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The debate over GSE reform is beginning

By Mike Konczal

As opposed to the conservative meme, the financial crisis was not simply about providing housing for low-income folks. Or even regular folks. It was a bubble-bust cycle that was in every category of credit -- CRE, credit cards, auto loans, etc. The common denominator for all of these problems was the emergence of a new lending channel that lacked sufficient risk regulation and safeguards against liquidity runs -- the shadow banking system and the originate-to-distribute private securitization lending channel that it funded.

But in the wake of the collapse, the U.S. housing market is a wreck, and nobody is sure how to fix it. On April 14, the U.S. Treasury Department released a list of seven questions to the public about the future of the U.S. housing market (criterion for each answer excluded here, in document):

1. How should federal housing finance objectives be prioritized in the context of the broader objectives of housing policy?

2. What role should the federal government play in supporting a stable, well-functioning housing finance system and what risks, if any, should the federal government bear in meeting its housing finance objectives?

3. Should the government approach differ across different segments of the market, and if so, how?

4. How should the current organization of the housing finance system be improved?

5. How should the housing finance system support sound market practices?

6. What is the best way for the housing finance system to help ensure consumers are protected from unfair, abusive or deceptive practices?

7. Do housing finance systems in other countries offer insights that can help inform U.S. reform choices?

Now people are going to begin the process of answering them. These questions are essential. The private mechanism of securitization has been destroyed, collapsed in the wake of the financial crisis and all the problems and conflicts that existed leading into it. Mortgage wealth is one of the primary means of intergenerational wealth transfer in this country. And ideally, the GSEs would provide liquidity to the housing market in the middle of a crisis (FHA has had to step in and do what the GSEs should be doing right now as the major banks have had to step back.)

I can already hear you saying, "Whatever, I'm never going to be a homeowner in the bleak 21st-century job market," but remember that all this liquidity and stabilization handles the rental market, too. Where you live. (Or your parents' mortgage or rental, if you live with them.) So there's no getting outside of this question.

Two papers are out discussing how to go about reforming the housing GSEs.

Center for American Progress

The first proposal is in this paper from Center for American Progress, "A Responsible Market for Housing Finance."

Our paper differs from proposals offered by others in at least two fundamental ways.1 First, we offer a more comprehensive vision of the housing finance system of the future, one that goes beyond only “GSE reform” (revising the government-sponsored enterprises Fannie Mae and Freddie Mac). The structural flaws exposed by the current mortgage crisis were largely -- albeit not exclusively -- found in the private-label mortgage securitization markets. Thus, any proposal that seeks to resolve the problems in our mortgage system must address the entire secondary mortgage market.

Second, while other proposals primarily aim to address the objective of liquidity -- attracting investment capital sufficient to meet the housing finance needs of U.S. housing -- our ideas are designed to fulfill a broader set of public purposes, including systemic stability and affordable housing finance.

Under this framework, privately owned and capitalized monoline Chartered Mortgage Issuers would be given exclusive charters to issue government-guaranteed MBS in order to ensure that a deep and liquid secondary market provides capital for favored mortgages. Key features of CMIs would include explicit government guarantee on MBS to ensure liquidity. The federal government would provide an explicit guarantee of the timely payment of interest and principal on MBS issued by the CMIs.

As David Min of the Center for American Progress explained to me, if you look at three goals of housing as liquidity, stability and affordability, the private market on its own has never been able to get any of them. Prior to the 1930s mortgages were scarce and the typical loan was a five-year, 50 percent down bullet loan where the homeowner would never pay down any principal (sound like a subprime loan with never paying off principal?). Major bubble-bust cycles occurred every five to seven years in the absence of countercyclical liquidity. Literally every sophisticated mortgage system in the world has a significant level of government involvement in it. Conservatives have pointed to Denmark, Canada and Germany as examples we might look to for a private system, but they ignore the fact that those countries have enormous subsidies as well as fencing, rules and regulations for how the mortgage model works.

I like this paper because it goes beyond just the GSEs and looks at the entire housing market, a scope of vision that is necessary for when the reform effort will hit full swing. It's a great place to start learning about the issues on the table for GSE reform, which will be one of the major financial reform battles of 2011.


The second proposal is from e21: Economic Policies for the 21st Century. It's written by Donald Marron and Phillip Swagel. Here's a good summary:

The two firms would become private companies that buy conforming mortgages and bundle them into securities that are eligible for government backing. The reformed firms would not have the investment portfolios that were the main source of risk under their previous structure. The federal government would offer a guarantee on mortgage-backed securities composed of conforming loans. This guarantee would be explicit, backed by the full faith and credit of the United States. To compensate taxpayers for taking on housing risk, Fannie and Freddie would pay an actuarially fair fee to the government in return for the guarantee, and the shareholders of the firms would take losses before the government guarantee kicks in. Other private firms such as bank subsidiaries would be allowed to compete by securitizing conforming loans and purchasing the government guarantee. Over time, entry into these activities would help ensure that the benefits of the government support are passed through to homeowners and would reduce the risk that the failure of any one firm would pose a threat to the housing market or the overall economy.

As Marron writes on his blog, "We were trying to fix what we see as the major flaws of the old model (lack of transparency, uncompensated taxpayer risk, misalignment of incentives), while maintaining its benefits (e.g., that mortgage credit kept flowing for conforming loans even during the depths of the crisis and that government-insured MBS are a useful asset class when the Fed wants to do quantitative /credit easing). In addition, we felt that some backstop role for the
government is inevitable as a matter of political economics and that it ought to be explicit at the outset."

