Federal Housing Finance Agency Acting Director Ed DeMarco has once again delivered an insightful commentary on the possible direction of the housing finance system devoid of political overtones.
His speech last week at the Federal Reserve Bank of Chicago’s annual bank structure conference serves as further reminder of why it is critically important to have someone at the helm of the FHFA who has a deep understanding of housing finance and capital markets.
DeMarco laid out the pros and cons of two alternatives for housing finance, an issuer-based and securities-based approach. However, neither option in the form described would be viable for ensuring long-term stability in housing markets.
The widespread failure of safety and soundness regulators across the board in the years preceding the financial crisis, including the predecessor of the FHFA, the Office of Federal Housing Enterprise Oversight, suggests that an issuer-based model dependent upon sound oversight is unlikely to prevent another crisis.
Nor can a pure securities-based private sector approach provide sufficient financing of mortgages without a catastrophic federal guarantee and process standardization. Moreover, housing finance reform must be viewed in light of the full spectrum of mortgage financing including securitization and portfolio lending.
Establishing an issuer-based model with multiple government-chartered companies able to issue mortgage securities is really an enhanced version of the current GSE model that would once again expose financial markets to significant systemic risk. First, the plan assumes that the federal government can effectively regulate these entities. One constant between the thrift crisis of the 1980s and the more recent financial crisis was the systemic failure of safety and soundness financial regulators to monitor the performance of federally chartered institutions. Massive regulatory reform after the thrift crisis was thought at the time to greatly lessen the potential for any future failures in the banking system; however, for a variety of reasons, regulators share equal responsibility for the financial crisis with the institutions that ran into trouble. After all, with examination teams sitting on-site at the largest regulated firms, it is surprising that there isn’t more focus on those examiners’ actions during the crisis.
It is therefore critical that effective housing finance reform not assume the existence of a strong regulatory apparatus because there are no guarantees that this can be maintained over a long period of time – no matter what current agency heads may state publicly.
A second fatal flaw in an issuer-based model is the systemic risk exposure from concentrating mortgage risk again in the hands of a few entities. While there may be no direct federal guarantee on any entity’s debt, the collapse of a single issuer could severely disrupt financial markets. While the mortgage security would be protected with the federal guarantee, a multiple issuer model dependent upon robust regulatory oversight puts in place a system prone to mutual assured destructive competition and market confusion. Weak regulation over a limited number of monoline entities attempting to differentiate themselves on the basis of price and/or service never has a happy ending.
A private sector securities-based model likewise is poised for failure without strong infrastructure and standardization or a catastrophic federal guarantee. A stable, liquid market for mortgage securities large enough to finance the U.S. housing market requires standardization and guarantees. Significant variations in data describing underlying collateral and its performance, contractual terms on loan servicing and representations and warranties greatly undermine market stability over time. We saw that while such process imperfections may not be problematic during benign economic times, they ultimately destabilize markets during downturns as investor uncertainty increases and confidence wanes. And while a private-sector securities model protects taxpayers from paying the tab on mortgage losses, if we want to maintain a mortgage market comparable to the one we currently have, it is unrealistic to assume the private sector can completely support it.
With a few modifications, the securities-based model has the best chance at providing a stable source of mortgage financing over all periods. Viewing housing finance as a large interconnected system, as critical to the economic security of the country as national defense or the U.S. highway system, the government should establish a separate federal corporation to set pricing of fully guaranteed mortgages for low-income borrowers, and a catastrophic guarantee for all other securitized mortgages. Credit, counterparty and servicing standards would be set by this corporation. Lenders would access the corporation for security issuance, bearing all credit risk except under catastrophic conditions. This would promote an active market for credit risk-sharing arrangements that would further reduce systemic risk by distributing credit risk broadly across market participants. Further the Ginnie Mae securitization platform should be leveraged and expanded to become a public utility for all mortgage securities given its successful track record.
With such changes, the housing finance system could finally turn the corner and get beyond the zombie securitization market that exists today.
Clifford Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.