More than two years after the collapse of Fannie Mae and Freddie Mac, the Obama administration offered three models on Friday for how to fix the housing finance market while significantly limiting the government’s role in providing mortgage credit to prospective homebuyers.
In its white paper, the White House offered no outright endorsement of any single plan, but instead laid out the pros and cons of each approach. It also provided relatively few details for how its three options would work. Although the paper was 31 pages, only 4 actually dealt with its various options, with the rest summing up the history of the mortgage market, the government sponsored enterprises’ collapse and recently enacted regulatory reform provisions.
In a surprise, the plan also briefly mentioned the Federal Home Loan Bank System, whose members have argued it worked well during the financial crisis and should not be touched. The administration said it supported limiting the level of advances for large members and reducing the size of the Home Loan Banks’ investment portfolios, which have spurred losses at several of the 12 banks.
All three options for the broader housing finance system called for the elimination of Fannie Mae and Freddie Mac, but differed on how much of a footprint the government should retain in the mortgage market. The paper explicitly rejected full privatization or nationalization, but acknowledged it was difficult to juggle competing interests and strike a balance in re-creating a stable mortgage market that kept taxpayer risk at bay and provided access to mortgages to families.
“These priorities are not always well aligned, so we will be forced to make difficult decisions as we choose the path for the long-term reform,” the paper stated. “Designing choices alone will not tell us what the best path is for the future of our mortgage system, for we are faced with difficult trade-offs.”
Under this scenario, the administration said policymakers could create a privatized system where government backing would be limited only to the Federal Housing Administration and other programs targeted for creditworthy lower- and moderate-income borrowers.
This approach would minimize distortions in capital allocation, reduce moral hazard in mortgage lending and limit direct taxpayer exposure to private lenders’ losses, the administration said.
Still, there would be potentially severe consequences, including reducing access to mortgage credit and increasing the difficultly for homebuyers to obtain a traditional 30-year fixed-rate mortgage.
The government may also lack the ability to effectively step in during a financial crisis to ensure access to capital, the administration said.
“It is unlikely that they could play a still more robust role as might be needed in the absence of broader government support in the market,” the paper said. “And absent sufficient government support to mitigate a credit crisis, there would be a greater risk of a more severe downturn, and thus the risk of greater cost to the taxpayer.”
Like the first approach, the administration sees a heavily privatized system with assistance from FHA, but also the creation of a guarantee mechanism that would expand during periods of economic stress. That means the government would have the ability “to scale up to a large share of the market as private capital withdraws in times of stress.”
This would correct the first option’s problem of the government’s inability to step in to help soften a contraction during a crisis, but it is unclear exactly how such a guarantee mechanism would function.
“There remains a significant operational challenge in designing and managing an organization that can remain small during normal economic times, yet with the capacity to take on much, much more business quickly during these times of need,” the paper wrote.
Additionally, access to credit, especially 30-year fixed-rate mortgages, would also likely be more expensive under such a plan, the administration noted.
While the final option also called for a dramatically reduced government role in the mortgage market, limiting direct intervention to FHA and other targeted programs, it would include a catastrophic reinsurance plan.
Under this scenario, a group of private mortgage guarantor companies would provide guarantees for securities backed by mortgages that meet strict underwriting standards. A government entity would then provide reinsurance to the holders of the securities, which would only be paid if shareholders were entirely wiped out. The government would charge a premium for its reinsurance which would be used to offset losses to taxpayers.
This would alleviate other problems caused by the previous two options, providing for the lowest-cost access to mortgage credit and allowing the government the ability to step in the event of a crisis.
“The capital requirements, oversight of the private mortgage guarantors, and premiums collected to cover future losses together help to reduce the risk to the taxpayer,” the paper said.
Still, like its predecessors, it is not without drawbacks.
“The broad reinsurance of private-lending activity by its nature exposes the government to risk and moral hazard,” the paper said. “If the oversight of the private mortgage guarantors is inadequate or the pricing of the reinsurance too low then private actors in the market may take on excessive risk and the taxpayer could again bear the cost.”
Stepping Back Government Support
The administration’s paper also laid out various steps to gradually reduce the government’s role in the mortgage market and shed light on “significant weaknesses” in the Federal Home Loan Bank System.
To help reduce the government’s prevalence in the mortgage market, the administration recommended the use of a variety of policy levers including increasing guarantee fee pricing, decreasing conforming loan limits, and increasing down payment requirements to help draw in more private capital to the market.
In addition to winding down Fannie and Freddie, the administration also called on the need to make a series of reforms to FHA including shrinking its market share, currently around 30%, to its pre-crisis levels of between 10% to 15%.
Even with such targets, the administration acknowledged the difficulty in getting from point A to point B.
“Determining the appropriate path on how to responsibly wind down Fannie Mae and Freddie Mac and reduce the size of FHA will be challenging and will require great care,” the white paper said.
The administration also made clear it would make recommendations on the “appropriate mix of incentives and deadlines” for the Federal Housing Finance Agency to “pursue to wind down these institutions at a pace that recognizes the fragile state of the housing market,” the paper said.
It also added that under its plan, there would be “sufficient funding to ensure the orderly and deliberate wind down of Fannie Mae and Freddie Mac.”
In regards to the Home Loan Banks, the administration said it supported efforts to limit the size of their advances to the largest institutions. It also recommended that a member institution be barred from belonging to more than one Home Loan Bank.
Noting losses caused by the banks’ investment portfolios, the administration said such portfolios “should be reduced and their composition altered to better serve the FHLB’s mission of providing liquidity and access to capital for insured depository institutions.”