Images of e21's model, before (the current state) and after:

The liquidity backstop mechanism is important. One of the obvious goals of the GSEs is the idea of being a discount window for the housing market; make it explicit that this is a goal and getting them back into that role, instead of the role of yet another drinker at the punchbowl of the credit cycle, is crucial to fixing this market.

A big question is how much they should be involved in creating conforming mortgages; would providing liquidity to private firms with more visible government subsidies just recreate the churning equity-stripping market of the 2004 for the 21st century?

-- Mike Konczal is a fellow at the Roosevelt Institute. He blogs about finance, economics and other topics at Rortybomb and New Deal 2.0, and you can follow him on Twitter.

By Washington Post editor  |  May 26, 2010; 11:07 AM ET
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"As opposed to the conservative meme, the financial crisis was not simply about providing housing for low-income folks."

I'm not sure that's an accurate representation of the conservative position. In fact, I'm not sure there is an aggregate position on the cause of the financial crisis from either side of the aisle, but even conservatives who focus on housing aren't saying "housing for low-income folks", they're talking about government incentives to offer mortgages to people who would not realistically qualify for the specific mortgage, or level of housing, they were getting. It's not about low-income housing--it's about giving people, often at levels way above low-income, mortgages that they could not afford. If you earn $50,000 a year, you should not qualify for a $500,000 loan. It's not realistic that a mortgage should be 90% of your monthly income. Getting folks, even middle and upper-middle class folks, into those kinds of loans is a recipe for future default.

Incentives meant to help low-income people may have ended up incentivizing those kinds of loans, but I don't think the problem is affordable housing for poor people, or that any significant number of conservative are putting the case quite that way. At least, not any conservative whose taken a serious look at the problem. And we've weathered housing bubbles before--there's clearly more going on here. Real estate depressions don't inherently mean 10% employment, or the bankruptcy of European nations and the potential collapse of the Euro. There's more going on here than GSEs or affordable housing.

However, the answer to the real estate market is not to perpetuate Fannie Mae and Freddie Mac, and then give them what amounts to a blank check to be payed by taxpayers. Irrespective of the once-noble goals of these GSEs when they began.

Posted by: Kevin_Willis | May 26, 2010 11:26 AM | Report abuse

There ought to be a single goal of housing policy: make sure people can get housing. On the supply side, whatever we are doing is just fine: the aggregate vacancy rate is well over 5%. However, this is in part because prices are still too high: if prices were right, people would stop doubling up and move into those vacancies. So the current focus should be affordability.

The problem with affordability is that subsidizing home purchases doesn't work, since in true Econ-101 fashion these subsidies flow primarily to increased selling prices. So worrying about the GSEs or FHA deeply misspecifies the issue. The real issue is how to get prices down without further destabilizing the system.

Posted by: wcwhiner | May 26, 2010 11:49 AM | Report abuse

A good solution for the GSEs: Dial it back. Remember when things actually seemed to be working? Go back to what worked. Done.

Posted by: Kevin_Willis | May 26, 2010 12:04 PM | Report abuse


it is easier for liberals to paint conservatives in that manner though.

My question for the author of this post is this is all well and good but if we don't fix the Federal Reserve's and the banks ability to manipulate the interest rates aren't we just tidying up the edges of the Titanic and setting her back on course for the next iceberg?

Posted by: visionbrkr | May 26, 2010 12:16 PM | Report abuse

Lending standards are key.

Frankly the rules should apply to the entire mortgage market -- not just the GSEs. Part of the problem is that the secondary market exploded in the 2000s and ended up causing a deterioration of lending standards across the industry. Without whole-sale reforms, Fannie and Freddie are likely to be engaged in a future race to the bottom.

The end game should be to provide liquidity to low-risk buyers at levels that they can afford.

No lender should be able to offer a NINJA loan with 103 or 107 percent financing on a Jumbo loan.

I don't know what the cap should be -- I agree with Kevin that $50K income should never qualify for a $500K mortgage -- but I figure you want to require a 10-20 percent down-payment, only offer vanilla 15 or 30 year fixed loans, perhaps you can index annual increases on the upper cap based on a combination of interest rate shifts and movement in the median wage (you could even tie the wage to local markets).

Posted by: JPRS | May 26, 2010 1:43 PM | Report abuse


I don't know if Mike reads the comments or not, but it's my understanding that mortgage interest rates are only indirectly connected to the Fed discount and short-term fund rate (the exception being over the past two years when the Fed started buying MBS directly from the GSEs in order to keep rates low).

The main factor that influences mortgage rates are the sales of MBS's themselves to private investors.

The Fed has its own set of problems; however, my sense is that you can remove a lot the systemic risk just by raising standards and limiting the range of consumer mortgage products (e.g. eliminate ARMs except for HIGHLY qualified borrowers with substantial down-payments -- e.g. 50 percent -- and make the 15 and 30 year fixed the default for everyone else).

Posted by: JPRS | May 26, 2010 2:13 PM | Report abuse

Mr. Konczal-

The GSEs (in conservatorship) are definitely providing liquidity - they fund on the order of 60 -75 percent of mortgages right now, including the bulk of any refinancings. The FHA is as well. The difference is that the GSEs in general funding lower risk loans (as in the past). On the other hand, one could argue that the FHA borrowers are receiving less implicity subsidy because they pay significant mortgage insurance premiums. The GSEs are passing on low interest rates but not requiring mortgage insurance premiums for many borrowers (or requiring relatively modest ones to those with less than 20% down).

Even pre-conservatorship, banks were not providing much longer term liquidity, except through warehouse lending. They were and are mostly just selling loans. Big banks were not holding many loans in portfolio (though are holding even fewer now).

Posted by: idw3 | May 26, 2010 7:07 PM | Report abuse

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