New Report: A Responsible Market for Housing Finance

Washington, D.C.–(ENEWSPF)–January 27, 2011. By The Mortgage Finance Working Group, sponsored by the Center for American Progress

Read the full report (pdf) Download the introduction and summary (pdf)

In the years prior to the Great Depression, American housing finance was characterized by wild boom-and-bust cycles, regionally disparate prices, and short-term balloon mortgages that severely restricted opportunities for average Americans to own a home. For close to 70 years following the reforms of the 1930s, that all changed. Well into the late 1990s, mortgage finance was continuously available, under terms and at prices that made sustainable homeownership available. A critically important element of this system was the development, starting in about 1970, of an effective secondary market for home mortgages—a marketplace where individual home mortgages are sold by lenders and packaged into mortgage-backed securities that can be sold to investors in the United States and around the world. This pool of capital provided widening opportunities for wealth accumulation for many American families, and supported significant, although not necessarily sufficient, quantities of affordable rental housing.

For some communities in our country, however, credit was constrained, leaving credit worthy borrowers behind. During the 1980s and 1990s, Community Development Financial Institutions, Community Development Corporations, and nonprofit organizations of all types, in partnership with local governments, mortgage lenders, and secondary market institutions demonstrated successful ways to discern the credit-worthy borrowers in underserved communities and to extend them safe, affordable mortgages. Unfortunately, just as these good innovations were picking up speed, so too were predatory mortgage finance products such as adjustable-rate mortgages with pricing gimmicks designed to encourage potential homeowners to borrow far more than they could manage.

These disastrous products exploded in volume, stole market share from the mainstream housing finance system, launched a precarious race to the bottom, and drove out sustainable affordable lending. Most of the predatory products were packaged into so-called private label mortgage-backed securities—securities finance giants. In 2008, the system collapsed in a hail of badly designed loans, mispriced risk, excessive leverage, and lack of supervision, greatly exacerbating the Great Recession.

Today, the federal government backstops some 90 percent of all home mortgage loans. Nearly half of the new home loans are guaranteed by the Federal Housing Administration, the Department of Veterans Affairs, or the Department of Agriculture’s Rural Housing Services programs. Almost all other home mortgage loans and most mortgage refinancings are financed through Fannie Mae and Freddie Mac, both of which are now in government conservatorship. The private secondary market in home mortgages disappeared in 2008 and remains moribund. Fannie Mae and Freddie Mac also now purchase more than 80 percent of all multifamily mortgages, loans to owners, and developers of rental residential properties. This new status quo is unsustainable.

We have the knowledge and the tools to create an American housing finance system that will be stable over the ups and downs of the economy—a system that relies upon private capital to equitably serve homeowners, renters and landlords, lenders, investors, and the larger American economy while promoting residential integration, the elimination of housing discrimination, and the provision of safe, decent, and affordable housing in all urban, suburban, and rural communities. The first step taken was Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, named after its two main sponsors, Sen. Christopher Dodd (D-CT) and Rep. Barney Frank (D-MA), which provides for creditable supervision of our nation’s banking and securities system, including greater standardization and transparency of mortgage-backed securities, and enhanced consumer protection for home mortgages.

The next step is to move away from our current nationalized mortgage finance system toward a system that once again relies on private-sector capital, through both depository institutions and the secondary mortgage market, to provide the bulk of mortgage finance for American homeowners and owners of rental property. This new mortgage finance system should be guided by five overarching principles:

  • Liquidity: Provide participants in the capital markets with the confidence to deliver a reliable supply of capital to ensure access to mortgage credit, every day and in every community, through large and small lenders alike
  • Stability: Rein in excessive risk taking and promote reasonable products backed by sufficient capital to protect our economy from destructive boom-bust cycles such as the one we are now struggling to overcome, and the ones that used to plague our economy before the reforms of the 1930s
  • Transparency and standardization: Require underwriting, documentation, and analytical standards that are clear and consistent across the board so consumers, investors, and regulators can accurately assess and price risk, and regulators can hold institutions accountable for maintaining an appropriate level of capital
  • Affordability: Ensure access to reasonably priced financing for both homeownership and rental housing
  • Consumer protection: Ensure that the system supports the long-term best interest of all borrowers and consumers and protects against predatory practices

