporters of the PATH Act, specifically, argued that a large government is unnecessary because uniformity and transparency can maintain liquidity in the secondary market.16 Despite these benefits, opponents argue that the potential costs associated with the first option are too large. The government would not be able effectively intervene during a time of crisis and credit access would shrink, they contend. A housing slump during which the government could not maintain sufficient mortgage credit availability would be at risk of developing into an even more severe downturn. Although most housing reform options would lead to higher mortgage rates, this option would cause the most substantial increase in mortgage rates—for most borrowers—among the three proposals discussed in the 2011 report to Congress.17

The guarantee mechanism outlined under the second option would enable the government to ensure sufficient mortgage credit availability during a crisis without all the costs it would incur guaranteeing mortgages during normal economic times. Moreover, during normal times, the absence of a broad-based government guarantee would reduce moral hazard throughout the housing sector and diminish the risk of a crisis. However, operating an organization with the flexibility and efficiency required to maintain a lean presence in most economic conditions but expand when necessary presents a challenge.18

Of the three proposals described in the 2011 report to Congress, the reinsurance option would provide borrowers with access to credit at the least expensive mortgage rates. Government reinsurance would draw more investors, increasing liquidity in the market. This increased liquidity would help offset some of the increase in mortgage pricing stemming from the cost of reinsurance premiums and first-loss private capital. Moreover, the constant presence of government reinsurance would make it easy to expand during times of economic instability, unlike the government backstop in option two. While reinsurance could increase market liquidity, it could also cause an excessive outflow of capital away from other industries while leading to overvaluation in the housing market. In addition, reinsurance could lead to moral hazard, wherein private guarantors take excessive risks and let taxpayers shoulder the cost of potential losses.19

Unlike many proposals for reform which call for the formation of new government guarantors, the Urban Institute’s proposal suggests using an existing entity: Ginnie Mae. Ginnie Mae 2.0 would institute changes such as a government guarantee on conventional mortgage-backed securities with minimal disruption because the mortgage market is already accustomed to Ginnie Mae. Meanwhile, Ginnie Mae 2.0 would limit taxpayers’ exposure by providing only catastrophic-risk guarantees and requiring private-credit enhancement on mortgages. Additionally, Ginnie Mae—a government-owned corporation—aims to break even, whereas the shareholder model of the GSEs induces a profit motive. Because Ginnie Mae need only break even and has no incentive to reach higher profitability targets, conventional mortgage costs would likely go down. Nevertheless, this proposal to expand Ginnie Mae’s operations would require a legislative overhaul and logistical changes that could prove significantly challenging.20

“There are tradeoffs to all of these proposals,” said Michael Fratantoni, chief economist at the Mortgage Bankers Association. “A private market would result in more innovation and competition but probably less stability, and we saw the impact an unstable housing finance system can have worldwide.” Fratantoni noted that a hybrid-securitization system, such as the one proposed in the Johnson-Crapo bill, could ensure market liquidity through a government backstop but also eliminate taxpayers’ risk exposure by allowing private capital to absorb potential losses.

Conclusion

Research shows that the housing market has yet to fully recover since the Great Recession and the subsequent responses of the U.S. government and the financial sector. While these stopgap responses served to stabilize the market amid crisis, the lack of systemic improvements has posed new challenges in the housing market. Specifically, inaction since the conservatorship of Fannie Mae and Freddie Mac has led to an outflow of private capital from the secondary mortgage market, increasing taxpayers’ risk to potential losses. Additionally, lenders have tightened access to credit through increased credit score and down payment standards, making it harder for prospective homebuyers to obtain loans. Moreover, the absence of robust private competition in the housing market has diminished its ability to balance both stability and growth. In order to address this problem, lawmakers must surgically reform the housing market, ensuring it reaps the benefits of private capital without being susceptible to the same risks that caused the subprime mortgage crisis.

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1. Congressional Budget Office, “Transitioning to Alternative Structures for Housing Finance,” December 2014, available at: https://www.cbo.gov/publication/49765  ↩

2. Ibid.  ↩

3. Ibid.  ↩

4. Ibid.  ↩

5. Federal Reserve System, “Senior Loan Officer Opinion Survey on Bank Lending Practices,” April 2016, available at: http://www.federalreserve.gov/boarddocs/snloansurvey/201605/fullreport.pdf  ↩

6. “Borrowing Constraints and Homeownership,” May 2016, available at: https://www.aeaweb.org/articles?id=10.1257/aer.p20161084  ↩

7. What Works Collaborative, “Critical Housing Finance Challenges for Policymakers,” April 2012, available at: http://www.jchs.harvard.edu/sites/jchs.harvard.edu/files/w12-2_herbert_belsky_apgar.pdf  ↩

8. Joint Center for Housing Studies of Harvard University, “The State of the Nation’s Housing,” 2016, available at: http://www.jchs.harvard.edu/sites/jchs.harvard.edu/files/jchs_2016_state_of_the_nations_housing_lowres.pdf  ↩

9. Congressional Budget Office, “Transitioning to Alternative Structures for Housing Finance,” December 2014, available at: https://www.cbo.gov/publication/49765

10. Federal National Mortgage Association Charter Act, Title II of National Housing Act, 12 U.S.C. 1716 et seq., as amended through July 21, 2010.  ↩

11. U.S. Department of the Treasury, “Reforming America’s Housing Finance Market,” February 2011, available at: https://www.treasury.gov/initiatives/Documents/Reforming%20America%27s%20Housing%20Finance%20Market.pdf  ↩

12. Diana Hancock and Wayne Passmore. 2016. “Macroprudential Mortgage-Backed Securitization: Can it Work?” In Principles of Housing Finance Reform, Susan M. Wachter and Joseph Tracy, editors. Philadelphia: University of Pennsylvania Press.

13. Urban Institute, “Housing Finance Reform Incubator,” July 2016, available at: http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000853-%20Housing-Finance-Reform-Incubator.pdf  ↩

14. Congressional Budget Office, “Transitioning to Alternative Structures for Housing Finance,” December 2014, available at: https://www.cbo.gov/publication/49765  ↩

15. Milliman, Inc., Analysis of Deep Coverage Mortgage Insurance,” October 2015, available at: http://www.usmi.org/wp-content/uploads/2015/10/Milliman-Report-Analysis-of-Deep-Coverage-MI-FINAL.pdf  ↩

16. Diana Hancock and Wayne Passmore. 2016. “Macroprudential Mortgage-Backed Securitization: Can it Work?” In Principles of Housing Finance Reform, Susan M. Wachter and Joseph Tracy, editors. Philadelphia: University of Pennsylvania Press.  ↩

17. U.S. Department of the Treasury, “Reforming America’s Housing Finance Market,” February 2011, available at: https://www.treasury.gov/initiatives/Documents/Reforming%20America%27s%20Housing%20Finance%20Market.pdf  ↩

18. Ibid.  ↩

19. Ibid.  ↩

20. Urban Institute, “Housing Finance Reform Incubator,” July 2016, available at: http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000853-%20Housing-Finance-Reform-Incubator.pdf  ↩