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How to Bring Private Capital Back to Mortgages

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Third in a series

With housing showing signs of recovery, policymakers need to get serious about addressing the biggest impediment to long-term stability in this sector, namely the federal government's role in housing finance in the future. 

This issue has many dimensions including which borrowers merit some form of subsidy, the type of subsidy provided and level. Housing remains one of the most heavily subsidized sectors of the economy if you consider the guarantees, tax deductions, and other direct and indirect benefits it provides to borrowers, lenders and other market participants. Beyond these fundamental decisions, there are aspects of the delivery mechanism for housing finance that must also be sorted out between the private and public sectors once the extent of federal involvement is determined. This would include the design and structure for mortgage security issuance and provision of credit guarantees, among other considerations which is the focus of this column.

Politics and emotions aside for a moment, there is no optimal solution to the form and extent of any federal guarantee in housing. This is really as much a matter of social welfare as it is of economics and so a variety of outcomes are possible. However, there are a number of bad outcomes if underlying deficiencies in the current process persist under a new structure. Some important guideposts for the new framework must ensure stability and liquidity for housing finance and ensure that certain less-fortunate segments of society have access to mortgage credit and affordable housing, which includes both ownership and renting alternatives.

Interestingly enough, much of the housing finance system actually performed quite well over an extensive period of time before this last housing boom exposed a number of critical deficiencies.  One important fact to keep in mind is that a major portion of the mortgage-backed security market was supported without any federal guarantee, notwithstanding the Too Big to Fail issue. The private label securitization market grew enormously during the boom with private guarantees such as bond insurance wraps.  The size of this market at its peak indicates that an explicit or implicit federal guarantee is not necessary for a vibrant securitization market to exist.  And while investors remain spooked by the utter collapse of the private-label market in the years since the crisis, such a market could once again emerge healthier assuming certain safeguards are built in.

There were many deficiencies in the PLS market. Several structural issues would need to be remedied before it could return. 

First, the PLS security issuance process was not sufficiently standardized.  As noted by the Federal Housing Finance Agency, the pooling and servicing agreements varied greatly in form and content and not surprising they differentially affected investors, borrowers, servicers and trustees. 

A second and lesser discussed concern is the excessive concentration each security had to an individual lender's loan underwriting and sourcing process.  Loans originated by lenders with abnormally deficient underwriting processes would be bundled together to form the underlying collateral of a particular PLS.  The devastating effects on credit losses resulting from flawed underwriting processes are clearly apparent to investors in securities issued by lenders with aberrant lending practices. 

A solution to both the disparity among private label PSAs and the lender concentration effect would be to allow for a common issuing entity to establish a standard PSA and provide lender and loan pooling, aggregation and MBS issuance services, among others. 

The importance of such a market utility is clear and while its disposition as a purely private organization, public or hybrid may be debated, it could be accommodated in a broader role for Ginnie Mae as outlined in my last column, given that the agency performs these functions for the Federal Housing Administration and the Department of Veterans Affairs today. With some restructuring and resource augmentation, Ginnie could provide these capabilities consistently to the entire securitization market. 

In some sense packaging and securitizing mortgages is nothing more than a financial production factory.  What allows such activities to profitably flourish are economies of scale and consistency in the manufacturing process, which minimizes product defects and hence promotes investor interest in the product set. The FHFA's initiatives to promote a standardized securitization platform is thus on the right track.

Of course the return of private capital in a world without any federal guarantee hinges in part on the disposition of the GSEs.  While an important issue, it merits separate focus for another column. Likewise, the role of the private sector in providing credit guarantees and the role of the credit rating agencies in the process is critical to jump starting a securitization market void of any direct federal subsidy other than for FHA and VA loans.  They too deserve to be taken up in a separate column in this series.

A natural concern that arises from solutions involving private guarantees only is market instability during periods of economic stress as witnessed during the crisis.  Without FHA and the GSEs, the flight of private capital from the mortgage market would have made things even worse (which is admittedly hard to imagine given the magnitude of the housing crash).  The FHA was able, even in a very ad hoc way, to surge in along with Fannie Mae and Freddie Mac and thus maintain access to credit and order in markets even during the worst days of the crisis.  As mentioned in my last column, with some changes to FHA's structure, its role could be enhanced to provide a more effective countercyclical balance to the ebb and flow of the private market than it provided recently.  And while it can be further debated whether the appropriate share of FHA should be 10% 20% or some other percentage of the market on average, there is a role for a federal guarantee to support the social welfare objectives mentioned earlier. 

The degree of federal support for housing has been a third rail issue for the industry and housing policy advocates, often sparking heated debate on this issue for good reason.  None of our public, private or quasi-public institutions successfully navigated the crisis that ensued, which is probably one of the reasons why this issue has yet to be tackled head on.  But by incorporating certain features in a system that ensure consistency in the pooling and issuance of securities, remove incentives to engage in adverse selection, fraud or process neglect, there are ways to drastically reduce the taxpayer's exposure to mortgage markets for the long term.

Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland. 

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Comments (5)
If you take subsidies and politics out of the mortgage market the only public role left is an appropriate and consistent regulatory environment that is not easilly gamed to avoid capital requirements. The markets can do and historically did the rest.
Posted by kvillani | Thursday, January 03 2013 at 3:51PM ET
These are sensible proposals, independent of the subsidy questions.

The problem is that no one trusts the banks any more. Their record of theft, fraud and corruption, especially among too big to fail banks, is just too great a hurdle for seasoned investors with sufficient capital to restart this market.

It pains me to say it, but we are stuck with a government backed mortgage business until this miasma of corruption and greed is either forgotten or cleaned out. I hope it's the latter, but as things are going, I fear it will be the former.
Posted by masaccio | Thursday, January 03 2013 at 3:58PM ET
Private capital is sitting in the wings ready to invest in the mortgage market. However, the current uncertainty surrounding the fate of the GSEs, and the role of government has put a hold on investment. It is clear that
Posted by seljer | Friday, January 04 2013 at 7:24PM ET
Unfortunately, My last comment was inadvertently sent before completion. It is clear that the first priority is to establish a comprehensive national housing policy clearly defining the role of government, lower and middle income housing objectives and the role of GNMA, Fannie and Freddie. A review of history might be helpful. Mission confusion/conflict was one of the major problems facing Fannie and Freddie. Congress and the Administration continued to set public purpose goals for the GSEs including aggressive home ownership goals for low and middle income families. Pressure from Congress and the loss of market share, led to their late entry into the sub-prime market. The GSEs are not free from blame in the sub-prime debacle. Once the GSEs began to portfolio loans, margins for conforming loans declined to a point where lenders lost money on originations. As a result lenders sought higher margins through exotic, highly toxic products with Wall Street support.

The PLS market performed well prior to the advent of sub-prime originations.
Posted by seljer | Monday, January 07 2013 at 11:43AM ET
Are average prices rising because more rich people, who aren't affected by the tightened mortgage rules, can afford the expensive homes? How many lower cost homes are actualy being sold? Who's buying these homes? These would help explain the reason for fewer sales and online loans no credit check applyings. It would be good to read a real 'news' article which tries to analyse and understand the reasons.
Posted by ValenS | Friday, March 29 2013 at 7:33AM ET
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