These principles form the framework for this proposal. We also focus on three specific goals:

  • Preserving the availability of 30-year fixed-rate mortgages, which allow families to fix their housing costs and thus better plan for their futures in an ever more volatile economy
  • Rebalancing U.S. housing policy so that private markets are the primary source of decent affordable rental housing, with public support where deep subsidy is needed
  • Ensuring that a broad array of large and small mortgage lenders (such as community banks, credit unions, and Community Development Financial Institutions) have access to secondary market finance so that they can continue to provide single- and multifamily mortgage loans in every community across our country

To develop a new mortgage finance system based on these principles and with these goals in mind, we approached the problem by dividing both the homeownership and rental housing markets into three parts:

  • Underserved borrowers or tenants, whose housing needs (whether as homeowners or renters) may require some direct government support
  • Middle-market borrowers or tenants whose housing needs require secondary market liquidity and long-term finance, both of which can be achieved through a limited government backstop of the mortgage finance marketplace
  • Higher income and wealthy borrowers and tenants, whose housing needs require government financial intervention only when mortgage markets freeze

Purchasing a home is one of the most important financial decisions most Americans will ever make. But the transactions between borrower and lender that happen in this primary market represent only a part of the housing finance system. To fund mortgage loans for homeowners and support rental housing, lenders need access to a pool of capital that in turn depends on a transparent, effectively regulated secondary market. This paper is concerned primarily with the secondary market, and in particular, the mortgage-backed securities market, which currently has about $9 trillion in securities outstanding.

Today (as before the crisis), the largest participants in this housing finance market are Fannie Mae and Freddie Mac. These two mortgage finance giants are currently in conservatorship and essentially owned by the federal government. They perform an array of secondary market functions that together provide financing for a significant portion of our nation’s rental housing and enable Americans to access long-term, fixed-rate mortgage finance. Access to stable, long-term mortages is a key to household stability and a means to accumulate assets that support retirement, education, and other family responsibilities.

Specifically, Fannie and Freddie buy loans from lenders. They hold some of these loans, particularly multifamily loans, on their balance sheet. But for the most part, the companies issue securities backed by those loans—mortgage-backed securities, or MBS. They also guarantee investors the timely payment of interest and principal on those securities, relieving investors of concerns about credit risk.

Fannie and Freddie provide investors with a basis for confidence that the securities will perform, as their own credit guarantee is backed by an implied—and since conservatorship, effectively explicit—guarantee by the U.S. government against the corporation’s failure. With that backstop, investors believe there will be a market for any MBS they may wish to sell later, regardless of economic conditions. The result is a deep and liquid market for mortgage-backed securities that was able to continue to operate in 2008 even when other capital markets were frozen. Fannie and Freddie, with their government backing, were able to provide the countercyclical liquidity that kept mortgage money available when private firms without government backing could not do so.

We need a new system that is capitalized with as much private capital as possible while still serving the nation’s housing needs.

The mortgage crisis occurred because we got away from the fundamental principles that guided the system for more than 70 years, and ignored the irresponsible actions of financial institutions and the dangers of unregulated, opaque markets. We know that when U.S. mortgage finance was essentially a purely private endeavor prior to the reforms of the 1930s, it failed. But we also know that the dominant role now played by the government through the conservatorship of Fannie and Freddie, and through federal agencies such as the Federal Housing Administration, which provides direct government guarantees, needs to be signifi- cantly reduced.

In short, we need a new system that is capitalized with as much private capital as possible while still serving the nation’s housing needs. Any government guarantee must be explicit and paid for; we must avoid a repetition of the uncompensated implicit government guarantee that backed Fannie and Freddie before they collapsed into government conservatorship.