The Senate's housing reform bill, to be formally unveiled Tuesday, signals the start of substantive legislative activity nearly five years after Fannie Mae and Freddie Mac entered conservatorship. What the proposal gets right is creating a federal catastrophic guarantee on mortgage securities. But it misses an opportunity to achieve a broad-sweeping and holistic reform of the housing finance system. 

Political expediency aside, the bill's failure to integrate all federal mortgage insurance programs under one roof risks perpetuating pervasive adverse selection against the Federal Housing Administration to the detriment of the U.S. taxpayer and FHA borrower.  Moreover, the legislation leaves untouched existing post-crisis policy that has greatly limited the ability to leverage and radically reshape a critical component of housing finance, namely the Federal Home Loan Bank System. 

Ironically, the confirmation of the next head of the Federal Housing Finance Agency may play as great a role in shaping the long-term success of secondary market reform as any legislation to reform Fannie Mae and Freddie Mac. The continued politicization of housing finance at this critical juncture will severely undercut any structural enhancements to the market.

A sticking point in getting a bill out of Congress on housing reform is the nature of the federal guarantee. 

Proponents of a fully privatized market have pointed to other types of mortgage financing such as covered bonds as evidence that U.S. housing would do just fine without any government subsidy.  However, these arguments overlook how investors in mortgage securities respond to economic shocks. 

A study by Federal Reserve researchers Wayne Passmore and Diana Hancock on the role of government guarantees shows how investor uncertainty over credit quality of mortgage securities can amplify market dislocations during periods of economic stress by subjecting markets to liquidity and asset price shocks. Inclusion of a catastrophic guarantee in the Senate bill greatly mitigates the potential for procyclical investor behavior while limiting taxpayer exposure to only grave economic circumstances, such as the mortgage crisis, which clearly transcend the ability of financial markets to maintain liquidity and credit.

Despite getting the form of the guarantee right, the bill introduced by Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., unfortunately perpetuates dysfunction in housing finance in other important areas. 

First, creation of the Federal Mortgage Insurance Corp. that has among its duties guarantee pricing and insurance fund management will extend the perennial issue of adverse selection against FHA. The FHA is woefully under-resourced to match up well against private investors and the resources of the FMIC, which would eventually be able to attract top talent. This will continue to push higher-risk loans to FHA, leaving the agency struggling to recapitalize the fund while shackled to politically-driven housing policy within the Department of Housing and Urban Development.  To avoid that fate, FHA should have been brought in under the FMIC.

Another flaw in Corker-Warner relates to oversight of the Federal Home Loan Bank System.  Since Congress merged the regulators for Fannie and Freddie and the FHLBs, the latter have remained out of the policy limelight.  During the mortgage crisis the FHLBs served a critical countercyclical function in providing advances, or loans made to lender members of the FHLBs, when liquidity dried up in the secondary market.  While a few FHLBs suffered near-death experiences, none have failed and the unique joint and several liability structure of the system offers an opportunity for the FHLBs to play a major role in housing finance going forward if given the chance to do so. 

However, in part overshadowed by the misfortunes of their larger government-sponsored enterprise siblings, the FHLBs remain relegated to somewhat secondary status with the regulatory and policymaking arena set out under Corker-Warner.  Instead, the bill should have spun the regulatory oversight of the FHLBs off to a standalone agency.  Given the new secondary market duties of the proposed FMIC, it is likely that the new corporation will not pursue reforms of the FHLB system that could increase the effectiveness of these institutions under the new secondary finance structure.

One of the biggest operational issues facing the FMIC that should not be underestimated is matching the right resources with the new securitization duties of the corporation.  Transferring staff and resources from the FHFA to the FMIC will not come close to ensuring that guarantees are priced well, that underwriting policies and the insurance fund are effectively managed or that the operational aspects of overseeing a complex securitization platform are executed with precision.  The staff at FHFA is well-trained, but those backgrounds are not matched well with the types of transactional and capital markets expertise required of the FMIC under Corker-Warner.  To avoid falling into the same trap as FHA, the new FMIC will need to recruit a large number of staff from the GSEs and other secondary market participants with that expertise.  And that starts with the head of the new agency. 

To succeed, the FMIC will require leaders with direct experience in mortgage secondary-market finance rather than affordable housing advocacy.  Placing a politician in the role to head an agency designated to fold in to the FMIC runs the risk of having FMIC suffer the same fate as FHA.  We've waited five years to get housing finance reform right, and while we may not yet be there, it can be rendered ineffective quickly with the wrong leadership.

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